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Pricing of variance swap rates and investment decisions of variance swaps: Evidence from a three-factor model

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  • Hong, Yi
  • Jin, Xing

Abstract

This paper proposes a tractable three-factor model with self-exciting jumps for the S&P 500 index and its variance. The statistical results show that this new model empirically outperforms the two-factor models widely studied in the literature in terms of fitting variance swap rates on the S&P 500 index across maturities ranging from one month to two years over the sample period from 2008 to 2020. We also provide closed-form solution for variance swap rates and analytically solve the optimal portfolio choice problem in variance swaps for an investor with a power utility function. Unlike the optimal investment with two variance swaps in two-factor models, the investor follows a “long-short-long” trading strategy involving three swap contracts. Hence, a third swap is not redundant in our three-factor model. In particular, our portfolio optimization exercises illustrate that ignoring a third variance swap in the investment problem may incur significant economic costs in the proposed model.

Suggested Citation

  • Hong, Yi & Jin, Xing, 2022. "Pricing of variance swap rates and investment decisions of variance swaps: Evidence from a three-factor model," European Journal of Operational Research, Elsevier, vol. 303(2), pages 975-985.
    • Handle: RePEc:eee:ejores:v:303:y:2022:i:2:p:975-985
    DOI: 10.1016/j.ejor.2022.03.007
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    Cited by:

    1. Jin, Xing & Hong, Yi, 2023. "Jump-diffusion volatility models for variance swaps: An empirical performance analysis," International Review of Financial Analysis, Elsevier, vol. 87(C).

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    More about this item

    Keywords

    Finance; Variance swap rates; Self-exciting jumps; Variance risk premium; Variance swap investments;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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