Variance swaps on defaultable assets and market implied time-changes
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Abstract: We compute the value of a variance swap when the underlying is modeled as a Markov process time changed by a L'{e}vy subordinator. In this framework, the underlying may exhibit jumps with a state-dependent L'{e}vy measure, local stochastic volatility and have a local stochastic default intensity. Moreover, the L'{e}vy subordinator that drives the underlying can be obtained directly by observing European call/put prices. To illustrate our general framework, we provide an explicit formula for the value of a variance swap when the underlying is modeled as (i) a L'evy subordinated geometric Brownian motion with default and (ii) a L'evy subordinated Jump-to-default CEV process (see citet{carr-linetsky-1}). {In the latter example, we extend} the results of cite{mendoza-carr-linetsky-1}, by allowing for joint valuation of credit and equity derivatives as well as variance swaps.
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Cited in
(13)- A general framework for time-changed Markov processes and applications
- Variance swaps on time-changed Lévy processes
- Time-changed CIR default intensities with two-sided mean-reverting jumps
- Multivariate subordination of Markov processes with financial applications
- Additive subordination and its applications in finance
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