Three Essays about Options on Leveraged Exchange

Traded Funds
Yahua Xu
Auckland University of Technology
yaxu@aut.ac.nz

July 1, 2015

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Background Knowledge

Exchange Traded Fund (ETF): An ETF is an investment fund

traded on stock exchanges. It has advantages such as low costs, tax
efficiency and stock-like features.
Leveraged ETF (LETF): A LETF is a special type of ETF and
designed to track a multiple daily return of a target asset.
LETFs tracking two important indices:
S&P 500 Index.
VIX Short Term Futures Index.

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Background Knowledge

Option: A call (put) option gives the holder the right to buy (sell) an
underlying asset at a specified strike price on a specified date:
Payoff of a Call Option: max{st k, 0}.
Payoff of a Put Option: max{k st , 0}.

LETF Option: The underlying asset is a LETF.

LETF Option Market:
The option on equity LETF was launched in 2011.
The option on volatility LETF was launched in 2012.
In my research, I am going to analyze dynamics of the two specified LETFs
and price options written on them.

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Background Knowledge

It is from a regulatory notice about the LETFs of the Financial Industry

Regulatory Authority (FIRA) published in June 2009:
While such products may be useful in some sophisticated trading
strategies, they are highly complex financial instruments that are
typically designed to achieve their stated objectives on a daily basis.
Due to the effects of compounding, their performance over longer
periods of time can differ significantly from their stated daily
objective.

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Analyzing Objectives

S&P 500 Index

Options

LETFs

UPRO VIX Index

SSO
SPY
SH
SDS
SPXU
(+3)
(+2)
(+1)
(1)
(2)
(3)
Options Options Options Options Options Options

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Analyzing Objectives

VIX Index
VIX Futures
VIX Short Term Futures Index
LETFs
SVXY
(1)

VIXY
(+1)

UVXY
(+2)

Options Options Options

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Equity LETF Prices

Figure: Equity LETF Prices

LETFs Price
70
60
50
40
30
20
10
0

SPXU (-3)

SDS (-2)

SH (-1)

SPY (+1)

SSO (+2)

UPRO (+3)

Note. Times series for equity LETF from 2011/06/01 to 2012/06/01.

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Research Questions (RQs)

RQ1
How is the empirical performance of the Heston model in regard of
pricing options on equity LETFs?

RQ2
What is the proper dynamic model for volatility LETFs? How is the
empirical performance of the model in regard of pricing options on
volatility LETFs?

RQ3
What are the option pricing formulas when jump risk is added into
stochastic volatility framework?

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Thesis Structure

Stochastic Volatility Framework

Chapter1

Chapter2

Heston Model for Equity LETFs

Logarithmic Model with Stochastic

Volatility (LRSV) for Volatility LETFs
Proposing LRSV for the volatility
LETFs;
Empirical analysis about the
performance of LRSV

Empirical analysis about the

performance of Heston

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Thesis Structure

Stochastic Volatility + Jump Framework

Chapter 3
Heston + Jump (Equity LETFs)

LRSV + Jump (Volatility LETFs)

LRSV +
LRSV +
Heston +
Heston +
Constant Jump Stochastic Jump Constant Jump Stochastic Jump

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Volatility Skew

Volatility Skew/Smile is the phenomena of options implied

volatilities varying with moneyness.
It is one of the most stylized facts observed in the option market:
Equity options exhibit negative volatility skew.
Volatility options exhibit positive volatility skew.

The stochastic volatility models are capable of capturing the volatility

skew observed in option market, as documented in the literature such
as Heston(1993) and Bates(1996).

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Volatility Skew
Figure: Negative Volatility Skew for Equity Option

SPY(+1)
0.50
0.45
0.40
0.35
0.30
0.25
0.20
0.15
0.10
0.05
0.00

Note. Smile for the maturity 0.14 for the LETF SPY(+1) for the day 2011/10/24.
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Volatility Skew
Figure: Positive Skew for Volatility Option

VIXY(+1)
2.50
2.00
1.50

1.00
0.50
0.00

Note. Smile for the maturity 0.14 for the LETF VIXY(+1) for the day 2011/10/24.
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Chapter I

Chapter I:
Options on Equity LETFs, Calibration and Error
Analysis

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Chapter I: Literature Review

Avellaneda and Zhang (2010) is the first to study the dynamics of the
equity LETF returns from a theoretical perspective:
The equity LETFs fail to reproduce the multiple return of the
underlying over a long period of time.
The long-run return of a LETF is path-dependent.
They proposed the Heston model for the dynamics of equity LETFs.

