The Price of Higher Order Catastrophe Insurance: The Case of VIX Options

Bjørn Eraker and Aoxiang Yang

Journal of Finance, 2022, vol. 77, issue 6, 3289-3337

Abstract: We develop a tractable equilibrium pricing model to explain observed characteristics in equity returns, VIX futures, S&P 500 options, and VIX options data based on affine jump‐diffusive state dynamics and representative agents endowed with Duffie‐Epstein recursive preferences. Our calibrated model replicates consumption, dividends, and asset market data, including VIX futures returns, the average implied volatilities in SPX and VIX options, and first‐ and higher‐order moments of VIX options returns. We document a time variation in the shape of VIX‐option‐implied volatility and a time‐varying hedging relationship between VIX and SPX options that our model both captures.

Date: 2022
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