Variance Swaps on Defaultable Assets and Market Implied Time-Changes

Matthew Lorig, Oriol Lozano Carbasse and Rafael Mendoza-Arriaga

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Abstract: We compute the value of a variance swap when the underlying is modeled as a Markov process time changed by a L\'{e}vy subordinator. In this framework, the underlying may exhibit jumps with a state-dependent L\'{e}vy measure, local stochastic volatility and have a local stochastic default intensity. Moreover, the L\'{e}vy subordinator that drives the underlying can be obtained directly by observing European call/put prices. To illustrate our general framework, we provide an explicit formula for the value of a variance swap when the underlying is modeled as (i) a L\'evy subordinated geometric Brownian motion with default and (ii) a L\'evy subordinated Jump-to-default CEV process (see \citet{carr-linetsky-1}). {In the latter example, we extend} the results of \cite{mendoza-carr-linetsky-1}, by allowing for joint valuation of credit and equity derivatives as well as variance swaps.

Date: 2012-09, Revised 2013-07
New Economics Papers: this item is included in nep-ban and nep-fmk
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Citations: View citations in EconPapers (4)

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