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Chapter I: Literature Review

The other studies such as Ahn et al. (2012) and Deng et al. (2014) also
employ the Heston model for pricing options on the equity LETFs:
Zhang (2010) only utilizes one days underlying ETF option data to
calibrate the Heston model. The information of model fitting is only
showed by figures.
Ahn et al. (2012) only utilizes the option data of June, 14, 2013. In
the calibration, they fix the correlation coefficient without giving
the reason.
Deng et al. (2014) also only uses one days option data, without
reporting any pricing error.

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Chapter I: Literature Review

How to systematically evaluate the performance of an option pricing

model?
The empirical study of Bakshi et al. (1997) on the performance of
several S&P 500 option pricing models provides a good reference:
The daily calibration is rolled based on a set of time series data.
Estimated parameters and pricing errors are both provided.

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Chapter I: Model and Option Pricing

Assume the price of the underlying asset st follows the Heston model:

dst
= (r q)dt + vt dt1 ,
st

dvt = ( vt )dt + vt dt2 ,

with initial value s0 known.
t = t1 , t2

t0

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is a Brownian motion with correlation coefficient .

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Chapter I: Model and Option Pricing

For a LETF with leverage ratio m, the price lt is related to st as follows:
dlt
dst
=m
+ (1 m)rdt,
lt
st

dvt = ( vt )dt + vt dt2 .

Moreover, the log return of lt can be expressed in terms of st , vt and m:

d ln lt = md ln st
|

m2 m
vt dt +(1 m)rdt,
2{z
}
volatility bias

When |m| > 1, the volatility bias is negative.

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Chapter I: Model and Option Pricing

The characteristic function of ln lt can be written as:





R
2
iz ln llt
iz(m ln sst m 2m 0t vu du+(1m)rt)
0
0
X (z) = E e
=E e


R
2
izm ln sst iz m 2m 0t vu du
0
= e i(1m)zrt E e



m2 m
i(1m)zrt
=e
t, zm, z
2
= e i(1m)zrt+A(t)+B(t)v0 +izmx .
where the expressions of A(t) and B(t) can be computed and their values
are based on the values of z, m, r , q, , , , .

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Chapter I: Model and Option Pricing

The option pricing formula can be obtained by inverting the characteristic

function via Fourier Transform:


Z
ke rt
1
iz ln k
c(t, k, m) =
Re X (z)e
dzR ,

iz(iz 1)
0

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Chapter I: Data
We have a rich dataset which contains prices of options on a sextet of
equity LETFs. The dataset spans from March 24, 2011 to February 16,
2015. The equity LETFs offered by Proshares are as follows:
Table 1: Equity LETFs
Fund Name
Ticker Name
UltraPro Short S&P 500 ETF SPXU
UltraShort S&P 500 ETF
SDS
Short S&P 500 ETF
SH
SPDR S&P 500 ETF
SPY
Ultra S&P 500 ETF
SSO
UltraPro S&P 500 ETF
UPRO

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Leverage Ratio
-3
-2
-1
+1
+2
+3

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Chapter I: Calibration

We adopt the norm-in-price criterion. At day t, we separately calibrate

options on the LETFs with different leverage ratios. The objective
function is:
2
1 X  market
V
(ti , Ki , mj ) V model (ti , Ki , mj ) ,
min
vt ,,,, Nj
i

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Chapter I: Calibration

For a given day t:

If the estimated parameters are the same, the model is good!
If different, analyze the distribution of pricing errors corresponding to
different leverage ratios. It is quite likely the larger the absolute value
of the leverage, the greater the pricing errors are.

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Chapter I: Calibration

A rolling calibration using several days option data:

We make a comparison of parameters (, , , ) obtained from each
days calibration to see if they are stable over time.
If the estimated parameters are stable over time, then the pricing
model is a robust.
If not, the jump risk may be needed to improve the model
performance.

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Chapter I: Contribution

It is the first to provide a systematic and comprehensive analysis for

the fit of the Heston model in pricing options on equity LETFs.

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Chapter II

Chapter II:
Options on Volatility LETFs with Positive
Volatility Skew

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Chapter II: Options on Volatility LETFs with Positive

Volatility Skew

The underlying index for the volatility LETFs is the VIX Short-Term
Futures Index.
The VIX futures index has a close relationship with the VIX index.
The modeling of VIX dynamics can serve as a good reference for the
dynamic model of volatility LETFs.

