Consistent Variance Curve Models

Abstract

We introduce a general approach to model a joint market of stock price and a term structure of variance swaps in an HJM-type framework. In such a model, strongly volatility-dependent contracts can be priced and risk-managed in terms of the observed stock and variance swap prices.

To this end, we introduce equity forward variance term-structure models and derive the respective HJM-type arbitrage conditions. We then discuss finite-dimensional Markovian representations of the fixed time-to-maturity forward variance swap curve and derive consistency results for both the standard case and for variance curves with values in a Hilbert space. For the latter, our representation also ensures non-negativity of the process.

We then give a few examples of such variance curve functionals and discuss briefly completeness and hedging in such models. As a further application, we show that the speed of mean-reversion in some standard stochastic volatility models should be kept constant when the model is recalibrated.

Keywords: Variance Swaps, Stochastic Volatility, HJM, Term Structure Models, Markov, Heston, Mean-Reversion, Fitted Heston

JEL Classification: D89