Pricing Variance, Gamma and Corridor Swaps Using Multinomial Trees

Posted: 20 May 2019

See all articles by Honglei Zhao

Honglei Zhao

Hanlon Financial Systems Lab; Stevens Institute of Technology

Zhe Zhao

Stevens Institute of Technology

Rupak Chatterjee

Stevens Institute of Technology

Thomas Lonon

Stevens Institute of Technology

Ionut Florescu

Stevens Institute of Technology

Date Written: July 13, 2017

Abstract

This article introduces a new methodology to approximate the prices of variance, gamma and corridor swaps in a stochastic volatility framework applicable to any given tree structure. The efficiency of this tree method is based on the decomposing the payoff structure into nested conditional expectations which may be calculated using a single pass through the tree. The total number of calculations is commensurable with the number of tree nodes, making it substantially faster than Monte Carlo simulations. We exemplify the methodology using two different tree structures that approximate several types of stochastic volatility models. Furthermore, this methodology is general enough to be applied to any given tree structure. Extensive numerical tests show that the methodology introduced is fast, efficient and accurate. The method was applied to volatility instruments quoted on the CBOE.

Keywords: variance swap, gamma swap, corridor swap, realized variance, stochastic volatility models, tree approximations

JEL Classification: C60, C52, C63

Suggested Citation

Zhao, Honglei and Zhao, Zhe and Chatterjee, Rupak and Lonon, Thomas and Florescu, Ionut, Pricing Variance, Gamma and Corridor Swaps Using Multinomial Trees (July 13, 2017). Journal of Derivatives, Vol. 25, No. 2, 2017; Stevens Institute of Technology School of Business Research Paper; https://doi.org/10.3905/jod.2017.25.2.007. Available at SSRN: https://ssrn.com/abstract=2836516 or http://dx.doi.org/10.2139/ssrn.2836516

Honglei Zhao

Hanlon Financial Systems Lab ( email )

Hoboken, NJ 07030
United States

Stevens Institute of Technology ( email )

Hoboken, NJ 07030
United States

Zhe Zhao

Stevens Institute of Technology ( email )

1 Castle Point
Hoboken, NJ 07030
United States

Rupak Chatterjee

Stevens Institute of Technology ( email )

Hoboken, NJ 07030
United States

Thomas Lonon

Stevens Institute of Technology ( email )

Hoboken, NJ 07030
United States

Ionut Florescu (Contact Author)

Stevens Institute of Technology ( email )

Castle Point on the Hudson
Hoboken, NJ 07030
United States

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