Valuation of VIX derivatives∗

Javier Mencı́a Enrique Sentana

Bank of Spain CEMFI
<javier.mencia@bde.es> <sentana@cemfi.es>
December 2009
Revised: March 2011

Abstract
We conduct an extensive empirical analysis of VIX derivative valuation models
before, during and after the recent financial crisis. Since the restrictive assump-
tions about mean reversion and heteroskedasticity of existing models yield large
distortions during the crisis, we propose generalisations with a time varying cen-
tral tendency, jumps and stochastic volatility, analyse their pricing performance,
and their implications for term structures of VIX futures and options, and option
volatility ”skews”. We find that a process without jumps for the observed VIX
index combining central tendency and stochastic volatility reliably prices VIX fu-
tures and options, respectively, across bull and bear markets.

Keywords: Central Tendency, Stochastic Volatility, Jumps, Term Structure,

Volatility Skews.

JEL: G13.

∗
We are grateful to Dante Amengual, Torben Andersen, Max Bruche, Peter Carr, Rob Engle, Javier
Gil-Bazo, Ioannis Paraskevopoulos, Francisco Peñaranda, Eduardo Schwartz and Neil Shephard, as well
as seminar participants at Oxford MAN Institute, Universidad de Murcia, Universitat Pompeu Fabra,
the SoFiE European Conference (Geneva, June 2009), the Finance Forum (Elche, November 2010) and
the Symposium of the Spanish Economic Association (Madrid, December 2010) for helpful comments,
discussions and suggestions. Of course, the usual caveat applies. Financial support from the Spanish
Ministry of Science and Innovation through grant ECO 2008-00280 (Sentana) is gratefully acknowledged.
The views expressed in this paper are those of the authors, and do not reflect those of the Bank of Spain.
Address for correspondence: Casado del Alisal 5, E-28014, Madrid, Spain, tel: +34 91 429 05 51, fax:
+34 91 429 1056.

Electronic copy available at: http://ssrn.com/abstract=1524193

1 Introduction
It is now widely accepted that the volatility of financial assets changes stochasti-
cally over time, with fairly calmed phases being followed by more turbulent periods of
uncertain length. For financial market participants, it is of the utmost importance to un-
derstand the nature of those variations because volatility is a crucial determinant of their
investment decisions. Although many model-based and model-free volatility measures
have been proposed in the academic literature (see Andersen, Bollerslev, and Diebold,
2009, for a recent survey), the Chicago Board Options Exchange (CBOE) volatility in-
dex, widely known by its ticker symbol VIX, has effectively become the standard measure
of volatility risk for investors in the US stock market. The goal of the VIX index is to
capture the volatility (i.e. standard deviation) of the S&P500 over the next month im-
plicit in stock index option prices. Formally, it is the square root of the risk neutral
expectation of the integrated variance of the S&P500 over the next 30 calendar days,
reported on an annualised basis. Despite this rather technical definition, both financial
market participants and the media pay a lot of attention to its movements. To some
extent, its popularity is due to the fact that VIX changes are negatively correlated to
changes in stock prices. The most popular explanation is that investors trade options on
the S&P500 to buy protection in periods of market turmoil, which increases the value of
the VIX. In fact, as Andersen and Bondarenko (2007) and many others show, the VIX
almost uniformly exceeds realised volatility because investors are on average willing to
pay a sizeable premium to acquire a positive exposure to future equity-index volatility.
For that reason, some commentators refer to it as the market’s fear gauge, even though
a high value does not necessarily imply negative future returns.
But apart from its role as a risk indicator, nowadays it is possible to directly invest in
volatility as an asset class by means of VIX derivatives. Specifically, on March 26, 2004,
trading in futures on the VIX began on the CBOE Futures Exchange (CFE). They are
standard futures contracts on forward 30-day implied vols that cash settle to a special
opening quotation (VRO) of the VIX on the Wednesday that is 30 days prior to the
3rd Friday of the calendar month immediately following the expiring month. Further,
on February 24, 2006, European-style options on the VIX index were also launched on
the CBOE. Like VIX futures, they are cash settled according to the difference between

Electronic copy available at: http://ssrn.com/abstract=1524193

the value of the VIX at expiration and their strike price. Importantly, they can also be
interpreted as options on VIX futures, which one can exploit to simplify their valuation
and avoid compounding errors made in valuing futures. VIX options and futures are
among the most actively traded contracts at CBOE and CFE, averaging close to 140,000
contracts combined per day, with much larger volumes on certain days. One of the main
reasons for the high interest in these products is that VIX derivative positions can be
used to hedge the risks of investments in the S&P500 index. Szado (2009) finds that such
strategies do indeed provide significant protection, especially in downturns. Moreover,
by holding VIX derivatives investors can achieve exposure to S&P500 volatility without
having to delta hedge their S&P500 option positions with the stock index. As a result,
it is often cheaper to be long in out-of-the-money VIX call options than to buy out-of-
the-money puts on the S&P500.
Although these new assets certainly offer additional investment and hedging oppor-
tunities, their correct use requires reliable valuation models that adequately capture the
features of the underlying volatility index. Somewhat surprisingly, several theoretical ap-
proaches to price VIX derivatives appeared in the academic literature long before they
could be traded. Specifically, Whaley (1993) priced volatility futures assuming that the
observed volatility index on which they are written follows a Geometric Brownian Mo-
tion (GBM). As a result, his model does not allow for mean reversion in the VIX, which,
as we shall see, is at odds with the empirical evidence. The two most prominent mean
reverting models proposed so far for volatility indices have been the square root pro-
cess (SQR) process considered by Grünbichler and Longstaff (1996), and the log-normal
Ornstein-Uhlenbeck (log-OU) process analysed by Detemple and Osakwe (2000).
Several authors have previously looked at the empirical performance of these pricing
models for VIX derivatives. In particular, Zhang and Zhu (2006) study the empirical
validity of the SQR model by first estimating its parameters from VIX historical data,
and then assessing the pricing errors of VIX futures implied by those estimates. Following
a similar estimation strategy, Dotsis, Psychoyios, and Skiadopoulos (2007) also use VIX
futures data to evaluate the gains of adding jumps to a SQR diffusion. In addition, they
estimate a GBM process. Surprisingly, this model yields reasonably good results, but
the time span of their sample is perhaps too short for the evident mean reverting features
of the VIX to play any crucial role.

2
 In turn, Wang and Daigler (2011) compare the empirical fit of the SQR and GBM
models using data on options written on the VIX. They also find evidence supporting the
GBM assumption. However, one could alternatively interpret their findings as evidence
in favour of the log-OU process, which also yields the Black (1976) option formula if the
underlying instrument is a VIX futures contract, but at the same time is consistent with
mean reversion.
Despite this empirical evidence, both the SQR and the log-OU processes show some
glaring deficiencies in capturing the strong persistence of the VIX, which produces large
and lasting deviations of this index from its long run mean. In contrast, the implicit
assumption in those models is that this volatility index mean reverts at a simple, non-
negative exponential rate. Such a limitation becomes particularly apparent during bear-
ish stock markets, in which volatility measures such as the VIX typically experience large
increases and remain at high levels for long periods. Arguably, the apparent success of
those models is to a large extent due to the fact that the sample periods considered in
the existing studies only cover the relatively long and quiet bull market that ended in
the summer of 2007.
In this context, the initial objective of our paper is to study the empirical ability
of existing mean-reverting models for volatility indices to price derivatives on the VIX
over a longer sample span that includes data before, during and after the unprecedented
recent financial crisis, which provides a unique testing ground for our study. To do so,
we use an extensive database that comprises all futures and European option prices on
the VIX from February 2006, when options were introduced, until December 2010. As a
result, we can study whether the SQR and log-OU models are able to yield reliable in-
and out-of-sample prices in a variety of market circumstances.
Our findings indicate that although a log-OU process for the VIX provides a better
fit than a SQR model, especially for VIX options, its performance deteriorates during
the market turmoil of the second part of our sample. For that reason, we generalise
the log-OU process by proposing several novel but empirically relevant extensions: a
time-varying central tendency in the mean, jumps, and stochastic volatility. A central
tendency, which was first introduced by Jegadeesh and Pennacchi (1996) and Balduzzi,
Das, and Foresi (1998) in the context of term structure models, allows the “average”
volatility level to be time-varying, while stochastic volatility permits a changing disper-

3
sion for the (log) volatility index, and together with jumps, introduces non-normality in
its conditional distribution.
Following Trolle and Schwartz (2009) among others, we specify our models in state
space form and calibrate their parameters by pseudo maximum likelihood. Since our ap-
proach accommodates both real and risk-neutral measures, we can use not only derivative
prices but also historical observations on the VIX itself. In order to compute the theo-
retical derivatives prices, we often need to invert the conditional characteristic function
using Fourier methods (see e.g. Carr and Madan, 1999).
To validate the models, we analyse the discrepancies between actual and theoretical
derivatives prices. But we also go beyond pricing errors, and analyse the implications
of the aforementioned extensions for the term structures of VIX futures and options,
and the option volatility “skews”, all of which are of considerable independent interest.
Since we combine futures and options data, we can also assess which of those additional
features is more relevant for pricing futures, and which one is more important for options.
Importantly, our approach differs from Sepp (2008), who prices VIX derivatives by
using data on the S&P500 only. Although the relevant distribution of future values of the
VIX conditional on current information might arguably depend not only on the current
level of the VIX but also on the value of the S&P500, it seems odd to completely neglect
the information content of contemporaneously observed VIX values. This is particularly
relevant in view of the fact that one cannot reproduce the spot VIX index by using
the model proposed by Sepp (2008) for the purposes of obtaining the required S&P500
option values that feed in the closed-form CBOE formula for this volatility index.1 In
order to avoid compounding valuation errors, therefore, we prefer to treat the current
VIX level as our “sufficient statistic”, and to treat VIX futures likewise for the purposes
of valuing options, instead of assigning that role to the S&P500. Ideally, though, one
would like to use both, but we leave this for future research. In this sense, it is important
to emphasise that the univariate stochastic processes that we consider for the VIX are
not necessarily incompatible with models for S&P500 options capable of reproducing
this observed volatility index.
1
A relevant analogy would be the use of a model for the dividends and risk premia of the 500
individual stocks that constitute the index for the purposes of valuing S&P500 derivatives discarding
the information in the index itself, even though any such multivariate model would very likely fail to
reproduce the value of the index.

4
 Nevertheless, our analysis can still shed some light on the long-lasting debate sur-
rounding the modelling of the (instantaneous) volatility of this broad stock market index.
In particular, given the relationship between the observed VIX and the unobserved in-
tegrated volatility of the S&P500, our results imply that the sophisticated stochastic
volatility models that many researchers and practitioners use for valuing S&P options
should probably allow for a slower mean reversion than usually considered, as well as for
time-varying volatility of volatility.
The rest of the paper is organised as follows. We describe the data in Section 2, and
explain our estimation strategy in Section 3. Then, we assess the empirical performance
of existing models in Section 4 and consider our proposed extensions in Section 5. Finally,
we conclude in Section 6. Auxiliary results are gathered in an Appendix.

2 Preliminary data analysis

2.1 The CBOE Volatility Index

VIX was originally introduced in 1993 to track the Black-Scholes implied volatilities
of options on the S&P100 with near-the-money strikes (see Whaley, 1993). The CBOE
redefined the index in 2003, renamed the original index as VXO, and released a time
series of daily closing prices starting in January 1990 (see Carr and Wu, 2006). Nowadays,
VIX is computed in real time using as inputs the mid bid-ask market prices for most calls
and puts on the S&P500 index for the front month and the second month expirations
with at least 8 days left (see CBOE, 2009).2 Figure 1a displays the entire historical
evolution of the VIX. Between January 1990 and December 2010 its average closing
value was 20.4. As other volatility measures, though, it is characterised by swings from
low to high levels, with a temporal pattern that shows mean reversion over the long
run but displays strongly persistent deviations from the mean during extended periods.
The lowest closing price (9.31) corresponds to December 22, 1993. Figure 1b, which
focuses on the sample period in our derivatives database, shows that volatility was also
remarkably low between February 2006 and July 2007, with values well below 20. During
this period, the lowest value was 9.89 on January 24, 2007, in what some have called
2
Currently, CBOE applies the VIX methodology to 3-month options on the S&P500 (VXV), as well
as 1-month options on the most important US stock market indices: DJIA (VXD), S&P100 (VXO),
Nasdaq-100 (VXN) and Russell 2000 (RVX). They also construct analogous short term volatility indices
for Crude Oil (OVX), Gold (GVZ) and the US $/eexchange rate (EVZ).

