DP7619 Valuation of VIX Derivatives

Author(s): Javier MencĂ­a, Enrique Sentana
Publication Date: January 2010
Keyword(s): Central Tendency, Jumps, Stochastic Volatility, Term Structure, Volatility Skews
JEL(s): G13
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=7619

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.