Model-Independent Pricing and Hedging of Seasoned Volatility Swaps

Summary

This paper extends a zero-vanna implied-volatility approximation from newly initiated volatility swaps to seasoned contracts. It also describes ways to hedge volatility swaps using either a strip of vanilla options or variance swaps. The option-strip weights are linked to trading intuition, while the variance-swap approach includes both first- and second-order hedges.

The practical motivation is that dynamically trading variance swaps may cost less and require less operational effort than continually rebalancing a continuous strip of options. The authors state that their pricing and hedging results are model-independent within stochastic-volatility models and require little computation. The excerpt gives no datasets, numerical tests, transaction-cost estimates, or details on hedge performance under market frictions. Its claims therefore describe a theoretical framework and implementation rationale, rather than establishing how the hedges perform in live markets.

Key ideas

• The zero-vanna implied-volatility approximation is extended to seasoned volatility swaps.
• A strip of vanilla options can be used to construct a volatility-swap hedge.
• Variance swaps provide first- and second-order hedges for volatility swaps.
• The proposed results are presented as model-independent within the class of stochastic-volatility models.
• The excerpt argues that variance-swap hedging may be operationally simpler than continuous option-strip rebalancing.

Tags

# Nonparametric Pricing and Hedging of Volatility Swaps in Stochastic Volatility Models


# Nonparametric Pricing and Hedging of Volatility Swaps in Stochastic Volatility Models









In this paper the zero vanna implied volatility approximation for the price of freshly minted volatility swaps is generalised to seasoned volatility swaps. We also derive how volatility swaps can be hedged using a strip of vanilla options with weights that are directly related to trading intuition. Additionally, we derive first and second order hedges for volatility swaps using only variance swaps. As dynamically trading variance swaps is in general cheaper and operationally less cumbersome compared to dynamically rebalancing a continuous strip of options, our result makes the hedging of volatility swaps both practically feasible and robust. Within the class of stochastic volatility models our pricing and hedging results are model-independent and can be implemented at almost no computational cost.

Shown in full with attribution under the source's licence. Licence: abstract CC0

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.