5
“the calm before the storm”. Indeed, although the Dow Jones Industrial Average closed
above 14,000 for the first time in history in the summer of 2007, some warning signals
were observed around this period. In particular, Bear Stearns disclosed that its two
subprime hedge funds had lost all of their value on July 18, 2007, and one day later
Fed Chairman Ben Bernanke warned the US Senate Banking Committee that subprime
losses could top $100 billion. Over the following year, VIX increased to values between
20 and 35. Finally, in the autumn of 2008 it reached unprecedented levels. In particular,
the largest historical closing price (80.86) took place on November 20, 2008, although on
October 24 the VIX reached an intraday value of 89.53. After this peak, VIX followed
a decreasing trend over the following months until the beginning of April, 2010, when
the Greek debt crisis started worsening. These markedly different regimes offer a very
interesting testing ground to analyse the performance of valuation models for volatility
derivatives. In particular, we can assess if the models calibrated with pre-crisis data
perform well under the extreme conditions of the 2008-2009 financial crisis. Similarly,
we can assess if models estimated with data that covers the 2008-2009 financial crisis
perform well during the 2010 sovereign debt crisis.
In order to characterise the time series dynamics of the VIX, we have estimated several
ARMA models using the whole VIX historical observations from 1990 to 2010. Figure 2a
compares the sample autocorrelations of the log VIX with those implied by the estimated
models. There is clear evidence of high persistence, with a first-order autocorrelation
above 0.98 and a slow rate of decay for higher orders. Consequently, an AR(1) model
seems unable to capture the shape of the sample correlogram. An alternative illustration
of the failure of this model is provided by the presence of positive partial autocorrelations
of orders higher than one, as Figure 2b confirms. Therefore, it is necessary to introduce
a moving average component to take into account this feature. An ARMA(1,1) model,
though, only offers a slight improvement. In contrast, an ARMA(2,1) model turns out
to yield autocorrelations and partial autocorrelations that are much closer to the sample
values. As we shall see below, our preferred continuous time models have ARMA(2,1)
representations in discrete time. Importantly, this result is not due to the behaviour of
the VIX during the financial crisis, since an ARMA(2,1) is also necessary to capture the
autocorrelation profile when we only consider data from 1990 until the summer of 2007.
We have also analysed the presence of time varying features in the volatility of the log

6
VIX. In particular, we have tested for Garch effects in the residuals of the ARMA(2,1)
estimation.3 Interestingly, we can easily reject the absence of Garch-type effects at
all conventional levels. In this sense, we shall see that our preferred continuous time
specification allows for time varying volatility.

2.2 VIX derivatives

Our sample contains daily closing bid-ask mid prices of futures and European put and
call options on the VIX, which we downloaded from Bloomberg. We consider the entire
history of these series since options were introduced in February 2006 until December
2010. In terms of maturity, we have data on all the contracts with expirations between
March 2006 and May (July) 2011 for options (futures). CFE may list futures for up to 9
near-term serial months, as well as 5 months on the February quarterly cycle associated
to the March quarterly cycle for options on the S&P500. In turn, CBOE initially lists
some in-, at- and out-of-the-money strike prices, and then adds new strikes as the VIX
index moves up or down. Generally, the options expiration dates are up to 3 near-term
months plus up to 3 additional months on the February quarterly cycle.
Following Dumas, Fleming, and Whaley (1998), we exclude derivatives with fewer
than six days to expiration due to their illiquidity. In addition, we only consider those
prices for which open interests and volumes are available. All in all, we have 8,665
and 87,870 prices of futures and options, respectively. Of those option prices, 58,099
correspond to calls and 29,771 to puts. We proxy for the riskless interest rate by using
the daily Eurodollar rates at 1-week, 1, 3 and 6 months and 1 year, which we interpolate
to match the maturities of the futures and option contracts that we observe.
Figure 3a shows the number of futures prices per day in our database. We have
between 4 and 6 daily prices during 2006; afterwards, 8 prices per day become available
on average. Figure 3b indicates that the number of option prices per day is also smaller
at the beginning of the sample, but it tends to stabilise in 2007 at around 20 for puts
and 40 for calls. The number of call prices per day increases again after mid 2009.
Figure 4a shows the evolution of the VIX term structure implicit in VIX futures.
This figure clearly confirms that there was a substantial level shift in the last quarter
3
Following Demos and Sentana (1998), we carry out a one-sided LM test of conditional homoskedas-
ticity against Garch as T R̃2 from the regression of the squared ARMA(2,1) residuals on a constant
and the first lag of the Riskmetrics volatility estimate (see RiskMetrics Group, 1996).

7
of 2008. The negative slope during that period, though, indicates that the market did
not expect the VIX to remain at such high values forever. Figure 4b compares futures
prices with the VIX. As can be seen, most future prices were above the volatility index
until mid 2007, which suggests that market participants perceived that the VIX was too
low during those years. For instance, on October 12, 2006, the VIX was 11.09, while the
price of VIX futures expiring on February 14, 2007, was 15.72. The spot price reflected
the expected volatility for the period of October 12 to November 11, while the futures
price reflected the expected volatility for the period of February 14 to March 16, 2007.
In contrast, most prices were below the VIX in the autumn of 2008, which confirms that
volatility was then perceived to be above its long run mean.
Figure 4c focuses on the VIX term structure at four particularly informative days.
Futures prices were extremely low on July 16, 2007, even though the first warning signals
about the impending crisis were starting to appear. Prices had already risen significantly
by August 15, 2008, one month before the collapse of Lehman Brothers. Nevertheless,
they were much higher on November 20, 2008, which is the day in which the VIX reached
its maximum historical closing value at 80.86. The increase is particularly remarkable
at the short end of the curve. Since then, though, VIX futures prices significantly came
down until the beginning of April 2010, right before the European sovereign debt crisis.

3 Pricing and estimation strategy

We assume that there is a risk free asset with instantaneous rate r. Let V (t) be
the VIX value at time t. We define F (t, T ) as the actual strike price of a futures
contract on V (t) that matures at T > t. Similarly, we will denote the prices at t of
call and put options maturing at T with strike price K by c(t, T, K) and p(t, T, K),
respectively. Importantly, since the VIX index is a risk neutral volatility forecast, not
a directly traded asset, there is no cost of carry relationship between the price of the
futures and the VIX (see Grünbichler and Longstaff, 1996, for more details). There is
no convenience yield either, as in the case of futures on commodities. Therefore, absent
any other market information, VIX derivatives must be priced according to some model
for the risk neutral evolution of the VIX. This situation is similar, but not identical, to
term structure models.
Let M index the asset pricing models that we consider. Then, the theoretical futures

8
price implied by model M will be:

Q
FM (t, T, V (t), φ) = EM [V (T )|I(t), φ], (1)

where Q indicates that the expectation is evaluated at the risk neutral measure, φ is
the vector of free parameters of model M , and I(t) denotes the information available at
time t, which includes V (t) and its past values.
We can analogously express the theoretical value of a European call option with strike
K and maturity at T under this model as

Q
cM [t, T, K, F (t, T ), φ] = exp(−rτ )EM [max(V (T ) − K, 0)|I(t), φ], (2)

where τ = T −t. Nevertheless, we can exploit the fact that V (T ) = F (T, T ) to price calls
using the futures contract that expires on the same date as the underlying instrument,
instead of the actual volatility index. In this way, we make sure that the pricing errors
of options are not caused by distortions in our futures valuation formulas. Similarly,
European put prices p(t, T, K) under M can be easily obtained from the put-call-forward
parity relationship

pM [t, T, K, F (t, T ), φ] = cM [t, T, K, F (t, T ), φ] − exp(−rτ )[F (t, T ) − K].

We estimate the parameters of all the models that we consider by pseudo maximum
likelihood using futures and options prices as well as data from the VIX index. To do
so, we assume the existence of pricing errors such that

F (t, T ) = FM (t, T, V (t), φ) + εf t,T ,

c(t, T, K) = cM [t, T, K, F (t, T ), φ] + εct,T (K),

p(t, T, K) = pM [t, T, K, F (t, T ), φ] + εpt,T (K),

where εf t,T ∼ N (0, σf2 ), εct,T (K) ∼ N (0, σo2 ) and εpt,T (K) ∼ N (0, σo2 ) are iid over time
and across strikes and maturities. A non-trivial advantage of this method over tradi-
tional calibration procedures is that we do not have to treat the model parameters as
deterministic functions of time. In addition, we can also obtain standard errors for our
parameter estimators, which can in turn be used to conduct formal hypothesis tests.
Furthermore, we can exploit the relationship between actual and risk-neutral measures
to estimate prices of risk (see the Appendix for details).

9
 For interpretation purposes, it is convenient to write the log likelihood at a particular
time t as

l[ot , ft , V (t)|I(t − 1)] = lo (ot |ft , V (t), I(t − 1)) + lf (ft |V (t), I(t − 1)) + lv [V (t)|I(t − 1)],

where ot and ft are, respectively, the set of option and futures prices traded at t,
lo (ot |ft , V (t), I(t − 1)) is the log density of the option prices conditional on futures prices
and VIX, lf (ft |V (t), I(t − 1)) is the log likelihood of the futures prices conditional on the
volatility index, and lv [V (t)|I(t − 1)] is the log density of the volatility index.
We consider three estimation samples that correspond to the distinct volatility phases
described in Section 2: (i) until 15-Aug-2008, (ii) until 31-March-2010 and (iii) full
sample. Finally, we evaluate the in- and out-of-sample empirical fit of the models over
those periods. Thus, we can assess model performance following major volatility increases
in global stock markets.

4 Existing one-factor models

4.1 Model specification

We first compare the two mean-reverting volatility models that have been used so
far in the literature: the square root and the log Ornstein-Uhlenbeck processes. As we
mentioned before, Grünbichler and Longstaff (1996) proposed the square root process
(SQR) to model a standard deviation index. This model, which was used by Cox,
Ingersoll, and Ross (1985) for interest rates and Heston (1993) for the instantaneous
variance of stock prices, satisfies the diffusion
p
dV (t) = κP [θ̄P − V (t)]dt + σ V (t)dW P (t),

where W P (t) is a Brownian motion under the real measure. Following Dai and Singleton
(2000), we specify a price of risk that is proportional to the instantaneous volatility.
p p
Specifically, we assume that Λ(t) = ς V (t), so that dW Q (t) = dW P (t) + ς V (t)dt.
Then, it is straightforward to show that V (t) satisfies the square root diffusion
p
dV (t) = κ[θ̄ − V (t)]dt + σ V (t)dW Q (t),

under the equivalent risk neutral measure, where κ = κP + σς and θ̄ = κP θ̄P /κ.

10
 As is well known, the risk-neutral distribution of 2cV (T ) given V (t) is a non-central
chi-square with ν = 4κθ̄/σ 2 degrees of freedom and non-centrality parameter ψ =
2cV (t) exp(−κτ ), where
2κ
c= .
σ 2 (1 − exp(−κτ ))
As a result, the price of the futures contract (1) can be expressed in this case as

FSQR (t, T, V (t), κ, θ̄, σ) = θ̄ + exp(−κτ )[V (t) − θ̄]. (3)

We can interpret θ̄ as the long-run mean of V (t), since the conditional expected value
of the volatility index converges to θ̄ as τ goes to infinity. In addition, κ is usually
interpreted as a mean-reversion parameter because the higher it is, the more quickly the
process reverts to its long run mean.4
The call price formula (2) for this model becomes

cSQR (t, T, K, κ, θ̄, σ) = V (t) exp(−(κ + r)τ )[1 − FN C2 (2cK; ν + 4, ψ)]

+θ̄[1 − exp(−κτ )] exp(−rτ )[1 − FN C2 (2cK; ν + 2, ψ)]

−K exp(−rτ )[1 − FN C2 (2cK; ν, ψ)], (4)

where FN C2 (·; ν, ψ) is the cumulative distribution function (cdf) of a non-central chi-

square distribution with ν degrees of freedom and non-centrality parameter ψ. Hence,
it is straightforward to express the call price as a function of F (t, T ) by exploiting the
relationship between futures prices and V (t) in (3).
More recently, Detemple and Osakwe (2000) considered the log-normal Ornstein-
Uhlenbeck (log-OU) diffusion:

d log V (t) = κ[θ̄P − log V (t)]dt + σdW P (t).

If once again we follow Dai and Singleton (2000) in specifying the price of risk as Λ(t) = ς,
then V (t) will satisfy the log-OU diffusion

d log V (t) = κ[θ̄ − log V (t)]dt + σdW Q (t).

under the risk neutral measure, where θ̄ = θ̄P − σς/κ

As is well known, this model implies that log V (t) would follow a conditionally ho-
moskedastic Gaussian AR(1) process if sampled at equally spaced discrete intervals.
4
As remarked by Hansen and Scheinkman (2009), the density of this distribution will be positive at
V (T ) = 0 if the Feller condition 2κθ̄ ≥ σ 2 is violated.

11
More generally, the conditional risk-neutral distribution of log V (T ) given V (t) would be
Gaussian with mean
µ(t, τ ) = θ̄ + exp(−κτ )[log V (t) − θ̄]

and variance
σ2
ϕ2 (τ ) = [1 − exp(−2κτ )]. (5)
2κ
As in the SQR process, θ̄ and κ can be interpreted as the long-run mean and mean-
reversion parameters, respectively, but now it is the log of V (t) that mean reverts to θ̄.
In this context, it is straightforward to show that the futures price is

FLog−OU (t, T, V (t), κ, θ̄, σ) = exp(µ(t, τ ) + 0.5ϕ2 (τ )),

while the call price can be expressed as

log(F (t, T )/K) + 21 ϕ2 (τ )

 
cLog−OU (t, T, K, κ, θ̄, σ) = exp(−rτ )F (t, T )Φ
ϕ(τ )
log(F (t, T )/K) − 21 ϕ2 (τ )
 
−K exp(−rτ )Φ (6)
ϕ(τ )

if we take the futures contract as the underlying instrument, where Φ(·) denotes the
standard normal cdf. This is the well known Black (1976) formula, although in this case
the implied volatility ϕ(τ ) in (5) is not constant across maturities. In this sense, the
pricing formula proposed by Whaley (1993) based on a geometric Brownian motion can
also be expressed as (6) if ϕ(τ ) is taken as a constant irrespective of τ .

