Risk Premiums and VIX Derivatives Pricing
68 Pages Posted: 16 Dec 2018
Date Written: October 2018
This paper documents several salient features of VIX derivatives that have not yet been studied in the literature. First, option implied skew exhibits significant fluctuations and extremely low correlations with at-the-money implied volatility. Second, there exists a highly persistent factor governing both short- and long-term skew. Third, the implied volatility and skew show strong serial correlations that increase with time to maturity. To capture the above-mentioned features, we propose a general affine jump-diffusion model. It features contemporaneous jumps in both VIX level and VIX variance, and the jump intensity is governed by a persistent separate factor. In addition, two central tendency factors are embedded to capture the time variation of long-term contracts. We study two types of risk premiums associated with VIX derivatives, namely VIX index risk premium and VIX variance risk premium. We find that although the term structures of both risk premiums are negative and downward sloping, with inversion occurring around market crises, they reflect different compensations required by investors bearing different risks. Furthermore, the jump intensity factor is increasingly important with time for term structures of risk premiums since the financial crisis in 2008, especially before crises, which exerts a transitory effect on short-end through jumps in VIX level yet a persistent effect on long-end via jumps in VIX variance. This finding indicates that since the crisis, market participants become more afraid of dramatic increases in either variance or variance of variance and are willing to pay higher premiums to hedge them.
Keywords: VIX Derivatives; Option Skew; Co-Jumps; Jump Intensity; Risk Premiums
JEL Classification: G01; G12; G13
Suggested Citation: Suggested Citation