A Cautious Note on the Design of Volatility Derivatives

This cautious note aims to point at the potential risks for the financial system caused by various increasingly popular volatility derivatives including variance swaps on futures of equity indices. It investigates the pricing of variance swaps under the 3/2 volatility model. Carr with Itkin and Sun have discussed the pricing of variance swaps under this type of model. This paper studies a special case of this model and observes an explosion of prices for squared volatility and variance swaps. It argues that such a price explosion may have deeper economic reasons, which should be taken into account when designing volatility derivatives. 1991 Mathematics Subject Classification: Primary 62P05; secondary 60G35, 62P20 JEL Classification: G10, G13