Consistent Modeling of VIX and Equity Derivatives Using a 3/2 plus Jumps Model

In this paper quasi-closed-form solutions are derived for the price of equity and VIX derivatives under the assumption that the underlying follows a 3/2 process with jumps in the index. The newly-found formulae allow for an empirical analysis to be performed. In the case of the pure-diffusion 3/2 model, the dynamics are rich enough to capture the observed upward-sloping implied-volatility skew in VIX options. This observation contradicts a common perception in the literature that jumps are required for the consistent modeling of equity and VIX derivatives. We find that the 3/2 plus jumps model is more parsimonious than competing models from its class; it is able to accurately capture the joint dynamics of equity and VIX derivatives, without sacrificing analytic tractability. The model produces a good short-term fit to the implied volatility of index options due to the richer dynamics, while retaining the analytic tractability of its pure-diffusion counterpart.