4.2 Empirical performance

We have estimated the parameters of these two models over the three sample periods
described at the end of Section 3. Table 1 reports the in- and out-of-sample root mean
square pricing errors (RMSE). The SQR model clearly yields larger price distortions
for futures than the log-OU, especially during the financial crisis, with almost doubled
RMSE’s. The log-OU model also displays smaller RMSE’s for options, both in and out
of sample. This is confirmed in Figure 5, which compares the daily RMSE’s of the two
models. As can be seen, the SQR yields smaller futures price errors until the Summer
of 2007, but from then on the log-OU is clearly superior. For options, the log-OU is
generally superior over the whole sample. Nevertheless, the performance of both models
deteriorates with the financial crisis, especially during its most critical episodes.

12
 Table 2 reports the parameter estimates that we obtain. Although the values are not
directly comparable because volatility is expressed in levels in the SQR model and in logs
in the log-OU model, in both cases the mean reversion parameter κ is quite sensitive to
the sample period used for estimation purposes. In contrast, the volatility parameter σ
is more stable for the log-OU process, probably because the log transformation is more
appropriate to capture the distortions produced by the large movements of the VIX that
took place at the end of our sample. Interestingly, the price of risk turns out to be
insignificant in the log-OU case, and is only significant for the SQR in the two larger
samples.
An alternative, more illustrative way to assess the validity of the log-OU model is by
computing the implied volatilities with the Black (1976) formula (6). As we mentioned
before, the implied volatility of the log-OU process is constant for different degrees of
moneyness, but not across different maturities because (5) depends on τ . Hence, if
this model were correct then we should obtain constant implied volatilities for a given
maturity regardless of moneyness. Figure 6 shows that this is not at all the case. In fact,
we generally observe that implied vols have a positive moneyness slope. In addition,
implied volatilities are much higher in November 2008 than in the other three dates for a
similar range of maturities. These empirical results suggest that the volatility of the VIX
might not be constant over time, as the log-OU models assume. In this sense, Figure
6 clearly shows that the log-OU process is not only unable to generate the observed
volatility skews, but it also fails to capture the average level of implied volatilities.

5 Extensions
5.1 Model specification

The results of the previous section indicate that a log-OU process offers a better
empirical fit than a SQR process. Unfortunately, its performance tends to deteriorate
during the recent financial crisis. For that reason, in this section we explore several
extensions of the log-OU model. Specifically, we introduce three empirically relevant
features: a time varying mean, jumps and stochastic volatility. We consider these ex-
tensions first in isolation, and then in combination. As a general rule, we model the
price of risk of the continuous part of the diffusions as in the one-factor models, while we
assume that jump risk is not priced. For the sake of brevity, though, we only describe

13
the risk-neutral measure in this section. Further details about prices of risk and real
measures can be found in the Appendix. All in all, we compare the following cases:

• Central tendency (CT):

d log V (t) = κ[θ(t) − log V (t)]dt + σdWvQ (t),

with
dθ(t) = κ̄[θ̄ − θ(t)]dt + σ̄dWθQ (t), (7)

where WvQ (t) and WθQ (t) are independent Brownian motions. As we mentioned
before, an important deficiency of previously existing models is that they assume
that a volatility index mean reverts at a simple, non-negative exponential rate,
which is in fact 0 in the GBM model proposed by Whaley (1993). However, the
long, persistent swings in the VIX in Figure 1a suggest that we need to allow for
more complex dynamics. In this sense, we show in the Appendix that the exact
discretisation of log V (t) in the above model is a Gaussian ARMA(2,1) process,
which is consistent with the evidence reported in Section 2 (see Figure 2). As
discussed in Jegadeesh and Pennacchi (1996) and Balduzzi, Das, and Foresi (1998),
(7) allows the volatility index to revert towards a central tendency, which in turn,
fluctuates stochastically over time around a long run mean θ̄. As a consequence,
the conditional mean of log V (T ) is a function of the distance between log V (t)
and the central tendency θ(t), as well as the distance between θ(t) and θ̄.5 More
explicitly,

E Q [log V (T )|I(t)] = θ̄ + δ(τ )[θ(t) − θ̄]

+ exp(−κτ )[log V (t) − θ(t)], (8)

where
κ κ̄
δ(τ ) = exp(−κ̄τ ) − exp(−κτ ).
κ − κ̄ κ − κ̄
Importantly, this model can also be expressed as the “superposition” (i.e. sum) of
two log-OU processes. Therefore, the nested structure in (7) is not restrictive.6
5
Unlike in the log-OU model, the convergence of (8) to the long run mean is not necessarily a
monotonic function of τ .
6
The “component” Garch model proposed by Ding and Granger (1996) to capture “long memory”
features of volatility (see also Engle and Lee, 1999) can be regarded as a discrete time analogue to (7).

14
• Jumps (J):

λ
d log V (t) = κ[θ̄ − log V (t)]dt + σdW Q (t) + dZ(t) − dt, (9)
κδ

where Z(t) is a pure jump process independent of W Q (t), with intensity λ, and
whose jump amplitudes are exponentially distributed with mean 1/δ, or Exp(δ)
for short. Note that the last term in (9) simply introduces a constant shift in the
distribution of log V (t) which ensures that θ̄ remains the long-run mean of log V (t).
Jumps in models for instantaneous volatility have been previously considered by
Duffie, Pan, and Singleton (2000) and Eraker, Johannes, and Polson (2003), among
others, while Todorov and Tauchen (2010) also consider jumps in modelling the
VIX. Unlike pure diffusions, this model allows for sudden movements in volatility
indices, which nevertheless have lasting effects due to the fact that the mean-
reversion parameter κ is bounded.

• Stochastic volatility (SV):

p
d log V (t) = κ[θ̄ − log V (t)]dt + ω(t)dW Q (t)

where ω(t) follows an OU-Γ process, which belongs to the class of Lévy OU pro-
cesses considered by Barndorff-Nielsen and Shephard (2001). Specifically,

dω(t) = −λ̄ω(t)dt + dZ̄(t) (10)

where Z̄(t) is a pure jump process with intensity λ̄ and Exp(δ̄) jump amplitude,
while W Q (t) is an independent Brownian motion. We use this extension to assess to
what extent the price distortions in the previous models are due to the assumption
of constant volatility over time. Importantly, the model that we adopt is consistent
with the presence of mean reversion in ω(t), since

E Q [ω(T ))|ω(t)] = δ̄ −1 + exp(−λ̄τ ) ω(t) − δ̄ −1 .

 
(11)

Hence, δ̄ −1 can be interpreted as the long run mean of the instantaneous volatility
of the log VIX, while λ̄ will be the corresponding mean reversion parameter. An-
other non-trivial advantage of this model over other alternatives such as a square
root process for ω(t) is that it allows the valuation of derivatives by inverting the
conditional characteristic function (see the Appendix for details).

15
 • Central tendency and jumps (CTJ):

λ
d log V (t) = κ[θ(t) − log V (t)]dt + σdWvQ (t) + dZ(t) − dt (12)
κδ

where θ(t) follows the diffusion (7) and Z(t) is a pure jump process with intensity
λ and Exp(δ) jump amplitude, while WvQ (t) and WθQ (t) are independent Brownian
motions. We again introduce a constant shift in (12) to ensure that θ̄ is the long
run mean of both θ(t) and log V (t).

• Central tendency and stochastic volatility (CTSV):

p
d log V (t) = κ[θ(t) − log V (t)]dt + ω(t)dWVQ (t)

where θ(t) follows the diffusion (7) while ω(t) is defined in (10). As in previous
cases, the jump variable Z̄(t) and the Brownian motions are mutually independent.

Except for the CT model, it is not generally possible to price derivative contracts for
these extensions in closed form. However, it is possible to obtain the required prices by
Fourier inversion of the conditional characteristic function. In particular, we use formula
(5) in Carr and Madan (1999) to invert the relevant characteristic functions, which we
derive in the Appendix.
Some of the previous extensions introduce as additional factors a time varying ten-
dency (CT, CTJ), a time varying volatility (SV) or both (CTSV), which we need to
filter out for estimation purposes. In this regard, we use the standard Kalman filter to
“estimate” θ(t). And although the jump variable Z(t) in (9) can also be interpreted as
an additional factor, its impact cannot be separately identified from the impact of the
diffusion shocks dW Q (t) because both variables share the same mean reversion coefficient
κ. Finally, following Trolle and Schwartz (2009) and others, we employ the extended
Kalman filter to deal with ω(t) (see again the Appendix for further details).

5.2 Empirical performance

Table 3 reports the in- and out-of-sample RMSE’s of the extensions introduced in
the previous section. As expected, the CT model is able to yield much smaller RMSE’s
for futures than the standard log-OU model, both in- and out-of-sample. Therefore,
the inclusion of a time-varying mean seems to be crucial for adequately capturing the

16
behaviour of futures prices. At the same time, given that we show in the Appendix that
option prices do not depend on θ(t) once we condition on the current futures price, it is
not surprising that the difference in parameter estimates hardly affects the RMSE’s of
options.
In contrast, the introduction of jumps in the baseline log-OU process only introduces
a slight improvement for options. As for futures prices, jumps yield almost no change,
which is again to be expected because we can also show that jumps generate identical
futures prices as a log-OU model up to first order.7 Similarly, adding jumps to the
CT model does not introduce any remarkable improvements on futures, and only minor
gains for options. In this sense, it is important to emphasise that Table 3 does not
assess the importance of jumps on the historical dynamics of the VIX, only their pricing
implications.
But when we consider stochastic volatility, we observe the opposite effect: the im-
provement over the standard log-OU model is greater for options than for futures. Hence,
stochastic volatility turns out to be more important to value options, while central ten-
dency is crucial to price futures. Intuitively, the reason is that the futures formula (1)
only involves the conditional mean of V (T ), whereas (2) is more sensitive to higher order
moments, such as the volatility of volatility. Not surprisingly, we obtain the best results
when we combine central tendency and stochastic volatility. In particular, the pricing
performance of the CTSV model during the crisis (August 08 - March 10) is remarkably
good compared to the other models, even if we only focus on out-of-sample statistics. In
this sense, we would like to emphasise the good out-of-sample performance of the CTSV
model when we use the parameters estimated with data prior to August 08, which does
not include the more extreme period of the crisis. Hence, the CTSV is not only able to
describe the behaviour of the VIX during the financial crisis, but it also seems to be a
good model for the different phases of the VIX in bull and bear markets.
Figure 7 compares the daily RMSE’s of the CTSV model with the analogous series
for the standard log-OU model. Apart from the superior fit, we can clearly see that
the performance of the CTSV model is relatively stable over the entire sample. As an
alternative comparison, we also compute the empirical cumulative distribution functions
7
Formally, when we consider a Taylor expansion of the futures price formula of model J around λ/δ
for λ/δ > 0 but small, we only observe deviations from the standard log-OU expression for the second
and higher terms.

17
of the daily square pricing errors that the different models generate. The smaller the
errors, the more shifted to the left those distributions will be. In this respect, Figure 8
shows that the CTSV model dominates all the other models in the first order stochastic
sense. The ordering of the remaining models, though, depends on the type of derivative
asset considered. In the case of futures, the models with central tendency (CT, CTJ and
CTSV) provide an almost identical fit. In turn, they are followed by the SV, standard
log-OU, J, and SQR models. But for options, the second best model is SV, which is
followed by the CTJ, J, CT, standard log-OU and SQR models. Thus, we observe
again that a central tendency is relatively more important for futures, while stochastic
volatility offers greater gains on options. At the same time, a central tendency does not
harm the option pricing performance of the CTSV model, while stochastic volatility does
not cause any distortions to futures prices. As for jumps, Figure 8 confirms that they do
indeed help in pricing options but they hardly provide any improvement for futures. In
any case, compared to stochastic volatility, jumps seem to yield a minor improvement
even for options. Lastly, the SQR model undoubtedly offers the worst results, especially
for options.
Table 4 reports the parameter estimates that we obtain in the different extensions
of the log-OU model introduced in Section 5. In the models with central tendency we
observe fast mean reversion of log V (t) to θ(t), which in turn mean-reverts rather more
slowly to its long rung mean θ̄ (i.e. κ  κ̄). Interestingly, while the estimates of these
parameters are very stable, jump intensities vary substantially for the VIX depending
on the sample period considered for estimation. Specifically, we obtain smaller values
of λ when we include the crisis period. For the full sample, we estimate around 5
jumps per year in the J specification, and 12 jumps per year in the CTJ model. On the
other hand, the estimates of the mean reversion parameter λ̄ in the stochastic volatility
models tend to be larger when central tendency is not simultaneously included. Since
this parameter is also responsible for jump intensity in the OU-Γ model, this result has
two interesting implications. First, a smaller value of λ̄ tends to reduce jump activity
in Z̄(t). Specifically, the expected number of jumps per year decreases from 12 in the
SV model to less than 2 in the CTSV extension. Second, the deviations of ω(t) from
its long run mean are more persistent in the CTSV case because mean reversion is
slower the smaller λ̄ is, as (11) indicates. These features are also important from a time

18
series perspective. As mentioned before, central tendency is consistent with ARMA(2,1)
dynamics in discrete time, while stochastic volatility introduces Garch-type persistent
variances for the log VIX. Lastly, the prices of risk turn out to be insignificant for these
extensions, which implies that the real and risk neutral measures are not statistically
different.
Finally, Table 5 shows the contribution of futures, options and VIX to the log-
likelihood. Once again, notice that the introduction of central tendency leads to a
substantial increase in the contribution of futures to the log-likelihood but causes much
smaller increases in the other components. A similar effect is observed for options when
we introduce stochastic volatility. In addition, we can also observe that jumps are re-
sponsible for significant improvements in the goodness of fit of the model. Thus, jumps
seem to be a relevant feature to describe the process followed by the VIX, even though
they only yield second order gains for pricing VIX derivatives.

