Pricing Variance, Gamma and Corridor Swaps Using Multinomial Trees
Posted: 20 May 2019
Date Written: July 13, 2017
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
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