Pricing Bermudan Variance Swaptions Using Multinomial Trees

Abstract

In a recent study, we present a tree methodology to evaluate the expected generalized realized variance in a general stochastic volatility model. This provides an efficient way of calculating the fair value of the strike for variance swaps. In this article, we expand the methodology to price nonlinear derivatives written on realized variance. Particularly we introduce a new option contract a Bermudan variance swaption, defined as an option on variance swap with early exercise dates. Within the same framework, we also show how to value forward-start variance swaps, VIX futures and VIX options. Numerical tests show that the methodology introduced is efficient and accurate.