The Irony in the Variance Swaps

Elie Ayache suggests that While the typical derivative paper is expressed in words and formulas aiming at the theoretical value of the derivative, it is really intended for derivative trading, which is the domain farthest away from theory

Irony, according to the Oxford English Dictionary, is (a) a figure of speech in which the intended meaning is the opposite of that expressed by the words used (b) a condition of affairs or events of a character opposite to what was, or might naturally be, expected (In French, ironie du sort). In the following lines, I will propose a rereading of quantitative finance where irony, as opposed to theory, emerges as a leitmotiv, perhaps even a main guide. Variance swaps will provide me with a literal rehearsal of this ironic point, as I will show that the element of irony is inscribed in the movement motivating their existence, indeed in their very contractual terms.

The irony in quantitative finance, or specifically, in derivative pricing theory, is captured by the following observation. While the typical derivative paper is expressed in words and formulas aiming at the theoretical value of the derivative, it is really intended for derivative trading, which is the domain farthest away from theory. This is irony in the first sense. And while rational option pricing, as epitomized by the work of Black, Scholes and Merton, has triggered the explosion of options markets, the ensuing liquidity of option prices has turned volatility into a traded commodity thereby contradicting the crucial theoretical assumption of constant volatility. This is irony in the second sense.

Logged-in members can download the article by clicking the link below. To log in or register visit here.

Related Posts

Introduction to Variance Swaps The purpose of this article is to introduce the properties of variance swaps, and give insights into the hedging and valuation of these instrument...
Can Anyone Solve The Smile Problem?   One of the most debated problems in the option smile literature today is the so-called “smile dynamics.” It is the key both to the consi...
Inefficient Markets The "crash of '87" was the most extreme stock market price jump of the twentieth century. The S&P 500 Index fell over 20 per cent in one trading d...
What I Knew and When I Knew It – Part 2 In November 1969 l and a partner, Jay Regan, launched what I believe was the world’s first market neutral hedge fund. We called it Convertible Hed...
The Boost C++ Libraries Overview and Applicability... By NASA; restored by Michel Vuijlsteke (Great Images in NASA Description) , via Wikimedia CommonsIn this article we give an overview of the Boost C++...
CSA Caps Convexity Impact on Hull & White Cal... Prices of CSA instruments are observed in a world which is not natural for LIBOR based payoffs in the sense that LIBOR forward is not martingale under...
Priority QI Tickets – Special Offer for Wilm... Quant Insights Conference – London, 16th November 2018 Discounted Live & Online Priority Tickets – Special Offer for Wilmott Inner Circle Members...
It’s the Debt, Stupid For the past ten years I have been a member of the Governing Council of the CSFI, the Centre for the Study of Financial Innovation, a London-based thi...
120802_ayache