Convex order of discrete, continuous and predictable quadratic variation & applications to options on variance

Abstract

We consider a square-integrable semimartingale and investigate the convex order relations between its discrete, continuous and predictable quadratic variation. As the main results, we show that if the semimartingale has conditionally independent increments and symmetric jump measure, then its discrete realized variance dominates its quadratic variation in increasing convex order. The results have immediate applications to the pricing of options on realized variance. For a class of models including time-changed Levy models and Sato processes with symmetric jumps our results show that options on variance are typically underpriced, if quadratic variation is substituted for the discretely sampled realized variance.

20 pages