5.3 Evolution of the factors

Figure 9a shows that the filtered values of the central tendency factor θ(t) are rather
insensitive to the particular specification that we use. Similarly, Figure 9b indicates that
our preferred CTSV model also generates almost indistinguishable filtered values for
θ(t) across the different estimation subsamples that we consider. Not surprisingly, these
figures also confirm that the log of the VIX oscillates around θ(t), which in turn changes
over time rather more slowly. In fact, the main reason for central tendency models to
work so well during the recent financial crisis is because they allow for large temporal
deviations of θ(t) from its long term value θ̄, thereby reconciling the large increases of
the VIX observed during that period with mean reversion over the long term.
To assess the extent to which the filtered values of θ(t) are realistic, Figure 9c com-
pares the “actual” futures prices for a constant 30-day maturity, which we obtain by
interpolation of the adjacent contracts, with the daily estimates of 30-day futures prices
generated by the log-OU, CT and CTSV models. By focusing on a constant maturity,
we can not only compare the absolute magnitude of the pricing errors, as in Figure 7a,
but also their sign and persistence. As can be seen, the pricing errors of the log-OU
process are not only substantially larger than those of the two CT extensions, but they
also display much stronger persistence. For instance, the log-OU model systematically

19
overprices futures from the beginning of the sample until the summer of 2007, but it
has the opposite bias from October 2008 until the end of the sample. The slower mean
reverting properties of the VIX are probably responsible for these persistent biases in
the log-OU model. We can also observe that the pricing errors of the CT and CTSV
models are almost identical. This feature shows once again that central tendency is the
most relevant extension for pricing futures.
Figure 10a compares the filtered instantaneous volatilities of the SV and CTSV mod-
els. Interestingly, both series display an almost identical pattern, with substantial per-
sistent oscillations over time. As it was the case for the central tendency θ(t) in Figure
9b, Figure 10b confirms that the filtered values of ω(t) obtained from the CTSV model
are also quite insensitive to the sample period used to estimate the model parameters.
Finally, we compute the 30-day ahead standard deviations of log V (t) implied by
the CTSV model to assess the extent to which the filtered values of ω(t) make sense.
In Figure 10c we compare those standard deviations with the Black (1976) implied
volatilities of at-the-money options that are exactly 30-day from expiration, which we
again obtain by interpolation. The high correlation between the two series shows that
the filtered values of stochastic volatility are indeed related to the changing perceptions
of the market about the standard deviation of the VIX.

5.4 Term structures of derivatives and implied volatility skews

So far, we have focused on the overall empirical performance of the different models.
In principle, though, our results could change for different time horizons or different
degrees of moneyness. For that reason, Table 6 shows the RMSE’s of futures contracts
for different ranges of maturity. We observe that the models without central tendency
tend to yield larger distortions for longer maturities. In contrast, the models with central
tendency are relatively worse at pricing the shortest maturity. Nevertheless, even the
worst RMSE of the CTSV model is still much smaller than the best RMSE of either the
SQR or the log-OU models without central tendency.
To gain some additional insight, in Figure 11 we look at the term structure of fu-
tures prices for the four days considered in Figure 4c. This figure confirms that central
tendency is crucial for the purposes of reproducing the changes in the level and slope of
the actual term structure of VIX futures prices. We can also observe that the J model

20
and the standard log-OU process yields prices which are almost identical, while the CTJ
model can be barely distinguished from the CT extension.
Tables 7 and 8 provide the RMSE’s of calls and puts for different ranges of maturity
and moneyness. In this case, we generally observe the highest price distortions for at-the-
money call and put options. The SQR, standard log-OU, J, CT and CTJ models seem
to do a better job for moneyness smaller than −0.3. However, once again we can confirm
that stochastic volatility models provide the best fit uniformly across all moneyness and
maturity ranges.
In Figure 12 we consider the term structure of call prices for a given strike for the
same four days as in Figures 4c and 11. All models manage to capture reasonably well
the shape of the term structure of option prices, which was upward sloping on 16-July-
2007, 15-August-2008 and 31-March-2010, and downward sloping on 20-November-2008.
However, only those models with stochastic volatility are able to reproduce the level of
call options market prices. The remaining models either underprice (20-November-2008)
or overprice (remaining dates) calls for all maturities.
In Figures 13 and 14 we assess whether jumps or stochastic volatility are better
at capturing the actual implied volatility skews depicted in Figure 6. For the sake of
completeness, we have also plotted the implied volatilities generated by the standard
log-OU model and its CT extension. These figures show that while the introduction
of jumps can reproduce the positive slope of the actual implied vols, only stochastic
volatility seems to correctly capture both their level and slope. Finally, Figures 15 and
16 confirm that the CTSV captures rather well the term structure of implied volatilities
skews across different strikes and maturities.

6 Conclusions
We carry out an extensive empirical analysis of VIX derivatives valuation models.
We consider daily prices of futures and European options from February 2006 until
December 2010. Therefore we not only cover an unusually tranquil period, but also
the early turbulences that took place between August 2007 and August 2008, the worst
months of the recent financial crisis (Autumn 2008), as well as the months in 2010 in
which the European sovereign debt crisis aggravated. These markedly different periods
provide a very useful testing ground to assess the empirical performance of the different

21
pricing models. We estimate the models by pseudo maximum likelihood using not only
futures and options data, but also historical data on the VIX itself, which allows us
to look at the relationship between real and risk neutral measures. We initially focus
on the two existing mean-reversion models: the square root (SQR) and the log-normal
Ornstein-Uhlenbeck processes (log-OU). Although SQR is more popular in the empirical
literature, we find that the log-OU model yields a better fit for future prices, especially
during the crisis, as well as a better fit for options. However, both models yield large price
distortions during the crisis. In addition, they do not seem to capture either the level
or the slope of the term structure of futures and option prices, or indeed the volatility
skew. Part of the problem is that these models implicitly assume that volatility mean
reverts at a simple exponential rate, which cannot accommodate the long and persistent
swings of the VIX observed in our sample. In this sense, we show that the simple AR(1)
structure that they imply in discrete time is not consistent with the empirical evidence
of ARMA dynamics for the VIX. In addition, these models are also inconsistent with
the strong presence of Garch-type heteroskedasticity that we find in the VIX.
We investigate the potential sources of mispricing by considering several empirically
relevant generalisations of the standard log-OU model. In particular, we introduce a
time varying central tendency, jumps and stochastic volatility. Our parameter estimates
indicate that the VIX rapidly mean-reverts to a central tendency, which in turn reverts
more slowly to a long run constant mean. This flexible structure can reconcile the large
variations of the VIX over our sample period with mean-reversion to a long run constant
value. Except for the central tendency model, though, it is not generally possible to
price derivatives in closed form for the extensions that we consider. For that reason, we
obtain the required prices by Fourier inversion of the conditional characteristic function.
Interestingly, our results indicate that a time varying central tendency is crucial to
price futures. At the same time, it is not detrimental for the valuation of options. We
also find evidence of time varying volatility in the VIX. But stochastic volatility plays
a much more important role for options while leaving futures prices almost unaffected.
In contrast, jumps do not change futures prices (up to first order), and only provide
a minor improvement for options. Importantly, our results remain valid when we focus
exclusively on the out-of-sample performance with parameters estimated using data prior
to the Autumn of 2008. In view of these findings, we conclude that a generalised log-OU

22
model that combines a time varying central tendency with stochastic volatility is needed
to obtain a good pricing performance during bull and bear markets, as well as to capture
the term structures of VIX futures and options, and the implied volatilities of options.
Another interesting finding is that we do not obtain statistically significant values for
the prices of risk.
Given the relationship between the observed VIX index and the unobserved integrated
volatility of the S&P500, our analysis also has important implications for models of this
broad stock index commonly used by participants in markets for stock index options.
Specifically, our results imply that stochastic volatility models for the S&P500 should
allow for slow mean reversion, and a time-varying volatility of volatility. Amengual
(2009) considers such a model for volatility swaps.
We could extend our empirical exercise to other recently introduced volatility deriva-
tives such as binary options or American options on VIX futures, or even the futures
and options on the CBOE Gold ETF Volatility Index. The use of more sophisticated
filtering procedures for the volatility of VIX might also be worth exploring. It would also
be interesting to investigate the incremental information content of the contemporaneous
observations of the S&P500 over and above the spot VIX for pricing VIX futures, and
above and beyond VIX futures for pricing VIX options. This question is also relevant
for the purposes of integrating the valuation of VIX derivatives with the valuation of
the underlying options on the S&P500 that are used to compute this volatility index,
as suggested by Lin and Chang (2009). We plan to address these points in subsequent
research.

23
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26
A Extensions of log-OU processes
A.1 General case

The extensions that we consider belong to the class of affine jump-diffusion state
processes analysed by Duffie, Pan, and Singleton (2000). In particular, consider an
N -dimensional vector Y(t) that satisfies the diffusion
p
dY(t) = K(Θ − Y(t))dt + S(t)dW(t) + dZ(t),

where W(t) is an N -dimensional vector of independent standard Brownian motions, K

is an N × N matrix, Θ is a vector of dimension N , S(t) is a diagonal matrix of dimension
N whose ith diagonal element is ci0 + c0i1 Y(t), and finally, Z(t) is a multivariate pure
jump process with intensity λ whose jump amplitudes have joint density fJ (·).
Duffie, Pan, and Singleton (2000) show that the conditional characteristic function
of Y(T ) can be expressed as

φY (t, T, u) = E[exp(iu0 Y(T ))|I(t)]

= exp(ϕ0 (τ ) + ϕ0Y (τ )Y(t)),

where ϕ0 (τ ) and ϕY (τ ) satisfy the following system of differential equations:

1
ϕ̇Y (τ ) = −K0 ϕY (τ ) + ς Y (τ ),
2
1
ϕ̇0 (τ ) = Θ0 KϕY (τ ) + ϕ0Y (τ )diag(c0 )ϕY (τ ) + λ[J(ϕY (τ )) − 1],
2
where Z
J(u) = exp(u0 x)fJ (x)dx,

and ς Y (τ ) is an N -dimensional vector whose k th element is

ςY,k (τ ) = ϕ0Y (τ )diag(ck1 )ϕY (τ ).

If we place log V (t) as the first element in of Y(t), then the conditional characteristic
function of log V (t) will be
φ(t, T, u) = φY (t, T, u0 ),

where u0 = (u, 0, · · · , 0)0 . Following Carr and Madan (1999), the price of a call option
with strike K can then be expressed as
Z ∞
exp(−α log(K))
c(t, T, K) = exp(−iu log(K))ψ(u)du, (A1)
π 0

27
where
exp(−rτ )φ(t, T, u − (1 + α)i)
ψ(u) =
α2 + α − u2 + i(1 + 2α)u
and α is a smoothing parameter. We evaluate (A1) by numerical integration. In our
experience, α = 1.1 yields good results.
Given that the estimation algorithm requires the evaluation of the objective function
at many different parameter values, we linearise option prices with respect to ω(t) in
the models with stochastic volatility to speed up the calculations. Our procedure is
analogous to the treatment of other stochastic volatility models, which are sometimes
linearised to employ the Kalman filter (see e.g. Trolle and Schwartz, 2009). Specifically,
we linearise call prices for day t around the volatility of the previous day as follows:
  
1
cSV (t, T, K, ω(t)) ≈ cSV t, T, K, ω t −
360
   
∂cSV (t, T, K, x) 
 1
+ ω (t) − ω t − .
∂x  1
x=ω (t− 360 ) 360

Due to the high persistence of ω(t), its previous day value turns out to be a very good
predictor, which reduces the approximation error of the above expansion. In fact, the
linearisation error, expressed in terms of the RMSE’s of options, is very small: around
0.57% when we use data up to July 2007, and below 0.25% in the remaining samples. In
any case, we calculate the exact pricing errors once we have obtained the final parameter
estimates.