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Chapter II: Literature Review

Detemple and Osakwe (2000) proposed a mean-reverting logarithmic

process for the VIX dynamics.
Sepp (2008) suggests incorporating stochastic volatility into the VIX
dynamics to model the feature of positive skew in VIX options.
Kaeck and Alexander (2010) developed a stochastic volatility of
volatility model for the logarithmic VIX dynamics.

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Chapter II: Literature Review

Bao et al. (2012) adopts the model of Kaeck and Alexander (2010)
for the dynamics of VXX (an ETN similar to VIXY (+1) tracking the
daily return of VIX Short Term Futures Index):
Bao et al. (2012) only focuses on the dynamics of the unleveraged
volatility ETF.
No research about the volatility Leveraged ETFs has been carried out.

Based on Bao et al.(2012), a logarithmic stochastic volatility model

for the volatility LETFs is proposed, which is the first model of this
kind.

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Chapter II: Model and Option Pricing

Assume the spot price of the VIX Short Term Future Index Vt follows the
logarithmic model with stochastic volatility (LRSV):

vt dt1 ,

dvt = v (v vt )dt + v vt dt2 ,

d ln Vt = ( ln Vt )dt +

with initial value V0 known.

t = t1 , t2

t0

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is a Brownian motion with correlation coefficient .

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Chapter II: Model and Option Pricing

For a LETF with leverage ratio m, the return xt is based on the underlying
asset return Vt :
dxt
dVt
=m
+ (1 m)rdt,
xt
Vt

dvt = v (v vt )dt + v vt dt2 ,

with the initial value x0 = x known.
Moreover, the log return of xt can be expressed in terms of Vt , vt and m:
d ln xt = md ln Vt
|

m2 m
vt dt +(1 m)rdt,
2{z
}
volatility bias

When |m| > 1, the volatility bias is negative.

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Chapter II: Model and Option Pricing

The characteristic function of ln xt can be written as:



R
h
i
2
Vt
iz ln xxt
m 2m 0t vu du+(1m)rt)
iz(m ln V
0
0
X (z) = E e
=E e


R
2
Vt
izm ln V
iz m 2m 0t vu du
0
= e i(1m)zrt E e



m2 m
i(1m)zrt
=e
t, zm, z
2
= e A(t)+B(t)v +C (t)x .
The expressions of A(t), B(t) and C (t) can be computed and they are
based on the values of z, m, r , q, , , , v , v and v .

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Chapter II: Model and Option Pricing

The option pricing formula can be obtained by inverting the characteristic

function via Fourier Transform:


Z
ke rt
1
iz ln k
c(t, k, m) =
Re X (z)e
dzR ,

iz(iz 1)
0

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Chapter II: Data

We have a rich dataset which contains prices of options on a set of

volatility LETFs. The dataset spans from March 19, 2012 to October 31,
2014. The volatility LETFs offered by Proshares are as follows:
Table 1: Volatility LETFs
Fund Name
Ticker Name
Short VIX Short-Term Futures ETF SVXY
VIX Short-Term Futures ETF
VIXY
Ultra VIX Short-Term Futures ETF UVXY

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Leverage Ratio
-1
+1
+2

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Chapter II: Calibration

The calibration procedure is similar to the previous part. Firstly, the

norm-in-price criterion is adopted. We implement calibration separately for
options written on different LETFs on the same day t. The objective
function is:
2
1 X  market
V
(ti , Ki , mj ) V model (ti , Ki , mj ) ,
min
vt ,,,,v ,v ,v Nj
i

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Chapter II: Calibration

For a given day t:

If the estimated parameters are the same, the model is good!
If different, analyze the distribution of pricing errors corresponding to
different leverage ratios. It is quite likely the larger the absolute value
of the leverage, the greater the pricing errors are.

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Chapter II: Calibration

A rolling calibration using several days option data:

We make a comparison of parameters (vt , , , , v , v , v ) obtained
from each days calibration to see if they are stable over time.
If the estimated parameters are stable over time, then the pricing
model is a robust.
If not, the jump risk may be needed to improve the model
performance.

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Chapter II: Contribution

It is the first model proposed for dynamics of volatility LETFs.

An extended calibration on a time series of option data will be carried
out to assess the models performance.

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Chapter III

Chapter III:
Analytical Extensions of Pricing Options on Equity
and Volatility LETFs

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Chapter III: Analytical Extensions of Pricing Options on

Equity and Volatility LETFs

In the first two chapters, we focus on utilizing the stochastic volatility

models addressing the characteristic of volatility skew observed in the
LETF option market:
The Heston model is adopted for the dynamics of an equity LETF to
incorporate the negative volatility skew.
The LRSV model is adopted for the dynamics of a volatility LETF to
incorporate the positive volatility skew.

