Author's School

Arts & Sciences

Author's Department

Mathematics

Document Type

Article

Publication Date

3-6-2018

Originally Published In

SIAM J. Finan. Math., 9(1), 347–380. https://doi.org/10.1137/17M1111292

Abstract

In this article, we consider the small-time asymptotics of options on a leveraged exchange-traded fund (LETF) when the underlying exchange-traded fund (ETF) exhibits both local volatility and jumps of either finite or infinite activity. We show that leverage modifies the drift, volatility, jump intensity, and jump distribution of a LETF in addition to inducing the possibility of default, even when the underlying ETF price remains strictly positive. Our main results are closed-form expressions for the leading-order terms of off-the-money European call and put LETF option prices near expiration, with explicit error bounds. These results show that the price of an out-of-the-money European call on a LETF with positive (negative) leverage is asymptotically equivalent, in short time, to the price of an out-of-the-money European call (put) on the underlying ETF, but with modified spot and strike prices. Similar relationships hold for other off-the-money European options. These observations, in turn, suggest a method to hedge off-the-money LETF options near expiration using options on the underlying ETF. Finally, we derive a second-order expansion for the implied volatility of an off-the-money LETF option and show both analytically and numerically how this is affected by leverage.

Comments

© 2018, Society for Industrial and Applied Mathematics

published in SIAM J. Finan. Math., 9(1), 347–380. https://doi.org/10.1137/17M1111292

DOI

10.1137/17M1111292

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