Pricing VXX option with default risk and positive volatility skew

This paper proposes and makes a comparative study of alternative models for VXX option pricing. Factors such as mean-reversion, jumps, default risk and positive volatility skew are taken into consideration. In particular, default risk is characterized by jump-to-default framework and the “positive volatility skew” issue is addressed by stochastic volatility of volatility and jumps. Daily calibration is conducted and comparative study of the models is performed to check whether they properly fit market prices and generate reasonable positive volatility skews and deltas. Overall, jump-to-default extended LRJ model with positive correlated stochastic volatility (called JDLRJSV in the paper) serves as the best model in all the required aspects.

► The first paper to deal with VXX option pricing in the literature. ► Model default risk of VXX in jump-to-default framework. ► Model positive volatility skew of VXX option by stochastic vol-of-vol. ► Stochastic vol-of-vol is positively correlated with VXX. ► Stochastic vol-of-vol is in a LRJ model, not in GBM model as Heston model does.