The Impact of Jump Distributions on the Implied Volatility of Variance
Posted: 17 Feb 2014
Date Written: February 15, 2014
We consider a tractable affine stochastic volatility model that generalizes the seminal Heston (1993) model by augmenting it with jumps in the instantaneous variance process. In this framework, we consider options written on the realized variance, and we examine the impact of the distribution of jumps on the associated implied volatility smile. We provide sufficient conditions for the asymptotic behavior of the implied volatility of variance for small and large strikes. In particular, by selecting alternative jump distributions, we show that one can obtain fundamentally different shapes of the implied volatility of variance smile -- some clearly at odds with the upward-sloping volatility skew observed in variance markets.
Keywords: Jump distributions stochastic volatility option pricing realized variance volatility derivatives
JEL Classification: C60, C61, C63, G10, G13
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