by Peter Carr, Roger Lee, Liuren Wu Under purely continuous price dynamics, the risk-neutral expected value of the return variance is equal to the negative of twice the risk-neutral expected value of the log return over the same horizon. The former represents the variance swap rate, and the latter is often referred to as the log profile, and can be synthesized by a particular portfolio of European options across a continuum of strikes and at the same maturity. When the price process contains discontinuous movements, variance swap rates and the log profile are no longer equal to each other. This paper derives the relation between the two quantities under different return dynamics specifications. Using quotes on both variance swaps and European options on the S&P 500 index, the paper tests alternative classes of index dynamics specifications, infers the return innovation structures, and extracts the stochastic variance from different return innovations.
MASSOUD HEIDARI LIUREN WU The U.S. agency mortgage backed securities (MBS) market is deep and highly liquid, yet modeling MBS is extremely challenging. This paper applies market participants' desired requirements for a good pricing model to MBS pricing models provided by six of the top MBS dealers. We find that five out of the six models fall short of the desired requirements. The five models are highly correlated, but less correlated with the best model, indicating potential herding among MBS analysts. The most undesirable property of the failed models is the high correlation with the underlying interest rate and options markets. Keywords: Mortgage-backed securities, option-adjusted spreads, market efficiency