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The Valuation of Volatility Options

Author

Listed:
  • Jérôme Detemple
  • Carlton Osakwe
Abstract
This paper examines the valuation of European- and American-style volatility options based on a general equilibrium stochastic volatility framework. Properties of the optimal exercise region and of the option price are provided when volatility follows a general diffusion process. Explicit valuation formulas are derived in four particular cases. Emphasis is placed on the MRLP(mean-reverting in the log) volatility model which has received considerable empirical support. In this context we examine the properties and hedging behavior of volatility options. Unlike American options, European call options on volatility are found to display concavity at high levels of volatility. JEL classification codes: G12, G23.

Suggested Citation

  • Jérôme Detemple & Carlton Osakwe, 2000. "The Valuation of Volatility Options," Review of Finance, European Finance Association, vol. 4(1), pages 21-50.
    • Handle: RePEc:oup:revfin:v:4:y:2000:i:1:p:21-50.
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    File URL: http://hdl.handle.net/10.1023/A:1009814324980
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    More about this item

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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