Pricing options on discrete realized variance with partially exact and bounded approximations

Wendong Zheng and Yue Kuen Kwok

Quantitative Finance, 2015, vol. 15, issue 12, 2011-2019

Abstract: We derive efficient and accurate analytic approximation formulas for pricing options on discrete realized variance (DRV) under affine stochastic volatility models with jumps using the partially exact and bounded (PEB) approximations. The PEB method is an enhanced extension of the conditioning variable approach commonly used in deriving analytic approximation formulas for pricing discrete Asian style options. By adopting either the conditional normal or gamma distribution approximation based on some asymptotic behaviour of the DRV of the underlying asset price process, we manage to obtain PEB approximation formulas that achieve a high level of numerical accuracy in option values even for short-maturity options on DRV.

Date: 2015
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DOI: 10.1080/14697688.2015.1008229

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