Title: Characteristic function-based approach for pricing long-run market uncertainty
Authors: Julian Williams - Durham University (United Kingdom)
Abderrahim Taamouti - Durham University Business School (United Kingdom) [presenting]
Handing Sun - Durham University (United Kingdom)
Yang Zhang - Durham University (United Kingdom)
Abstract: High-order moments derivatives such as variance and skewness swaps are increasingly popular risk management tools for foreign exchange exposures. We propose a simple characteristic function based method for determining the risk-neutral value of a spanning contract contingent on the future outcome of an asset price. Contrary to the existing approaches that require using large cross sectional data on option prices, the price of such contract can be computed by a single quadrature evaluation of the characteristic function and can be used to calculate the moment swaps beyond variance, such as skewness and kurtosis. Based on our approach, fractional moment swaps can be estimated directly from spot and yield curve data via maximum likelihood. Finally, based on our method, we show that the GARCH based predicted moment swaps perform well against both option implied variance and skewness swaps and traded variance swaps.