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frolloos


Total Posts: 104
Joined: Dec 2007
 
Posted: 2020-01-09 06:08
A paper (hopefully one of my last on volswaps!) on robust hedging of volswaps using varswaps only. I think that would make the hedging of volswaps more feasible than continuously rebalancing a strip of options.

questions and comments welcome.

https://arxiv.org/abs/2001.02404

One man's Theta is another man's Gamma - Me

frolloos


Total Posts: 104
Joined: Dec 2007
 
Posted: 2020-01-16 15:07
Update:

I have actually derived a more accurate formula for the hedge ratio (i.e. the number of varswaps to hold to hedge 1 volswap), and I will update my arXiv paper shortly. But here is the formula for the impatient:



where K_{vol} is the seasoned volswap price and K_{var} is the seasoned varswap price. The seasoned volswap price can be derived from the observable smile in a model-free manner as detailed in the paper.

Now here is I think the nice part. I ran, under the Heston model, 500 simulations of daily hedging of a 1 year volswap with a varswap according to my formula above, and the histogram below shows that it is quite accurate. What I mean with a hedge pnl of say .2% is that the terminal value of the volswap is 20% and the hedge value is 20.2%.

For Kvol I used the exact Heston value for now, because I first wanted to test the hedge formula, and I am confident it is good now. If using my model-free approx for Kvol then the hedge pnl result will of course be less accurate as below but I think still quite good.

Hopefully, in addition to winning myself a nobel prize in approximations, this stuff can start to give more liquidity in volswaps.

Will post when arXiv paper has been updated with the formula and numerical results.




One man's Theta is another man's Gamma - Me
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