Discussion Paper Details

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Title: Valuation of VIX Derivatives

Author(s): Javier Mencía and Enrique Sentana

Publication Date: January 2010

Keyword(s): Central Tendency, Jumps, Stochastic Volatility, Term Structure and Volatility Skews

Programme Area(s): Financial Economics

Abstract: We conduct an extensive empirical analysis of VIX derivative valuation models over the 2004-2007 bull market and the subsequent financial crisis. We show that existing models yield large distortions during the crisis because of their restrictive volatility mean reverting assumptions. We propose generalisations with a time varying central tendency, jumps and stochastic volatility, analyse their pricing performance, and their implications for the term structures of VIX futures and options, and the option volatility "skews". We find that a model combining central tendency and stochastic volatility is required to reliably price VIX futures and options, respectively, across bull and bear markets.

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Bibliographic Reference

Mencía, J and Sentana, E. 2010. 'Valuation of VIX Derivatives'. London, Centre for Economic Policy Research.