Testing derivatives pricing models under higher-order moment swaps

Ako Doffou

Studies in Economics and Finance, 2019, vol. 36, issue 2, 154-167

Abstract: Purpose - This paper aims to test three parametric models in pricing and hedging higher-order moment swaps. Using vanilla option prices from the volatility surface of the Euro Stoxx 50 Index, the paper shows that the pricing accuracy of these models is very satisfactory under four different pricing error functions. The result is that taking a position in a third moment swap considerably improves the performance of the standard hedge of a variance swap based on a static position in the log-contract and a dynamic trading strategy. The position in the third moment swap is taken by running a Monte Carlo simulation. Design/methodology/approach - This paper undertook empirical tests of three parametric models. The aim of the paper is twofold: assess the pricing accuracy of these models and show how the classical hedge of the variance swap in terms of a position in a log-contract and a dynamic trading strategy can be significantly enhanced by using third-order moment swaps. The pricing accuracy was measured under four different pricing error functions. A Monte Carlo simulation was run to take a position in the third moment swap. Findings - The results of the paper are twofold: the pricing accuracy of theHeston (1993) model and that of two Levy models with stochastic time and stochastic volatility are satisfactory; taking a position in third-order moment swaps can significantly improve the performance of the standard hedge of a variance swap. Research limitations/implications - The limitation is that these empirical tests are conducted on existing three parametric models. Maybe more critical insights could have been revealed had these tests been conducted in a brand new derivatives pricing model. Originality/value - This work is 100 per cent original, and it undertook empirical tests of the pricing and hedging accuracy of existing three parametric models.

Keywords: Higher-order moment swaps; Log-contract; Static position; Variance swaps; Volatility surface; G12; G13 (search for similar items in EconPapers)
Date: 2019
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Persistent link: https://EconPapers.repec.org/RePEc:eme:sefpps:sef-04-2018-0106

DOI: 10.1108/SEF-04-2018-0106

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