The Valuation of Volatility Options |
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Authors: | Jérôme Detemple and Carlton Osakwe |
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Institution: | (1) Boston University School of Management, 595 Commonwealth Avenue, Boston, MA, 02215, U.S.A.;(2) CIRANO, USA |
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Abstract: | This paper examines the valuation of European- and American-style volatilityoptions based on a general equilibrium stochastic volatility framework.Properties of the optimal exercise region and of the option price areprovided when volatility follows a general diffusion process. Explicitvaluation formulas are derived in four particular cases. Emphasis is placedon the MRLP (mean-reverting in the log) volatility model which has receivedconsiderable empirical support. In this context we examine the propertiesand hedging behavior of volatility options. Unlike American options,European call options on volatility are found to display concavity at highlevels of volatility. |
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Keywords: | American options early exercise premium European options hedging optimal exercise stochastic volatility viability |
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