Working Paper: CEPR ID: DP7619
Authors: Javier Menca; Enrique Sentana
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.
Keywords: central tendency; jumps; stochastic volatility; term structure; volatility skews
JEL Codes: G13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Existing VIX derivative pricing models (G13) | Poor performance during market turmoil (G19) |
| Mean-reverting assumptions (C22) | Significant pricing distortions (D49) |
| LOGOU model (C20) | Better fit for options than SQR model (C52) |
| Generalized model (C20) | Reconcile observed large variations in VIX (E32) |
| Time-varying central tendency (C22) | Significantly improves pricing of futures (G13) |
| Stochastic volatility (C58) | More critical for options pricing (G13) |
| Combined approach using time-varying central tendency and stochastic volatility (C32) | Superior performance across different market conditions (G19) |