A.2 Central tendency

We specify the prices of risk that link the Wiener processes under P and Q as

dWvQ (t) = dWvP (t) + Λv (t)dt,

dWθQ (t) = dWθP (t) + Λθ (t)dt,

where Λv (t) = ς and Λθ (t) = ς¯. Hence, the diffusions under the real measure can be
expressed as

d log V (t) = κ[θP (t) − log V (t)]dt + σdWvP (t),

dθP (t) = κ̄[θ̄P − θP (t)]dt + σ̄dWθQ (t),

where
σς σ̄¯
ς
θ̄P = θ̄ + + ,
κ κ̄
28
and
σς
θP (t) = θ(t) + .
κ
Following León and Sentana (1997), it can be shown that the conditional distribution
of log V (T ) given information up to time t is Gaussian with mean µCT (t, τ ) given in (8)
and variance

σ2
ϕ2CT (τ ) = [1 − exp(−2κτ )]
2κ
 2 " 1−exp(−2κ̄τ ) 1−exp(−2κτ ) #
2 κ 2κ̄
+ 2κ
+σ̄ 1−exp(−(κ+κ̄)τ ) .
κ − κ̄ −2 κ+κ̄

By exploiting log-normality, we can write futures prices as

FCT (t, T, V (t), κ, θ, σ) = exp(µCT (t, τ ) + 0.5ϕ2CT (τ )),

while call prices follow the usual Black (1976) formula with volatility ϕCT (τ ).
In terms of time series dynamics, it can be shown that θ(t) and log V (t) jointly follow
a Gaussian VAR(1) if sampled at equally spaced intervals. Specifically,
   
θ(T ) θ(t)
= gτ + Fτ + ετ ,
log V (T ) log V (t)

where  
1 − exp(−κ̄τ )
gτ = κ θ̄,
1 − exp(−κτ ) − κ−κ̄ (exp(−κ̄τ ) − exp(−κτ ))
 
exp(−κ̄τ ) 0
Fτ = κ .
κ−κ̄
[exp(−κ̄τ ) − exp(−κτ )] exp(−κτ )
and ετ ∼ iid N (0, Στ ), where Στ is a symmetric 2 × 2 matrix with elements

σ̄ 2
Στ (1, 1) = [1 − exp(−2κ̄τ )]
2κ̄
κσ̄ 2 1 − exp(−2κ̄τ ) 1 − exp(−(κ + κ̄)τ )
 
Στ (1, 2) = −
κ − κ̄ 2κ̄ κ + κ̄
and Στ (2, 2) = ϕ2CT (τ ). From here, it is straightforward to obtain the marginal process
followed by log V (t), which corresponds to the following ARMA(2,1) model:

log V (t) = h0 (τ ) + h1 (τ ) log V (t − τ ) + h2 (τ ) log V (t − 2τ ) + u(t) + g(τ )u(t − τ )

29
where u(t), u(t − τ ), · · · ∼ iid N (0, p2 (τ )) and

h0 (τ ) = θ̄ (1 − h1 (τ ) − h2 (τ )) ,

h1 (τ ) = Fτ (1, 1) + Fτ (2, 2),

h2 (τ ) = −Fτ (1, 1)Fτ (2, 2),

 
2

0
g(τ )p (τ ) = Fτ (2, 1) −Fτ (1, 1) Στ ,
1
 
2 2

Fτ (2, 1)
(1 + g (τ ))p (τ ) = Fτ (2, 1) −Fτ (1, 1) Στ + Στ (2, 2).
−Fτ (1, 1)

A.3 Jumps

Once again, we assume that dWvQ (t) = dWvP (t) + ςdt holds and that jump risk is not
priced. Then, it can be shown that log V (t) satisfies the diffusion
λ
d log V (t) = κ[θ̄P − log V (t)]dt + σdWvP (t) − dt
κδ
under the real measure, where θ̄P = θ̄ + σς/κ.
The conditional characteristic function reduces to

φJ (t, T, u) = exp [ϕJ,0 (τ ) + ϕJ,V (τ ) log V (t)] ,

where
σ 2 u2
 
λ
ϕJ,0 (τ ) = iu θ̄ − [1 − exp(−κτ )] − [1 − exp(−2κτ )]
κδ 4κ
 
λ δ − iu exp(−κτ )
+ log
κ δ − iu
and
ϕJ,V (τ ) = iu exp(−κτ ).

A.4 Stochastic volatility

p
We consider a price of risk such that dWvQ (t) = dWvP (t) + ς ω(t)dt, but we again
assume that jump risk related to Z(t) is not priced. Then, the process under the real
measure can be expressed as
h ςγ i p
d log V (t) = κ θ̄ + ω(t) − log V (t) dt + γ ω(t)dW P (t),
κ
dω(t) = −λ̄ω(t)dt + dZ̄ P (t).

Since in this case the processes under the real and risk neutral measures are different,
we will describe them separately.

30
A.4.1 Risk neutral measure

The conditional characteristic function simplifies to

φSV (t, T, u) = exp [ϕSV,0 (τ ) + ϕSV,V (τ ) log V (t) + ϕSV,ω (τ )ω(t)] ,

where

ϕSV,V (τ ) = iu exp(−κτ ),
u2
ϕSV,ω (τ ) = [exp(−2κτ ) − exp(−λτ )] ,
2(2κ − λ)

and
ϕSV,0 (τ ) = iθ̄u[1 − exp(−κτ )] + λ [κ(τ, u) − τ ] ,

with Z τ
δ
κ(τ, u) = u2
dx. (A2)
0 δ− 2(2κ−λ)
[exp(−2κx) − exp(−λx)]

A.4.2 Real measure

We can write the characteristic function under the real measure as

φPSV (t, T, u) = E P [exp(iu log V (T ) + ivω(T ))|V (t), ω(t)]

= exp ϕPSV,0 (τ ) + ϕPSV,V (τ ) log V (t) + ϕPSV,ω (τ )ω(t) ,

 

where
ϕPSV,0 (τ ) = iuθ̄[1 − exp(−κτ )] + λ̄[κ(τ ) − τ ],

ϕPSV,V (τ ) = iu exp(−κτ ),

ς 
ϕPSV,ω (τ ) = iv exp(−λ̄τ ) − iu

exp(−κτ ) − exp(−λ̄τ )
κ − λ̄
u2  
+ exp(−2κτ ) − exp(−λ̄τ )
2(2κ − λ̄)

and
Z τ
δ
κ(τ ) = dx.
ς [exp(−κx)−exp(−λ̄x)] u2 [exp(−2κx)−exp(−λ̄x)]
0 δ − iv exp(−λ̄x) + iu −
κ−λ̄ 2(2κ−λ̄)

31
 Based on the characteristic function, it is possible to show that

E [log V (T )|V (t), ω(t)] = θ̄[1 − exp(−κτ )]

 
λ̄ς 1 − exp(−κτ ) 1 − exp(−λ̄τ )
− −
δ(κ − λ̄) κ λ̄
+ exp(−κτ ) log V (t)
ς  
− exp(−κτ ) − exp(−λ̄τ ) ω(t)
κ − λ̄
1
E [ω(T )|V (t), ω(t)] = [1 − exp(−λ̄τ )] + exp(−λ̄τ )ω(t),
δ
 
λ̄ 1 − exp(−λ̄τ ) 1 − exp(−2κτ )
V [log V (T )|V (t), ω(t)] = −
(2κ − λ̄)δ λ̄ 2κ
2
 
2ς λ̄ 1 − exp(−2κτ ) 1 − exp(−2λ̄τ ) 1 − exp(−(κ + λ̄)τ )
+ 2 + −2
δ (κ − λ̄)2 2κ 2λ̄ κ + λ̄
1  
+ exp(−λ̄τ ) − exp(−2κτ ) ω(t),
2κ − λ̄
1 − exp(−2λ̄τ )
V P [ω(T )|V (t), ω(t)] = ,
δ2
and
 
P 2ς λ̄ 1 − exp(−(κ + λ̄)τ ) 1 − exp(−2λ̄τ )
cov [log V (T ), ω(T )|V (t), ω(t)] = − 2 −
δ (κ − λ̄) κ + λ̄ 2λ̄

A.5 Central tendency and jumps

For this case we use the same prices of risk as in the CT model and assume that jump
risk is not priced. The, we obtain
λ
d log V (t) = κ[θP (t) − log V (t)]dt + σdWvP (t) + dZ(t) − dt,
κδ
dθP (t) = κ̄[θ̄P − θP (t)]dt + σ̄dWθQ (t),

under the real measure, where

σς σ̄¯
ς
θ̄P = θ̄ + + ,
κ κ̄
and
σς
θP (t) = θ(t) + .
κ
The conditional characteristic function becomes

φCT J (t, T, u) = E [exp(iu log V (T ) + ivθ(T )|V (t), θ(t)]

= exp [ϕCT J,0 (τ ) + ϕCT J,θ (τ )θ(t) + ϕCT J,V (τ ) log V (t)] ,

32
where

ϕCT J,0 (τ ) = iv θ̄ [1 − exp(−κ̄τ )]

   
λ κκ̄ 1 − exp(−κ̄τ ) 1 − exp(−κτ )
+iu θ̄ − −
κδ κ − κ̄ κ̄ κ
2 2 2 2
σ̄ v σ u
− [1 − exp(−2κ̄τ )] − [1 − exp(−2κτ )]
4κ̄ 4κ
2 
σ̄ 2 u2
 
κ 1 − exp(−2κ̄τ ) 1 − exp(−2κτ ) 1 − exp(−(κ + κ̄)τ )
− + −2
2 κ − κ̄ 2κ̄ 2κ κ + κ̄
 
2 κ 1 − exp(−2κ̄τ ) 1 − exp(−(κ + κ̄)τ )
−uvσ̄ −
κ − κ̄ 2κ̄ κ + κ̄
 
λ δ − iu exp(−κτ )
+ log
κ δ − iu
λ κ
−iu [exp(−κ̄τ ) − exp(−κτ )] ,
κδ κ − κ̄
κ
ϕCT J,θ (τ ) = iv exp(−κ̄τ ) + iu [exp(−κ̄τ ) − exp(−κτ )] ,
κ − κ̄
and
ϕCT J,V (τ ) = iu exp(−κτ ).

Using the characteristic function, we can show that

 
κ
E [log V (T )|V (t), θ(t)] = θ̄ 1 − exp(−κτ ) − (exp(−κ̄τ ) − exp(−κτ ))
κ − κ̄
κ
+ [exp(−κ̄τ ) − exp(−κτ )] θ(t) + exp(−κτ ) log V (t),
κ − κ̄

σ2
 
λ
V [log V (T )|V (t), θ(t)] = + 2 [1 − exp(−2κτ )]
2κ κδ
 2  
2 κ 1 − exp(−2κ̄τ ) 1 − exp(−2κτ ) 1 − exp(−(κ + κ̄)τ )
+σ̄ + −2 ,
κ − κ̄ 2κ̄ 2κ κ + κ̄
 
2 κ 1 − exp(−2κ̄τ ) 1 − exp(−(κ + κ̄)τ )
V [log V (T ), θ(T )|V (t), θ(t)] = σ̄ − .
κ − κ̄ 2κ̄ κ + κ̄

A.6 Central tendency and stochastic volatility

The price of risk is such that dWVQ (t) = dWVP (t)+ ς ω(t)dt and dWθQ (t) = dWθP (t)+
p

ς¯dt, which yields

h ςγ i p
d log V (t) = κ θ(t) + ω(t) − log V (t) dt + γ ω(t)dWVP (t),
κ
dθ(t) = κ̄[θ̄ − θ(t)]dt + σ̄dWθP (t),
P

dω(t) = −λ̄ω(t)dt + dZ̄ P (t),

33
under the real measure, where
ς¯σ̄
θ̄P = θ̄ + .
κ̄

A.6.1 Risk neutral measure

The conditional characteristic function is

 
ϕCT SV,0 (τ ) + ϕCT SV,V (τ ) log V (t)
φCT SV (t, T, u) = exp ,
+ϕCT SV,ω (τ )ω(t) + ϕCT SV,θ (τ )θ(t)
where

ϕCT SV,V (τ ) = iu exp(−κτ ),

u2
ϕCT SV,ω (τ ) = [exp(−2κτ ) − exp(−λτ )] ,
2(2κ − λ)
κ
ϕCT SV,θ (τ ) = iu [exp(−κ̄τ ) − exp(−κτ )] ,
κ − κ̄
and
 
κ 1 − exp(−κ̄τ ) 1 − exp(−κτ )
ϕCT SV,0 (τ ) = iuκ̄θ̄ −
κ − κ̄ κ̄ κ
 2 " 1−exp(−2κ̄τ ) 1−exp(−2κτ ) #
1 κ +
− σ̄ 2 u2 2κ̄ 2κ
1−exp(−(κ+κ̄)τ )
2 κ − κ̄ −2 κ+κ̄
+λ [κ(τ, u) − τ ] ,

with κ(τ, u) defined in (A2).

