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Model Risk in Variance Swap Rates

Author

Listed:
  • Carol Alexander

    (ICMA Centre, Henley Business School, University of Reading)

  • Stamatis Leontsinis

    (Fulcrum Asset Management, London)

Abstract

Different theoretical and numerical methods for calculating the fair-value of a variance swap give rise to systematic biases that are most pronounced during volatile periods. For instance, differences of 10-20 percentage points would have been observed on fair-value index variance swap rates during the backing crisis in 2008, depending on the formula used and its implementation. Our empirical study utilizes more than 16 years of FTSE 100 daily options prices to compare three fair-value variance swap rates. The exchange's variance swap rate formula, used to quote volatility indices such as VIX, has an upward bias induced by Reimann sum numerical integration that empirically outweighs the negative jump and discrete monitorisation biases that are inherent in this fair-value formula. On average, the exchange's methodology provides less accurate predictors of discretely-monitored realised volatility than the approximate swap rate formula introduced in the paper, which we implement using an almost exact analytical integration technique.

Suggested Citation

  • Carol Alexander & Stamatis Leontsinis, 2011. "Model Risk in Variance Swap Rates," ICMA Centre Discussion Papers in Finance icma-dp2011-10, Henley Business School, University of Reading.
    • Handle: RePEc:rdg:icmadp:icma-dp2011-10
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    File URL: http://www.icmacentre.ac.uk/files/discussion-papers/DP2011-10.pdf
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    Cited by:

    1. Tsukahara, Fábio Yasuhiro & Kimura, Herbert & Sobreiro, Vinicius Amorim & Zambrano, Juan Carlos Arismendi, 2016. "Validation of default probability models: A stress testing approach," International Review of Financial Analysis, Elsevier, vol. 47(C), pages 70-85.
    2. Kaeck, Andreas & Alexander, Carol, 2012. "Volatility dynamics for the S&P 500: Further evidence from non-affine, multi-factor jump diffusions," Journal of Banking & Finance, Elsevier, vol. 36(11), pages 3110-3121.

    More about this item

    Keywords

    Model Risk; Variance Swap; Volatility Index; VIX; FTSE 100; FTSE;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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