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The Valuation of Volatility Options

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  • Jérôme Detemple
  • Carlton Osakwe

Abstract

This paper examines the valuation of European- and American-style volatility options based on a general equilibrium stochastic volatility framework. Properties of the optimal exercise region and of the option price are provided when volatility follows a general diffusion process. Explicit valuation formulas are derived in four particular cases. Emphasis is placed on the MRLP(mean-reverting in the log) volatility model which has received considerable empirical support. In this context we examine the properties and hedging behavior of volatility options. Unlike American options, European call options on volatility are found to display concavity at high levels of volatility. JEL classification codes: G12, G23.
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Suggested Citation

  • Jérôme Detemple & Carlton Osakwe, 1999. "The Valuation of Volatility Options," CIRANO Working Papers 99s-43, CIRANO.
    • Handle: RePEc:cir:cirwor:99s-43
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    References listed on IDEAS

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    More about this item

    Keywords

    Stochastic volatility; European options; American options; optimal exercise; early exercise premium; hedging; viability; Volatilité stochastique; options européennes; options américaines; exercice optimal; prime d'exercice anticipé; couverture de risque; viabilité;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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