VIX Option Pricing and CBOE VIX Term Structure: A New Methodology for Volatility Derivatives Valuation
65 Pages Posted: 9 Feb 2010
Abstract
The study proposes an arbitrage-free methodology of VIX term structure modeling that is tailored to handle the most actively traded VIX options. Under the model, the evolution of future VIX is completely determined by the volatility function of forward VIX squared normalized by VIX futures prices. A general volatility function with one- to three-factor models is used to examine their pricing for VIX options across strikes and maturities from February 24, 2006 to September 30, 2008. The primary contributions of this article are (i) taking as given CBOE VIX Term Structure to specify a general stochastic structure upon forward VIX, (ii) proposing an arbitrage-free closed-form solution to the VIX option value with the general volatility function that incorporates mean-reversion and hump effects to test two multifactor models, (iii) finding that the class of multifactor models outperforms the classes of one- and two-factor models, and (iv) finding that models with hump volatility function perform better than other models. Pricing with three-factor models gives the benefit of eliminating most moneyness and maturity biases, especially for ATM and OTM options. Correctly specified and calibrated, the single-factor Hump model may be superior to inappropriate multi-factor Exponential models in pricing.
Keywords: CBOE VIX Term Structure, forward VIX, multifactor models, Hump
JEL Classification: G12, G13, G14
Suggested Citation: Suggested Citation
Do you have negative results from your research you’d like to share?
Recommended Papers
-
Transform Analysis and Asset Pricing for Affine Jump-Diffusions
By Darrell Duffie, Jun Pan, ...
-
Transform Analysis and Asset Pricing for Affine Jump-Diffusions
By Darrell Duffie, Jun Pan, ...
-
The Impact of Jumps in Volatility and Returns
By Michael S. Johannes, Bjorn Eraker, ...
-
Implied Volatility Functions: Empirical Tests
By Bernard Dumas, Jeff Fleming, ...
-
Recovering Risk Aversion from Option Prices and Realized Returns
-
Recovering Probabilities and Risk Aversion from Option Prices and Realized Returns
-
Stock Return Characteristics, Skew Laws, and the Differential Pricing of Individual Equity Options
By Gurdip Bakshi, Nikunj Kapadia, ...
-
Stock Return Characteristics, Skew Laws, and the Differential Pricing of Individual Equity Options
By Nikunj Kapadia, Gurdip Bakshi, ...
-
Nonparametric Estimation of State-Price Densities Implicit in Financial Asset Prices
By Yacine Ait-sahalia and Andrew W. Lo