BICs for Derivatives Pricing - The Case of Volatility Derivatives

Abstract

This article introduces the BICs approach, as it matters for derivatives valuation. Our presentation illustrates this through a class of contracts that has been the subject of an abundant recent literature: volatility based derivatives. This includes Volatility Swaps, Volatility options, Variance Swaps, Corridors and Options. BICs defined BICs stand for Basis Instrument Contracts; BICs are derivatives contracts of reference through which any derivatives contract, however complex or illiquid can be decomposed. They correct and generalize some operational defects of Arrow Debreu securities in multi-period markets. With BICs, one can still replicate the payoff of any derivatives contract under consideration statically in multi-period markets, yet their number may grow linearly rather than exponentially with the number of trading periods. BICs are independent of model assumptions.