Review of Derivatives Research

, Volume 13, Issue 2, pp 125–140 | Cite as

A forward started jump-diffusion model and pricing of cliquet style exotics

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Abstract

In this paper we present an alternative model for pricing exotic options and structured products with forward-starting components. As presented in the recent study by Eberlein and Madan (Quantitative Finance 9(1):27–42, 2009), the pricing of such exotic products (which consist primarily of different variations of locally/globally, capped/floored, arithmetic/geometric etc. cliquets) depends critically on the modeling of the forward–return distributions. Therefore, in our approach, we directly take up the modeling of forward variances corresponding to the tenor structure of the product to be priced. We propose a two factor forward variance market model with jumps in returns and volatility. It allows the model user to directly control the behavior of future smiles and hence properly price forward smile risk of cliquet-style exotic products. The key idea, in order to achieve consistency between the dynamics of forward variance swaps and the underlying stock, is to adopt a forward starting model for the stock dynamics over each reset period of the tenor structure. We also present in detail the calibration steps for our proposed model.

Keywords

Exotic options Forward volatility smiles Variance swaps Cliquets 

JEL Classification

G12 G13 C63 

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Copyright information

© Springer Science+Business Media, LLC 2009

Authors and Affiliations

  1. 1.Department of Mathematical SciencesUniversity of CopenhagenCopenhagenDenmark

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