A.6.2 Real measure

We can write the characteristic function under the real measure as

φP (t, T, u1 , u2 , u3 ) = E [exp[iu1 log V (T ) + iu2 θ(T ) + iu3 ω(T )]|V (t), θ(t), ω(t)]

= exp ϕPCT SV,0 (τ ) + ϕPCT SV,V (τ ) log V (t) + ϕPCT SV,θ (τ )θ(t) + ϕPCT SV,ω (τ )ω(t) ,
 

where

ϕPCT SV,0 (τ ) = iu2 θ̄(1 − exp(−κ̄τ ))

 
κκ̄ 1 − exp(−κ̄τ ) 1 − exp(−κτ )
+iu1 θ̄ −
κ − κ̄ κ̄ κ
2
σ̄ 1 − exp(−2κ̄τ )
−u22
2 2κ̄
2
 2  
2 σ̄ κ 1 − exp(−2κ̄τ ) 1 − exp(−2κτ ) 1 − exp(−(κ + κ̄)τ )
−u1 + −2
2 κ − κ̄ 2κ̄ 2κ κ + κ̄
 
2 κ 1 − exp(−2κ̄τ ) 1 − exp(−(κ + κ̄)τ )
−u1 u2 σ̄ −
κ − κ̄ 2κ̄ κ + κ̄
+λ̄[κ(τ ) − τ ],

34
 ϕPCT SV,V (τ ) = iu1 exp(−κτ ),
κ
ϕPCT SV,θ (τ ) = iu2 exp(−κ̄τ ) + iu1 [exp(−κ̄τ ) − exp(−κτ )]
κ − κ̄
ς 
ϕPCT SV,ω (τ ) = iu3 exp(−λ̄τ ) − iu1

exp(−κτ ) − exp(−λ̄τ )
κ − λ̄
2
u1  
+ exp(−2κτ ) − exp(−λ̄τ )
2(2κ − λ̄)
and
Z τ
δ
κ(τ ) = dx.
ς [exp(−κx)−exp(−λ̄x)] u21 [exp(−2κx)−exp(−λ̄x)]
0 δ − iu3 exp(−λ̄x) + iu1 −
κ−λ̄ 2(2κ−λ̄)

Based on the characteristic function, it is possible to show that

 
P κκ̄ 1 − exp(−κ̄τ ) 1 − exp(−κτ )
E [log V (T )|V (t), θ(t), ω(t)] = θ̄ −
κ − κ̄ κ̄ κ
 
λ̄ς 1 − exp(−κτ ) 1 − exp(−λ̄τ )
− −
δ̄(κ − λ̄) κ λ̄
+ exp(−κτ ) log V (t)
κ
+ [exp(−κ̄τ ) − exp(−κτ )] θ(t)
κ − κ̄
ς  
− exp(−κτ ) − exp(−λ̄τ ) ω(t)
κ − λ̄
P
E [θ(T )|V (t), θ(t), ω(t)] = θ̄ [1 − exp(−κ̄τ )] + exp(−κ̄τ )θ(t)
1
E [ω(T )|V (t), θ(t), ω(t)] = [1 − exp(−λ̄τ )] + exp(−λ̄τ )ω(t),
δ̄
 
λ̄ 1 − exp(−λ̄τ ) 1 − exp(−2κτ )
V [log V (T )|V (t), θ(t), ω(t)] = −
(2κ − λ̄)δ̄ λ̄ 2κ
 2  
2 κ 1 − exp(−2κ̄τ ) 1 − exp(−2κτ ) 1 − exp(−(κ + κ̄)τ )
+σ̄ + −2
κ − κ̄ 2κ̄ 2κ κ + κ̄
2
 
2ς λ̄ 1 − exp(−2κτ ) 1 − exp(−2λ̄τ ) 1 − exp(−(κ + λ̄)τ )
+ 2 + −2
δ̄ (κ − λ̄)2 2κ 2λ̄ κ + λ̄
1  
+ exp(−λ̄τ ) − exp(−2κτ ) ω(t),
2κ − λ̄
1 − exp(−2κ̄τ )
V [θ(T )|V (t), θ(t), ω(t)] = σ̄ 2
2κ̄
1 − exp(−2λ̄τ )
V [ω(T )|V (t), θ(t), ω(t)] = ,
δ̄ 2
σ̄ 2 κ 1 − exp(−2κ̄τ ) 1 − exp(−(κ + κ̄)τ )
 
cov [log V (T ), θ(T )|V (t), θ(t), ω(t)] = −
κ − κ̄ 2κ̄ κ + κ̄
and
 
2ς λ̄ 1 − exp(−(κ + λ̄)τ ) 1 − exp(−2λ̄τ )
cov [log V (T ), ω(T )|V (t), θ(t), ω(t)] = − 2 −
δ̄ (κ − λ̄) κ + λ̄ 2λ̄

35
 Table 1
Root mean square pricing errors in standard one-factor models

(a) Futures

Validation
Model Estimation Feb 06-Aug 08 Aug 08-Mar 10 Apr 10-Dec 10 Full sample
SQR Full sample 3.818 11.675 10.645 8.517
Until Mar 10 4.108 12.491 11.120 9.065
Until Aug 08 2.602 7.480 8.514 5.850

Log-OU Full sample 3.597 5.914 5.056 4.755

Until Mar 10 3.033 6.380 5.699 4.883
Until Aug 08 1.958 6.659 7.123 5.032

(a) Options

Validation
Model Estimation Feb 06-Aug 08 Aug 08-Mar 10 Apr 10-Dec 10 Full sample
SQR Full sample 0.480 0.721 0.594 0.616
Until Mar 10 0.451 0.726 0.607 0.614
Until Aug 08 0.353 0.962 0.821 0.767

Log-OU Full sample 0.322 0.494 0.471 0.436

Until Mar 10 0.313 0.497 0.487 0.440
Until Aug 08 0.306 0.553 0.557 0.484

Notes: The root mean square errors that correspond to out-of-sample periods are reported in italics.
“SQR” denotes square root model while “log-OU” refers to the log-normal Ornstein-Uhlenbeck process.

36
 Table 2
Parameters estimates of the standard one-factor models under the real measure

Model Estimation κ θ̄ σ ς σf σo
SQR Full Sample 2.977 24.313 5.226 0.283 0.358 0.616
(0.360) (2.936) (0.006) (0.069) (0.001) (0.000)
Until Mar 10 3.310 24.303 5.303 0.327 0.396 0.616
(0.404) (2.957) (0.008) (0.076) (0.002) (0.000)
Until Aug 08 1.769 19.234 3.535 0.068 0.171 0.353
(0.368) (3.983) (0.006) (0.104) (0.001) (0.000)

Log-OU Full Sample 2.936 3.099 0.958 0.018 0.189 0.436

(0.005) (0.128) (0.000) (0.392) (0.001) (0.000)
Until Mar 10 2.788 3.093 0.927 0.146 0.182 0.423
(0.007) (0.140) (0.001) (0.421) (0.001) (0.000)
Until Aug 08 1.795 2.923 0.793 0.135 0.100 0.306
(0.010) (0.205) (0.001) (0.463) (0.001) (0.000)

Notes: “SQR” denotes square root model while “log-OU” refers to the log-normal Ornstein-Uhlenbeck
process. Standard errors, displayed in parentheses, have been obtained by using the outer-product of
the score to estimate the information matrix.

37
 Table 3
Root mean square pricing errors in the extended log-OU models

(a) Futures
Validation
Extension Estimation Feb 06-Aug 08 Aug 08-Mar 10 Apr 10-Dec 10 Full sample
CT Full sample 0.372 0.847 0.792 0.646
Until Mar 10 0.348 0.773 1.004 0.653
Until Aug 08 0.332 0.786 1.056 0.667

J Full sample 3.748 6.173 5.080 4.928

Until Mar 10 3.191 6.669 5.731 5.070
Until Aug 08 2.036 7.000 7.270 5.238

SV Full sample 2.234 4.821 4.873 3.782

Until Mar 10 1.853 5.134 5.344 3.921
Until Aug 08 1.756 5.720 5.662 4.239

CTJ Full sample 0.382 0.900 0.747 0.665

Until Mar 10 0.353 0.804 0.913 0.646
Until Aug 08 0.339 0.817 0.956 0.658

CTSV Full sample 0.377 0.839 0.901 0.666

Until Mar 10 0.346 0.786 1.025 0.663
Until Aug 08 0.359 0.787 1.147 0.697

(b) Options
Validation
Extension Estimation Feb 06-Aug 08 Aug 08-Mar 10 Apr 10-Dec 10 Full sample
CT Full sample 0.312 0.482 0.471 0.428
Until Mar 10 0.299 0.483 0.493 0.432
Until Aug 08 0.286 0.517 0.554 0.462

J Full sample 0.285 0.459 0.386 0.389

Until Mar 10 0.280 0.457 0.412 0.393
Until Aug 08 0.272 0.506 0.467 0.429

SV Full sample 0.201 0.241 0.275 0.237

Until Mar 10 0.199 0.242 0.277 0.238
Until Aug 08 0.196 0.247 0.281 0.240

CTJ Full sample 0.271 0.449 0.389 0.381

Until Mar 10 0.263 0.448 0.424 0.388
Until Aug 08 0.250 0.476 0.468 0.410

CTSV Full sample 0.178 0.212 0.227 0.205

Until Mar 10 0.177 0.212 0.231 0.205
Until Aug 08 0.174 0.219 0.236 0.209

Notes: The root mean square errors that correspond to out-of-sample periods are reported in italics.
“CT” indicates time varying Central Tendency. “J” refers to jumps. “SV” denotes Stochastic Volatility.
“CTJ” combines CT and J. “CTSV” combines CT and SV.

38
 Table 4. Parameters estimates of the extended log-OU models under the real measure

Extension Estimation κ κ̄ θ̄ λ δ σ σ̄ λ̄ δ̄ ς ς¯ σf σo
CT Full Sample 6.664 0.345 2.957 - - 1.155 0.465 - - -0.129 0.113 0.024 0.428
(0.017) (0.003) (0.640) - - (0.001) (0.001) - - (0.505) (0.486) (0.000) (0.000)
Until Mar 10 8.094 0.420 2.946 - - 1.189 0.480 - - -0.019 0.117 0.021 0.410
(0.026) (0.003) (0.585) - - (0.001) (0.001) - - (0.586) (0.529) (0.000) (0.000)
Until Aug 08 7.927 0.457 2.830 - - 1.107 0.483 - - -0.073 0.040 0.019 0.286
(0.048) (0.006) (0.759) - - (0.002) (0.001) - - (0.706) (0.739) (0.000) (0.000)

J Full Sample 3.185 - 3.097 4.992 4.999 0.692 - - - -0.006 - 0.196 0.389
(0.005) - (0.113) (0.245) (0.086) (0.005) - - - (0.521) - (0.001) (0.000)
Until Mar 10 3.048 - 3.090 5.349 5.495 0.694 - - - 0.169 - 0.191 0.387
(0.007) - (0.125) (0.370) (0.131) (0.006) - - - (0.548) - (0.001) (0.000)
Until Aug 08 1.946 - 2.913 20.568 9.198 0.338 - - - 0.270 - 0.104 0.272
(0.008) - (0.180) (1.363) (0.211) (0.016) - - - (1.035) - (0.001) (0.000)

SV Full Sample 1.117 - 3.063 - - - - 12.789 2.220 0.741 - 0.138 0.239

(0.004) - (0.002) - - - - (0.036) (0.004) (0.385) - (0.001) (0.000)
Until Mar 10 0.960 - 2.978 - - - - 13.278 2.452 0.773 - 0.123 0.225
(0.004) - (0.002) - - - - (0.038) (0.005) (0.426) - (0.001) (0.000)
Until Aug 08 0.696 - 2.874 - - - - 14.321 3.052 0.678 - 0.091 0.198

39
(0.006) - (0.003) - - - - (0.120) (0.011) (0.552) - (0.000) (0.000)

CTJ Full Sample 5.947 0.334 2.961 12.315 5.944 0.672 0.438 - - -0.187 0.109 0.024 0.381
(0.015) (0.004) (0.594) (0.157) (0.017) (0.005) (0.001) - - (0.743) (0.462) (0.000) (0.000)
Until Mar 10 7.205 0.404 2.953 20.480 7.207 0.660 0.459 - - -0.010 0.115 0.021 0.375
(0.023) (0.003) (0.563) (0.320) (0.025) (0.007) (0.001) - - (0.907) (0.510) (0.000) (0.000)
Until Aug 08 7.088 0.437 2.834 19.361 6.996 0.582 0.482 - - -0.068 0.046 0.019 0.250
(0.038) (0.007) (0.803) (0.517) (0.041) (0.012) (0.001) - - (1.228) (0.744) (0.000) (0.000)

CTSV Full Sample 7.813 0.354 2.827 - - - 0.226 1.383 0.273 0.247 0.026 0.024 0.206
(0.010) (0.003) (0.177) - - - (0.001) (0.006) (0.001) (0.425) (0.277) (0.000) (0.000)
Until Mar 10 7.989 0.425 2.783 - - - 0.267 1.226 0.269 0.324 0.004 0.021 0.198
(0.013) (0.003) (0.206) - - - (0.001) (0.007) (0.001) (0.480) (0.328) (0.000) (0.000)
Until Aug 08 8.376 0.469 2.855 - - - 0.269 0.542 0.173 -1.412 0.178 0.019 0.174
(0.032) (0.006) (0.273) - - - (0.002) (0.011) (0.002) (0.186) (0.477) (0.000) (0.000)

Notes: “CT” indicates Central Tendency, a log-OU process where the long run mean follows another log-OU diffusion. “J” introduces jumps in the standard
log-OU model, whose size follows an exponential distribution. “SV” denotes Stochastic Volatility, a log-OU model where the volatility is a Gamma OU Lévy
process. “CTJ” combines central tendency and jumps. “CTSV” combines central tendency and stochastic volatility. Standard errors, displayed in parentheses,
have been obtained by using the outer-product of the score to estimate the information matrix.
 Table 5
Contribution to the log-likelihood of futures, options and VIX

Log-OU models
Data SQR Standard CT J SV CTJ CTSV
Futures -3398.6 2145.4 19222.4 1838.0 4919.5 19140.3 19363.2
Options -82136.7 -51811.8 -50119.4 -41647.9 61.8 -39919.7 12207.8
VIX -2460.4 1313.2 1410.7 1294.0 1323.7 1385.7 1417.6
Total -87995.7 -48353.2 -29486.3 -38515.9 6305.0 -19393.7 32988.6

Notes: “SQR” denotes square root model and “log-OU” refers to a log-normal Ornstein-Uhlenbeck
process. “CT” indicates Central Tendency, a log-OU process where the long run mean follows an-
other log-OU diffusion. “J” introduces jumps in the standard log-OU model, whose size follows an
exponential distribution. “SV” denotes Stochastic Volatility, a log-OU model where the volatility
is a Gamma OU Lévy process. “CTJ” combines central tendency and jumps. “CTSV” combines
central tendency and stochastic volatility.

