Risk Premiums and VIX Derivatives Pricing

68 Pages Posted: 16 Dec 2018

See all articles by Peixuan Yuan

Peixuan Yuan

Rutgers, The State University of New Jersey - Rutgers Business School at Newark & New Brunswick

Date Written: October 2018

Abstract

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

Yuan, Peixuan, Risk Premiums and VIX Derivatives Pricing (October 2018). Available at SSRN: https://ssrn.com/abstract=3290247 or http://dx.doi.org/10.2139/ssrn.3290247

Peixuan Yuan (Contact Author)

Rutgers, The State University of New Jersey - Rutgers Business School at Newark & New Brunswick ( email )

Janice H. Levin Bldg., Room 121
94 Rockafeller Road
Piscataway, NJ 08854-8054
United States

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