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Model Risk in Variance Swap Rates

ICMA Centre Discussion Papers in Finance No. DP2011-10

25 Pages Posted: 1 Jun 2011 Last revised: 17 Jun 2011

Carol Alexander

University of Sussex - School of Business, Management and Economics

Stamatis Leontsinis

RWC Asset Management

Date Written: June 15, 2011

Abstract

Different theoretical and numerical methods for calculating the fair-value of a variance swap give rise to systematic biases that are most pronounced during volatile periods. For instance, differences of 10-20 percentage points would have been observed on fair-value index variance swap rates during the banking crisis in 2008, depending on the formula used and its implementation. Our empirical study utilizes more than 16 years of FTSE 100 daily options prices to compare three fair-value variance swap rates. The exchange's variance swap rate formula, used to quote volatility indices such as VIX, has an upward bias induced by Riemann sum numerical integration that empirically outweighs the negative jump and discrete-monitorization biases that are inherent in this fair-value formula. On average, the exchange's methodology provides less accurate predictors of discretely-monitored realised volatility than the approximate swap rate formula introduced in this paper, which we implement using an almost exact analytical integration technique.

Keywords: Model Risk, Variance Swap, Volatility Index, VIX, FTSE 100, VFTSE

JEL Classification: G01, G12, G15

Suggested Citation

Alexander, Carol and Leontsinis, Stamatis, Model Risk in Variance Swap Rates (June 15, 2011). ICMA Centre Discussion Papers in Finance No. DP2011-10. Available at SSRN: https://ssrn.com/abstract=1855682 or http://dx.doi.org/10.2139/ssrn.1855682

Carol Alexander (Contact Author)

University of Sussex - School of Business, Management and Economics ( email )

Falmer, Brighton BN1 9SL
United Kingdom

HOME PAGE: http://www.sussex.ac.uk/bam

Stamatis Leontsinis

RWC Asset Management ( email )

60 Petty France
London, SW1H 9EU
United Kingdom

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