40
 Table 6
Root mean square pricing errors of futures prices by maturity

Log-OU models
Maturity N SQR Standard CT J SV CTJ CTSV
Less than 1 month 1036 2.846 1.922 0.999 1.954 2.344 1.035 0.975
From 1 to 3 months 2290 6.760 3.811 0.819 3.954 3.837 0.865 0.821
From 3 to 6 months 3093 9.786 5.015 0.421 5.232 4.043 0.415 0.468
More than 6 months 2246 9.880 6.007 0.471 6.189 3.887 0.460 0.532
Total 8665 8.517 4.755 0.646 4.928 3.782 0.665 0.666

Notes: “SQR” denotes square root model and “log-OU” refers to a log-normal Ornstein-Uhlenbeck
process. “CT” indicates Central Tendency, a log-OU process where the long run mean follows an-
other log-OU diffusion. “J” introduces jumps in the standard log-OU model, whose size follows an
exponential distribution. “SV” denotes Stochastic Volatility, a log-OU model where the volatility
is a Gamma OU Lévy process. “CTJ” combines central tendency and jumps. “CTSV” combines
central tendency and stochastic volatility. The column labeled N gives the number of prices per
category. Results are based on full sample estimates.

41
 Table 7
Root mean square pricing errors of call prices by moneyness and maturities

(a) τ < 1 month

Log-OU models
Moneyness N SQR Standard CT J SV CTJ CTSV
< −0.3 2199 0.165 0.133 0.131 0.145 0.120 0.145 0.123
[−0.3, −0.1) 2080 0.529 0.354 0.364 0.401 0.183 0.381 0.206
[−0.1, 0.1) 2260 0.792 0.534 0.516 0.567 0.241 0.512 0.240
[0.1, 0.3) 2254 0.694 0.542 0.462 0.436 0.288 0.408 0.241
≥ 0.3 3085 0.372 0.339 0.307 0.215 0.223 0.215 0.189

(b) 1 month< τ < 3 months

Log-OU models
Moneyness N SQR Standard CT J SV CTJ CTSV
< −0.3 3553 0.324 0.205 0.202 0.172 0.194 0.172 0.184
[−0.3, −0.1) 4217 0.665 0.452 0.447 0.380 0.254 0.374 0.219
[−0.1, 0.1) 4701 0.728 0.492 0.488 0.478 0.161 0.475 0.151
[0.1, 0.3) 4638 0.711 0.469 0.467 0.437 0.227 0.435 0.200
≥ 0.3 8089 0.505 0.377 0.382 0.261 0.239 0.262 0.170

(c) τ > 3 months

Log-OU models
Moneyness N SQR Standard CT J SV CTJ CTSV
< −0.3 3229 0.435 0.256 0.261 0.185 0.230 0.199 0.213
[−0.3, −0.1) 3719 0.626 0.451 0.426 0.362 0.276 0.353 0.188
[−0.1, 0.1) 4491 0.570 0.435 0.412 0.422 0.207 0.402 0.197
[0.1, 0.3) 3971 0.677 0.474 0.480 0.451 0.270 0.441 0.231
≥ 0.3 5613 0.651 0.447 0.470 0.313 0.284 0.333 0.230

(d) All maturities

Log-OU models
Moneyness N SQR Standard CT J SV CTJ CTSV
< −0.3 8981 0.341 0.211 0.212 0.171 0.193 0.176 0.183
[−0.3, −0.1) 10016 0.624 0.433 0.423 0.378 0.250 0.368 0.205
[−0.1, 0.1) 11452 0.685 0.480 0.466 0.477 0.197 0.456 0.190
[0.1, 0.3) 10863 0.695 0.487 0.471 0.442 0.257 0.432 0.221
≥ 0.3 16787 0.539 0.395 0.402 0.272 0.252 0.280 0.196

Notes: Moneyness is defined as log(K/F (t, T )), where K and F (t, T ) are the strike and futures prices,
respectively. “SQR” denotes square root model and “log-OU” refers to a log-normal Ornstein-Uhlenbeck
process. “CT” indicates Central Tendency, a log-OU process where the long run mean follows another
log-OU diffusion. “J” introduces jumps in the standard log-OU model, whose size follows an exponential
distribution. “SV” denotes Stochastic Volatility, a log-OU model where the volatility is a Gamma OU
Lévy process. “CTJ” combines central tendency and jumps. “CTSV” combines central tendency and
stochastic volatility. The column labeled N gives the number of prices per category. τ denotes time to
maturity. Results are based on full sample estimates.

42
 Table 8
Root mean square pricing errors of put prices by moneyness and maturities

(a) τ < 1 month

Log-OU models
Moneyness N SQR Standard CT J SV CTJ CTSV
< −0.3 457 0.262 0.213 0.193 0.256 0.139 0.256 0.151
[−0.3, −0.1) 1657 0.574 0.394 0.405 0.447 0.196 0.425 0.223
[−0.1, 0.1) 2239 0.800 0.540 0.529 0.569 0.246 0.520 0.251
[0.1, 0.3) 1787 0.753 0.586 0.507 0.484 0.296 0.459 0.253
≥ 0.3 1385 0.424 0.386 0.355 0.283 0.240 0.283 0.216

(b) 1 month< τ < 3 months

Log-OU models
Moneyness N SQR Standard CT J SV CTJ CTSV
< −0.3 1970 0.347 0.245 0.240 0.237 0.234 0.244 0.211
[−0.3, −0.1) 4274 0.662 0.466 0.460 0.399 0.253 0.393 0.213
[−0.1, 0.1) 3966 0.743 0.512 0.511 0.496 0.169 0.495 0.152
[0.1, 0.3) 2272 0.802 0.550 0.546 0.504 0.236 0.507 0.211
≥ 0.3 1505 0.575 0.436 0.431 0.323 0.252 0.321 0.204

(c) τ > 3 months

Log-OU models
Moneyness N SQR Standard CT J SV CTJ CTSV
< −0.3 1698 0.428 0.294 0.292 0.280 0.249 0.287 0.218
[−0.3, −0.1) 2764 0.642 0.487 0.461 0.412 0.294 0.408 0.206
[−0.1, 0.1) 2174 0.661 0.493 0.480 0.484 0.229 0.477 0.214
[0.1, 0.3) 990 0.867 0.592 0.609 0.556 0.293 0.561 0.260
≥ 0.3 633 0.637 0.457 0.469 0.374 0.268 0.376 0.319

(d) All maturities

Log-OU models
Moneyness N SQR Standard CT J SV CTJ CTSV
< −0.3 4125 0.375 0.263 0.258 0.257 0.232 0.264 0.208
[−0.3, −0.1) 8695 0.639 0.460 0.450 0.413 0.257 0.404 0.213
[−0.1, 0.1) 8379 0.739 0.515 0.508 0.513 0.208 0.497 0.199
[0.1, 0.3) 5049 0.798 0.571 0.546 0.508 0.270 0.502 0.237
≥ 0.3 3523 0.534 0.421 0.410 0.318 0.251 0.318 0.233

Notes: Moneyness is defined as log(K/F (t, T )), where K and F (t, T ) are the strike and futures prices,
respectively. “SQR” denotes square root model and “log-OU” refers to a log-normal Ornstein-Uhlenbeck
process. “CT” indicates Central Tendency, a log-OU process where the long run mean follows another
log-OU diffusion. “J” introduces jumps in the standard log-OU model, whose size follows an exponential
distribution. “SV” denotes Stochastic Volatility, a log-OU model where the volatility is a Gamma OU
Lévy process. “CTJ” combines central tendency and jumps. “CTSV” combines central tendency and
stochastic volatility. The column labeled N gives the number of prices per category. τ denotes time to
maturity. Results are based on full sample estimates.

43
 Figure 1: Historical evolution of the VIX index

(a) 1990-2010

80

70

60

50

40

30

20

10

May90 Jan93 Oct95 Jul98 Apr01 Jan04 Oct06 Jul09

(b) 2006-2010
90
20−Nov−08

80

70

60

16−Jul−07 15−Aug−08 31−Mar−10

50

40

30

20

10

Mar06 Oct06 Apr07 Nov07 Jun08 Dec08 Jul09 Jan10 Aug10

 Figure 2: Time series autocorrelations of the log-VIX and estimated ARMA models

(a) Autocorrelations
1
AR(1)
ARMA(1,1)
0.98
ARMA(2,1)
Actual
0.96

0.94

0.92

0.9

0.88

0.86
1 2 3 4 5 6 7 8 9 10

(b) Partial autocorrelations

0.12
AR(1)
ARMA(1,1)
0.1
ARMA(2,1)
Actual
0.08

0.06

0.04

0.02

−0.02
2 3 4 5 6 7 8 9 10

Note: Results are based on the 1990-2010 sample (5280 daily observations).
 Figure 3a: Number of futures prices per day
10

1
Mar06 Oct06 Apr07 Nov07 Jun08 Dec08 Jul09 Jan10 Aug10

Figure 3b: Number of option prices per day

140

Calls
120 Puts

100

80

60

40

20

0
Mar06 Oct06 Apr07 Nov07 Jun08 Dec08 Jul09 Jan10 Aug10
 Figure 4a: Term structure of VIX futures

60

40

20

8
6 Nov10
4 Jul09
Feb08
Months to expiration 2 Oct06 Date

Figure 4b: VIX futures prices vs. VIX index

80
VIX
Futures
70

60

50

40

30

20

10
Mar06 Oct06 Apr07 Nov07 Jun08 Dec08 Jul09 Jan10 Aug10

Figure 4c: Term structure of VIX futures at four particular days

1 2 3 4 5 6 7 8
35 70
16/07/2007 (left)
15/08/2008 (left)
20/11/2008 (right) 60
31/03/2010 (left)
30

50

25 40

30

20

20

15 10
1 2 3 4 5 6 7 8
 Figure 5: Daily root mean square errors of standard one-factor pricing models

(a) Futures
25
SQR
Log−OU

20

15

10

0
Mar06 Oct06 Apr07 Nov07 Jun08 Dec08 Jul09 Jan10 Aug10

(b) Options
2.5
SQR
Log−OU

1.5

0.5

0
Mar06 Oct06 Apr07 Nov07 Jun08 Dec08 Jul09 Jan10 Aug10

Note: “SQR” denotes square root model and “log-OU” refers to a log-normal Ornstein-Uhlenbeck
process. Results are based on full sample estimates.
 Figure 6: Implied volatilities of call prices

(a) 16-July-2007 (b) 15-August-2008

0.45 0.45

0.4 0.4

Log−OU, 91 days Log−OU, 94 days

0.35 0.35
Log−OU, 67 days
Log−OU, 63 days

0.3 91 days 63 days 0.3 94 days 67 days

Log−OU, 36 days
36 days Log−OU, 32 days
0.25 0.25
32 days

0.2 0.2

0.15 0.15
−0.25 −0.2 −0.15 −0.1 −0.05 0 0.05 0.1 0.15 0.2 0.25 −0.25 −0.2 −0.15 −0.1 −0.05 0 0.05 0.1 0.15 0.2 0.25

Moneyness Moneyness

(c) 20-November-2008 (d) 31-March-2010

0.45 0.45

0.4 88 days 0.4

61 days
Log−OU, 111 days
0.35 Log−OU, 88 days 0.35 111 days
Log−OU, 76 days
Log−OU, 61 days 76 days
27 days
0.3 0.3

