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Stochastic Skew and Target Volatility Options
Author(s) -
Grasselli Martino,
Marabel Romo Jacinto
Publication year - 2016
Publication title -
journal of futures markets
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.88
H-Index - 55
eISSN - 1096-9934
pISSN - 0270-7314
DOI - 10.1002/fut.21720
Subject(s) - stochastic volatility , skew , volatility smile , forward volatility , volatility (finance) , econometrics , variance swap , volatility swap , implied volatility , economics , valuation (finance) , stochastic game , heston model , sabr volatility model , computer science , mathematical economics , finance , telecommunications
Target volatility options (TVO) are a new class of derivatives whose payoff depends on some measure of volatility. These options allow investors to take a joint exposure to the evolution of the underlying asset, as well as to its realized volatility. In equity options markets the slope of the skew is largely independent of the volatility level. A single‐factor Heston based volatility model can generate steep skew or flat skew at a given volatility level but cannot generate both for a given parameterization. Since the payoff corresponding to TVO is a function of the joint evolution of the underlying asset and its realized variance, the consideration of stochastic skew is a relevant question for the valuation of TVO. In this sense, this article studies the effect of considering a multifactor stochastic volatility specification in the valuation of the TVO as well as forward‐start TVO. © 2015 Wiley Periodicals, Inc. Jrl Fut Mark 36:174–193, 2016