TARGET VOLATILITY OPTION PRICING

Giuseppe Di Graziano and Lorenzo Torricelli
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Giuseppe Di Graziano: Deutsche Bank AG, 1 Great Winchester Street, London EC2N 2DB, United Kingdom and Department of Mathematics, King's College London, London WC2R 2LS, United Kingdom
Lorenzo Torricelli: Department of Mathematics, University College London, London WC1E 6BT, United Kingdom

Chapter 8 in Finance at Fields, 2012, pp 207-223 from World Scientific Publishing Co. Pte. Ltd.

Abstract: AbstractIn this paper we present two methods for the pricing of Target Volatility Options (TVOs), a recent market innovation in the field of volatility derivative. TVOs allow investors to take a joint view on the future price of a given underlying (e.g. stocks, commodities, etc) and its realized volatility. For example, a target volatility call pays at maturity the terminal value of the asset minus the strike, floored at zero, scaled by the ratio of the target volatility (an arbitrary constant) and the realized volatility of the underlying over the life of the option. TVOs are popular with investors and hedgers because they are typically cheaper than their vanilla equivalent. We present two approaches for the pricing of TVOs: a power series expansion and a Laplace transform method. We also provide both model dependent and model independent solutions. The pricing methodologies have been tested numerically and results are provided.

Keywords: Mathematical Finance; Financial Mathematics; Risk Management; Asset Pricing; Computational Finance; Derivatives; Option Pricing; Portfolio Optimization (search for similar items in EconPapers)
Date: 2012
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