Swap rate variance swaps
We study the hedging and valuation of generalized variance swaps defined on a forward swap interest rate. Our motivation is the fundamental role of variance swaps in the transfer of variance risk, and the extensive empirical evidence documenting that the variance realized by interest rates is stochastic. We identify a hedging rule involving a static European contract and the gains of a dynamic position on forward interest rate swaps. Two distinguishing features arise in the context of interest rates: the nonlinear and multidimensional relationship between the values of the dynamically traded contracts and the underlying swap rate, and the possible stochasticity of the interest rate at which gains are reinvested. The combination of these two features leads to additional terms in the cumulative dynamic trading gains, which depend on realized variance and are taken into consideration in the determination of the appropriate static hedge. We characterize the static payoff function as the solution of an ordinary differential equation, and derive explicitly the associated dynamic strategy. We use daily interest rate data between 1997 and 2007 to test the effectiveness of our hedging methodology in arithmetic and geometric variance swaps and verify that the hedging error is small compared with the bid--ask spread in swaption prices.
If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.
Volume (Year): 12 (2012)
Issue (Month): 2 (May)
|Contact details of provider:|| Web page: http://www.tandfonline.com/RQUF20|
|Order Information:||Web: http://www.tandfonline.com/pricing/journal/RQUF20|
When requesting a correction, please mention this item's handle: RePEc:taf:quantf:v:12:y:2012:i:2:p:249-261. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Michael McNulty)
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.