Pricing Volatility Index Option in Constant Elasticity of Variance Model

Abstract:

As one of the most important tools to manage the risk of volatility, a lot of attention has been paid to volatility index options. In order to price these options, a willow tree of underlying index was built in the constant elasticity of variance model. Then, the value of volatility index at each node in the willow tree of underlying index was determined. Next, the willow tree of volatility index was used to price volatility index options by backward induction. Finally, an efficient way to price volatility index options was proposed. Numerical results show that the pricing results given by the willow tree are consistent with the results obtained from nested Monte Carlo simulation when the number of nodes on each time period in the willow tree is bigger than 200.