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Stochastic Skew and Target Volatility Options

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  • Martino Grasselli
  • Jacinto Marabel Romo

Abstract

Target volatility options (TVO) are a new class of derivatives whose payoff depends on some measure of volatility. These options allow investors to take a joint exposure to the evolution of the underlying asset, as well as to its realized volatility. In equity options markets the slope of the skew is largely independent of the volatility level. A single‐factor Heston based volatility model can generate steep skew or flat skew at a given volatility level but cannot generate both for a given parameterization. Since the payoff corresponding to TVO is a function of the joint evolution of the underlying asset and its realized variance, the consideration of stochastic skew is a relevant question for the valuation of TVO. In this sense, this article studies the effect of considering a multifactor stochastic volatility specification in the valuation of the TVO as well as forward‐start TVO. © 2015 Wiley Periodicals, Inc. Jrl Fut Mark 36:174–193, 2016

Suggested Citation

  • Martino Grasselli & Jacinto Marabel Romo, 2016. "Stochastic Skew and Target Volatility Options," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 36(2), pages 174-193, February.
    • Handle: RePEc:wly:jfutmk:v:36:y:2016:i:2:p:174-193
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    Cited by:

    1. Elisa Alos & Rupak Chatterjee & Sebastian Tudor & Tai-Ho Wang, 2018. "Target volatility option pricing in lognormal fractional SABR model," Papers 1801.08215, arXiv.org.
    2. Wang, Xingchun, 2021. "Pricing volatility-equity options under the modified constant elasticity of variance model," Finance Research Letters, Elsevier, vol. 38(C).
    3. Roberto Daluiso & Emanuele Nastasi & Andrea Pallavicini & Stefano Polo, 2021. "Reinforcement learning for options on target volatility funds," Papers 2112.01841, arXiv.org.
    4. Hongkai Cao & Alexandru Badescu & Zhenyu Cui & Sarath Kumar Jayaraman, 2020. "Valuation of VIX and target volatility options with affine GARCH models," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 40(12), pages 1880-1917, December.

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