Technical Note No.

22* Options, Futures, and Other Derivatives, Eighth Edition John Hull Valuation of a Variance Swap This note proves the result in equation (25.6) which leads to the valuation of a variance swap. Suppose that the stock price follows process dS = (r q) dt + dz S in a risk-neutral world where is itself stochastic. From Itos lemma d ln S = (r q 2 /2) dt + dz By subtracting these two equations we obtain 2 dS dt = d ln S 2 S Integrating between time 0 and time T , the realized average variance rate, V , between time 0 and time T is given by 1 VT = 2 or 2 V = T
0 T 0

dS ST ln S S0

2 ST dS ln S T S0

(1)

Taking expectations in a risk-neutral world 2 2 ST E(V ) = (r q)T E ln T T S0 or 2 2 F0 ST E ln E(V ) = ln T S0 T S0 where F0 is the forward price of the asset for a contract maturing at time T . Consider S 1 max(K ST , 0)dK 2 K=0 K * c Copyright John Hull. All Rights Reserved. This note may be reproduced for use in conjunction with Options, Futures, and Other Derivatives by John C. Hull. 1 (2)

for some value S of S. When S < ST this integral is zero. When S > ST it is
S K=ST

1 S ST (K ST )dK = ln + 1 2 K ST S
K=S

Consider next

1 max(ST K, 0)dK K2

When S > ST this is zero. When S < ST it is

ST K=S

S ST 1 (ST K)dK = ln + 1 2 K ST S

From these results it follows that

S K=0

1 max(K ST , 0)dK + K2

K=S

1 S ST max(ST K, 0)dK = ln + 1 2 K ST S

for all values of S so that ST ST ln = 1 S S

S K=0

1 max(K ST , 0)dK K2

K=S

1 max(ST K, 0)dK K2

(3)

This shows that a variable that pays o ln ST can be replicated using options. This result can be used in conjunction with equation (1) to provide a replicating portfolio for V . Taking expectations in a risk-neutral world in equation (3) ST E ln S F0 = 1 S
S K=0

1 RT e p(K)dK K2

K=S

1 RT e c(K)dK K2

(4)

where c(K) and p(K) are the prices of European call and put options with strike price K and maturity T and R is the risk-free interest rate for a maturity of T . Combining equations (2) and (4) and noting that ST E ln S0 = ln S ST + E ln S0 S

F0 2 S 2 E(V ) = ln ln T S0 T S0 2 T F0 2 1 + S T
S K=0

1 RT e p(K)dK + K2

K=S

1 RT e c(K)dK K2

which reduces to 2 F0 2 E(V ) = ln T S T This is equation (25.6). 2 F0 2 1 + S T

S K=0

1 RT e p(K)dK + K2

K=S

1 RT e c(K)dK K2