Spectral methods for volatility derivatives

DOI10.1080/14697680902773603zbMATH Open1188.91208arXiv0905.2091OpenAlexW3121614020MaRDI QIDQ3182744FDOQ3182744

Authors: Claudio Albanese, Harry Lo, Aleksandar Mijatović 

Publication date: 16 October 2009

Published in: Quantitative Finance (Search for Journal in Brave)

Abstract: In the first quarter of 2006 Chicago Board Options Exchange (CBOE) introduced, as one of the listed products, options on its implied volatility index (VIX). This created the challenge of developing a pricing framework that can simultaneously handle European options, forward-starts, options on the realized variance and options on the VIX. In this paper we propose a new approach to this problem using spectral methods. We use a regime switching model with jumps and local volatility defined in cite{FXrev} and calibrate it to the European options on the S&P 500 for a broad range of strikes and maturities. The main idea of this paper is to "lift" (i.e. extend) the generator of the underlying process to keep track of the relevant path information, namely the realized variance. The lifted generator is too large a matrix to be diagonalized numerically. We overcome this difficulty by applying a new semi-analytic algorithm for block-diagonalization. This method enables us to evaluate numerically the joint distribution between the underlying stock price and the realized variance, which in turn gives us a way of pricing consistently European options, general accrued variance payoffs and forward-starting and VIX options.

Full work available at URL: https://arxiv.org/abs/0905.2091

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zbMATH Keywords

volatility modelingvolatility smile fittingvolatility surfacesstochastic volatility quantitative finance

Mathematics Subject Classification ID

Derivative securities (option pricing, hedging, etc.) (91G20) Numerical methods (including Monte Carlo methods) (91G60) Spectral, collocation and related methods for initial value and initial-boundary value problems involving PDEs (65M70)

Cites Work

• The pricing of options and corporate liabilities
• The Variance Gamma Process and Option Pricing
• Consistent variance curve models
• On the pricing and hedging of volatility derivatives
• An Algorithm for Computing Reducing Subspaces by Block Diagonalization
• Moment swaps
• Valuation of volatility derivatives as an inverse problem
• Numerical Considerations in Computing Invariant Subspaces

Cited In (9)

• A consistent pricing model for index options and volatility derivatives
• A remark on Lin and Chang's paper `consistent modeling of S\&P 500 and VIX derivatives'
• A robust spectral method for solving Heston's model
• Stochastic volatility models and the pricing of VIX options
• KERNEL CONVERGENCE ESTIMATES FOR DIFFUSIONS WITH CONTINUOUS COEFFICIENTS
• Volatility derivatives in market models with jumps
• A backward Monte Carlo approach to exotic option pricing
• Swap rate variance swaps
• Options on realized variance by transform methods: a non-affine stochastic volatility model

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