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Variance swap with mean reversion, multifactor stochastic volatility and jumps

Author

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  • Pun, Chi Seng
  • Chung, Shing Fung
  • Wong, Hoi Ying

Abstract

This paper examines variance swap pricing using a model that integrates three major features of financial assets, namely the mean reversion in asset price, multi-factor stochastic volatility (SV) and simultaneous jumps in prices and volatility factors. Closed-form solutions are derived for vanilla variance swaps and gamma swaps while the solutions for corridor variance swaps and conditional variance swaps are expressed in a one-dimensional Fourier integral. The numerical tests confirm that the derived solution is accurate and efficient. Furthermore, empirical studies have shown that multi-factor SV models better capture the implied volatility surface from option data. The empirical results of this paper also show that the additional volatility factor contributes significantly to the price of variance swaps. Hence, the results favor multi-factor SV models for pricing variance swaps consistent with the implied volatility surface.

Suggested Citation

  • Pun, Chi Seng & Chung, Shing Fung & Wong, Hoi Ying, 2015. "Variance swap with mean reversion, multifactor stochastic volatility and jumps," European Journal of Operational Research, Elsevier, vol. 245(2), pages 571-580.
    • Handle: RePEc:eee:ejores:v:245:y:2015:i:2:p:571-580
    DOI: 10.1016/j.ejor.2015.03.026
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    References listed on IDEAS

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    1. Hoi Ying Wong & Jing Zhao, 2010. "Currency option pricing: Mean reversion and multi‐scale stochastic volatility," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 30(10), pages 938-956, October.
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    4. Chung, Shing Fung & Wong, Hoi Ying, 2014. "Analytical pricing of discrete arithmetic Asian options with mean reversion and jumps," Journal of Banking & Finance, Elsevier, vol. 44(C), pages 130-140.
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    6. Fusai, Gianluca & Marena, Marina & Roncoroni, Andrea, 2008. "Analytical pricing of discretely monitored Asian-style options: Theory and application to commodity markets," Journal of Banking & Finance, Elsevier, vol. 32(10), pages 2033-2045, October.
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