Pricing and Hedging Options on Assets with Options on Related Assets

Abstract

The problem studied is the pricing of options on the CBOE Skew index. The option pricing theory developed seeks to hedge the risk using positions in the market for options on a related asset and the option is then priced at the cost of this hedge. The theory is applied to pricing VIX options using the market for SPY options and pricing options on JPM using the market for XLF options. The approach is then applied to illustrate the pricing of CBOE Skew Index options using the market for SPY options. The Skew Index smile is then seen to imply the VIX and SKEW of the Skew Index itself.