The Valuation of Volatility Options

Posted: 21 May 2001

See all articles by Jerome Detemple

Jerome Detemple

Boston University - Department of Finance & Economics; Center for Interuniversity Research and Analysis on Organization (CIRANO)

Carlton Osakwe

Mount Royal University - Bissett School of Business

Abstract

This paper examines the valuation of European- and American-style volatility options based on a general equilibrium stochastic volatility framework. Properties of the optimal exercise region and of the option price are provided when volatility follows a general diffusion process. Explicit valuation formulas are derived in four particular cases. Emphasis is placed on the MRLP (mean-reverting in the log) volatility model which has received considerable empirical support. In this context we examine the properties and hedging behavior of volatility options. Unlike American options, European call options on volatility are found to display concavity at high levels of volatility.

Keywords: American options, early exercise premium, European options, hedging, optimal exercise, stochastic volatility, viability

Suggested Citation

Detemple, Jerome and Osakwe, Carlton-James U., The Valuation of Volatility Options. European Finance Review, Vol. 4, No. 1. Available at SSRN: https://ssrn.com/abstract=264297

Jerome Detemple (Contact Author)

Boston University - Department of Finance & Economics ( email )

595 Commonwealth Avenue
Boston, MA 02215
United States
(617) 353-4297 (Phone)
(617) 353 6667 (Fax)

Center for Interuniversity Research and Analysis on Organization (CIRANO)

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Montreal, Quebec H3C 3J7
Canada

Carlton-James U. Osakwe

Mount Royal University - Bissett School of Business ( email )

4825 Richard Road SW
Calgary, Alberta T3E 6K6
Canada

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