The Impact of Jump Distributions on the Implied Volatility of Variance

Posted: 17 Feb 2014

See all articles by Elisa Nicolato

Elisa Nicolato

Aarhus University - Department of Business and Economics

Camilla Pisani

Aarhus University - Department of Economics and Business Economics

David Sloth

Danske Bank - Danske Markets

Date Written: February 15, 2014

Abstract

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

Suggested Citation

Nicolato, Elisa and Pisani, Camilla and Sloth, David, The Impact of Jump Distributions on the Implied Volatility of Variance (February 15, 2014). Available at SSRN: https://ssrn.com/abstract=2396482 or http://dx.doi.org/10.2139/ssrn.2396482

Elisa Nicolato

Aarhus University - Department of Business and Economics ( email )

Nordre Ringgade 1
Aarhus C, DK-8000
Denmark

Camilla Pisani

Aarhus University - Department of Economics and Business Economics ( email )

Fuglesangs Allé 4
Aarhus V, 8210
Denmark

David Sloth (Contact Author)

Danske Bank - Danske Markets ( email )

Holmens Kanal 2-12
DK-1092 Copenhagen K
Denmark

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