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Chapter III: Literature Review

Some research declares that the inclusion of jumps into the stochastic
volatility model may better explain the volatility skew:
Bates (1996) is the first to introduce a jump component into the
stochastic volatility model to analyze the Deutsche Mark Option
market.
Bakshi et al. (1997) conjecture that jumps in volatility may be
necessary to fully explain the volatility smile observed in the S&P 500
option market.
Duffie et al. (2000) also found that the inclusion of jumps improves the
model fitting.
Broadie et al. (2007) utilize an extensive data sample of S&P 500
futures option. Both time series and cross section test show that jump
in volatility can improve the model fit.

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Chapter III: Literature Review

The specification of jumps is furthermore important:

Typical jump models such as Bates (1996) usually assume the jump
intensity is constant.
Bates (2000) found that the time-varying jump risk and stochastic
volatility work together to better explain the negative skewness.
Eraker (2004) also assumes that the jump arrival intensity is
state-dependent.

However, evidence supporting the specification of jumps is mixed.

Therefore, we are going to analyze both cases.

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Chapter III: Heston Model Extension with Constant Jump

Intensity

The dynamics of the underlying asset price st is specified as follows:

dst
= (r q)dt + vt dt1 ,
st

dvt = ( vt )dt + vt dt2 + JdNt ,

with initial value s0 known.
t1 and t2 has correlation coefficient , Nt is a Poisson Process with
constant intensity . The magnitude J of jumps is an exponential random
variable, i.e. J exp ( J1 ).

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Chapter III: Heston Model Extension with Stochastic Jump

Intensity
The dynamics of the underlying asset price st is specified as follows:

dst
= (r q)dt + vt dt1 ,
st

dvt = ( vt )dt + vt dt2 + JdNt ,

p
dt = ( t )dt + t dt3 ,
with initial value s0 known.
t1 and t2 has correlation coefficient , and t1 and t3 has correlation
coefficient 0. Nt is a Poisson Process with stochastic intensity t . The
magnitude J of jumps is an exponential random variable, i.e. J exp ( J1 ).
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Chapter III: Heston Model Extension with Stochastic Jump

Intensity

We denote by lt the spot price of the LETF. The characteristic function of

ln ll0t can be written as:




R
2
iz ln llt
iz(m ln sst m 2m 0t vu du+(1m)rt)
0
0
X (z) = E e
=E e



m2 m
i(1m)zrt
=e
t, zm, z
.
2

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Chapter III: LRSV Extension with Constant Jump Intensity

We assume the underlying asset price Vt follows the logarithmic model

with stochastic volatility (LRSV), and is specified as follows:

vt dt1 ,

dvt = v (v vt )dt + v vt dt2 + JdNt ,

d ln Vt = ( ln Vt )dt +

with initial value V0 known.

t1 and t2 has correlation coefficient . Nt is a Poisson Process with
constant intensity . The magnitude J of jumps is an exponential random
variable, i.e. J exp ( J1 ).

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Chapter III: LRSV Extension with Stochastic Jump

Intensity
We assume the price Vt follows the logarithmic model with stochastic
volatility (LRSV), and is specified as follows:

vt dt1 ,

dvt = v (v vt )dt + v vt dt2 + JdNt ,

p
dt = ( t )dt + t dt3 ,

d ln Vt = ( ln Vt )dt +

with initial value V0 known.

t1 and t2 has correlation coefficient , and t1 and t3 has correlation
coefficient 0. Nt is a Poisson Process with stochastic intensity t . The
magnitude J of jumps is an exponential random variable, i.e. J exp ( J1 ).

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Chapter III: LRSV Extension with Stochastic Jump

Intensity

We denote by lt the spot price of the LETF. The characteristic function of

ln ll0t can be written as:




R
2
iz ln llt
iz(m ln sst m 2m 0t vu du+(1m)rt)
0
0
X (z) = E e
=E e



m2 m
i(1m)zrt
=e
t, zm, z
.
2

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Chapter III: Option Pricing

The option pricing formula can be obtained by inverting the characteristic

function via Fourier Transform:


Z
ke rt
1
iz ln k
c(t, k, m) =
Re X (z)e
dzR ,

iz(iz 1)
0

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Chapter III: Sensitivity Analysis

We will carry out sensitivity analysis for the models to see the impact
of the parameters.

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Chapter III: Contribution

It is the first to introduce jump risk to the stochastic volatility

framework for the dynamics of equity and volatility LETFs.

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Thank You

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