Volatility risk structure for options depending on extrema

Tomonori Nakatsu

Journal of Computational Finance

Abstract: In this paper, we give a decomposition formula to calculate the vega index (sensitivity with respect to changes in volatility) for options with prices that depend on the extrema (maximum or minimum) and terminal value of the underlying stock price; this is assumed to follow a one-dimensional perturbed diffusion process. As a numerical application, we compute the vega index for lookback, European and up-in call options under the Black–Scholes model perturbed with a constant elasticity of variance model-type perturbation. We compare these values with the standard nonperturbed Black–Scholes model, which, interestingly, turn out to be very different.

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