0.25 0.25
Log−OU, 27 days 21 days
Log−OU, 21 days
0.2 0.2

0.15 0.15
−0.25 −0.2 −0.15 −0.1 −0.05 0 0.05 0.1 0.15 0.2 0.25 −0.25 −0.2 −0.15 −0.1 −0.05 0 0.05 0.1 0.15 0.2 0.25

Moneyness Moneyness

Note: Implied volatilities have been obtained by inverting the Black (1976) call price formula (5).
Moneyness is defined as log(K/F (t, T )).
Figure 7: Daily root mean square errors of standard log-OU and central tendency log-OU
with stochastic volatility

(a) Futures

Standard log−OU
CTSV
12

10

Mar06 Oct06 Apr07 Nov07 Jun08 Dec08 Jul09 Jan10 Aug10

(b) Options
1.6

Standard log−OU
1.4 CTSV

1.2

0.8

0.6

0.4

0.2

Mar06 Oct06 Apr07 Nov07 Jun08 Dec08 Jul09 Jan10 Aug10

Notes: “Standard log-OU” refers to a log-normal Ornstein-Uhlenbeck process. “CTSV” generalises

the standard log-OU by introducing a time varying central tendency and stochastic volatility.
Results are based on full sample estimates.
 Figure 8: Empirical cumulative distribution function of the square pricing errors

(a) Futures
1

0.9 SQR
Standard log−OU
0.8
CT
J
0.7
SV
0.6 CTJ
CTSV
0.5

0.4

0.3

0.2

0.1

0
0 0.5 1 1.5 2 2.5 3 3.5 4

(b) Options
1

0.9

0.8

0.7

0.6

0.5

0.4 SQR
Standard log−OU
0.3 CT
J
0.2 SV
CTJ
0.1 CTSV

0
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4

Notes: “SQR” denotes square root model and “log-OU” refers to a log-normal Ornstein-Uhlenbeck
process. “J” introduces jumps in the standard log-OU model, whose size follows an exponential
distribution. “CT” indicates Central Tendency, a log-OU process where the long run mean follows
another log-OU diffusion. “SV” denotes Stochastic Volatility, a log-OU model where the volatility
is a Gamma OU Lévy process. “CTJ” combines central tendency and jumps. “CTSV” combines
central tendency and stochastic volatility. Results are based on full sample estimates.
 Figure 9a: Filtered θ(t) for different log-OU models with central tendency
4.5
log(VIX)
CT
CTJ
4
CTSV

3.5

2.5

2
Mar06 Oct06 Apr07 Nov07 Jun08 Dec08 Jul09 Jan10 Aug10

Figure 9b: Filtered θ(t) for different estimation samples in the log-OU model with central
tendency and stochastic volatility
4.5
log(VIX)
Until Aug08
Until Mar10
4
Full Sample

3.5

2.5

2
Mar06 Oct06 Apr07 Nov07 Jun08 Dec08 Jul09 Jan10 Aug10

Figure 9c: Differences between model-based and actual one-month futures prices
12
log−OU
10
CT
8 CTSV

−2

−4

−6

−8

−10
Mar06 Oct06 Apr07 Nov07 Jun08 Dec08 Jul09 Jan10 Aug10

Notes: θ(t) denotes the time varying central tendency around which the VIX mean-reverts in central
tendency models. “CT” indicates Central Tendency, a log-OU process where the long run mean follows
another log-OU diffusion. “CTJ” combines central tendency and jumps with exponential sizes. “CTSV”
combines central tendency and stochastic volatility. Results in Figures 9a and 9c are based on full sample
estimates. One month actual futures prices in Figure 9c have been obtained by interpolation of the prices
at the adjacent maturities.
 Figure 10a: Filtered ω(t) for different log-OU models with stochastic volatility
Mar06 Oct06 Apr07 Nov07 Jun08 Dec08 Jul09 Jan10 Aug10
4.5 4
log(VIX) (left)
SV (right) 3.5
CTSV (right)
4
3

2.5
3.5

3
1.5

1
2.5
0.5

2 0
Mar06 Oct06 Apr07 Nov07 Jun08 Dec08 Jul09 Jan10 Aug10

Figure 10b: Filtered ω(t) for different estimation samples in the log-OU model with central
tendency and stochastic volatility
4
Until Aug08
3.5 Until Mar10
Full sample
3

2.5

1.5

0.5

0
Mar06 Oct06 Apr07 Nov07 Jun08 Dec08 Jul09 Jan10 Aug10

Figure 10c: One month volatilities of the VIX

0.5
Implied volatility of one−month at−the−money options
0.45 One month ahead std. dev. of log(VIX) under CTSV

0.4

0.35

0.3

0.25

0.2

0.15
Mar06 Oct06 Apr07 Nov07 Jun08 Dec08 Jul09 Jan10 Aug10

Notes: Different vertical scales are used for the VIX and the volatilities in Figure 9a. “SV” denotes a
log-OU model with stochastic volatility, while “CTSV” refers to a log-OU model with central tendency
and stochastic volatility. One-month implied vols in Figure 9c have been obtained by interpolation of the
implied vols of options with moneyness | log(K/F (t, T ))| < .1, which in turn result from inverting the
Black (1976) call price formula. Results in Figures 10a and 10c are based on full sample estimates.
 Figure 11: Fit of the term structure of futures prices

(a) 16-July-2007 (b) 15-August-2008

25 25
Actual
24 SQR 24
Standard log−OU
23 CT 23
J
22 SV 22
CTJ
21 CTSV 21

20 20

19 19

18 18

17 17

16 16
2 3 4 5 6 7 8 9 10 11 2 3 4 5 6 7

Months to maturity Months to maturity

(c) 20-November-2008 (d) 31-March-2010

70 25

65 24

60 23

55 22

50 21

45 20

40 19

35 18

30 17

25 16
1 2 3 4 5 6 7 8 1 2 3 4 5 6 7

Months to maturity Months to maturity

Notes: “SQR” denotes square root model and “log-OU” refers to a log-normal Ornstein-Uhlenbeck process.
“J” introduces jumps in the standard log-OU model, whose size follows an exponential distribution. “CT”
indicates Central Tendency, a log-OU process where the long run mean follows another log-OU diffusion.
“SV” denotes Stochastic Volatility, a log-OU model where the volatility is a Gamma OU Lévy process.
“CTJ” combines central tendency and jumps. “CTSV” combines central tendency and stochastic volatility.
Results are based on full sample estimates.
 Figure 12: Fit of the term structure of call prices for fixed strikes

(a) 16-July-2007, Strike=15 (b) 15-August-2008, Strike=20

5.5 5.5
Actual
SQR
5 5
Standard log−OU
CT
4.5 J 4.5
SV
CTJ
4 CTSV 4

3.5 3.5

3 3

2.5 2.5

2 2
2 3 4 5 6 7 8 9 10 1.5 2 2.5 3 3.5 4 4.5 5

Months to maturity Months to maturity

(c) 20-November-2008, Strike=60 (d) 31-March-2010, Strike=25

12 3.5

11
3
10

9 2.5

8
2
7
1.5
6

5 1

4
0.5
3

2 0
1 1.5 2 2.5 3 3.5 4 4.5 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5

Months to maturity Months to maturity

Notes: “SQR” denotes square root model and “log-OU” refers to a log-normal Ornstein-Uhlenbeck process.
“J” introduces jumps in the standard log-OU model, whose size follows an exponential distribution. “CT”
indicates Central Tendency, a log-OU process where the long run mean follows another log-OU diffusion.
“SV” denotes Stochastic Volatility, a log-OU model where the volatility is a Gamma OU Lévy process.
“CTJ” combines central tendency and jumps. “CTSV” combines central tendency and stochastic volatility.
Results are based on full sample estimates.
 Figure 13: Fit of the implied volatilities of call prices (i)

(a) 16-July-2007. τ = 36 days (b) 16-July-2007. τ = 63 days (c) 16-July-2007. τ = 91 days

0.45 0.45 0.45
Actual
0.4 Standard log−OU 0.4 0.4
CT
CTJ
0.35 CTSV 0.35 0.35

0.3 0.3 0.3

0.25 0.25 0.25

0.2 0.2 0.2

0.15 0.15 0.15

−0.2 −0.1 0 0.1 0.2 −0.2 −0.1 0 0.1 0.2 −0.2 −0.1 0 0.1 0.2

Moneyness Moneyness Moneyness

(d) 15-August-2008. τ = 32 days (e) 15-August-2008. τ = 67 days (f) 15-August-2008. τ = 94 days

0.45 0.45 0.45

0.4 0.4 0.4

0.35 0.35 0.35

0.3 0.3 0.3

0.25 0.25 0.25

0.2 0.2 0.2

0.15 0.15 0.15

−0.2 −0.1 0 0.1 0.2 −0.2 −0.1 0 0.1 0.2 −0.2 −0.1 0 0.1 0.2

Moneyness Moneyness Moneyness

Note: Implied volatilities have been obtained by inverting the Black (1976) call price formula. Moneyness is defined as log(K/F (t, T )). “Log-
OU” refers to a log-normal Ornstein-Uhlenbeck process. “CTJ” combines central tendency and jumps. “CTSV” combines central tendency and
stochastic volatility. Results are based on full sample estimates.
 Figure 14: Fit of the implied volatilities of call prices (ii)

(a) 20-November-2008. τ = 27 days (b) 20-November-2008. τ = 61 days (c) 20-November-2008. τ = 88 days

0.45 0.45 0.45
Actual
0.4 Standard log−OU 0.4 0.4
CT
CTJ
0.35 CTSV 0.35 0.35

0.3 0.3 0.3

0.25 0.25 0.25

0.2 0.2 0.2

0.15 0.15 0.15

−0.2 −0.1 0 0.1 0.2 −0.2 −0.1 0 0.1 0.2 −0.2 −0.1 0 0.1 0.2

Moneyness Moneyness Moneyness

(d) 31-March-2010. τ = 21 days (e) 31-March-2010. τ = 76 days (f) 31-March-2010. τ = 111 days
0.45 0.45 0.45

0.4 0.4 0.4

0.35 0.35 0.35

0.3 0.3 0.3

0.25 0.25 0.25

0.2 0.2 0.2

0.15 0.15 0.15

−0.2 −0.1 0 0.1 0.2 −0.2 −0.1 0 0.1 0.2 −0.2 −0.1 0 0.1 0.2

Moneyness Moneyness Moneyness

Note: Implied volatilities have been obtained by inverting the Black (1976) call price formula. Moneyness is defined as log(K/F (t, T )). “Log-
OU” refers to a log-normal Ornstein-Uhlenbeck process. “CTJ” combines central tendency and jumps. “CTSV” combines central tendency and
stochastic volatility. Results are based on full sample estimates.
 Figure 15: Fit of the implied volatilities of call prices (i)

(a) 16-July-2007, Actual data (b) 16-July-2007, CTSV

0.5 0.5

0.45 0.45

0.4 0.4

0.35 0.35

0.3 0.3

0.25 0.25

0.2 0.2

0.15 36 0.15
63
0.1 91 0.1
125
0.05 305 0.05

0 0
12 13 14 15 16 17 18 19 20 21 22 12 13 14 15 16 17 18 19 20 21 22

Strike Strike

(c) 15-August-2008, Actual data (d) 15-August-2008, CTSV

0.5 0.5

0.45 0.45

0.4 0.4

0.35 0.35

0.3 0.3

0.25 0.25

0.2 0.2

0.15 32 0.15
67
0.1 94 0.1
122
0.05 0.05
156

0 0
16 18 20 22 24 26 28 30 16 18 20 22 24 26 28 30

Strike Strike

Note: Implied volatilities have been obtained by inverting the Black (1976) call price formula. The
legends indicate the number of remaining days until maturity for each implied volatility smirk.
The range of strikes is such that it covers the range of moneyness values from -.25 to .25, where
moneyness is defined as log(K/F (t, T )). “CTSV” is a log-normal Ornstein Uhlenbeck process that
combines central tendency and stochastic volatility. Results are based on full sample estimates.
 Figure 16: Fit of the implied volatilities of call prices (ii)

(a) 20-November-2008, Actual data (b) 20-November-2008, CTSV

0.5 0.5

0.45 0.45

0.4 0.4

0.35 0.35

0.3 0.3

0.25 0.25

0.2 0.2
27
0.15 0.15
61
88
0.1 0.1
118
0.05 145 0.05

0 0
40 45 50 55 60 65 70 75 80 85 40 45 50 55 60 65 70 75 80 85

Strike Strike

(c) 31-March-2010, Actual data (d) 31-March-2010, CTSV

0.5 0.5

0.45 0.45

0.4 0.4

0.35 0.35

0.3 0.3

0.25 0.25

0.2 0.2
21
0.15 49 0.15
76
0.1 111 0.1
138
0.05 165 0.05

0 0
15 20 25 30 15 20 25 30

Strike Strike

Note: Implied volatilities have been obtained by inverting the Black (1976) call price formula. The
legends indicate the number of remaining days until maturity for each implied volatility smirk.
The range of strikes is such that it covers the range of moneyness values from -.25 to .25, where
moneyness is defined as log(K/F (t, T )). “CTSV” is a log-normal Ornstein Uhlenbeck process that
combines central tendency and stochastic volatility. Results are based on full sample estimates.