Leveraged ETFs are funds that target a multiple of the daily return of a reference asset; eg UYG (Proshares) targets twice the daily return of XLF (Financial SPDR) and SKF targets minus twice the daily return of XLF.
It is well known that these leveraged funds have exposure to realized volatility. In particular, the relation between the leveraged and the unleveraged funds over a given time-horizon (larger than 1 day) is uncertain and will depend on the realized volatility. This talk examines this phenomenon theoretically and empirically first, and then uses this to price options on leveraged ETFs in terms of the prices of options on the underlying ETF. The resulting model allows to model the volatility skews of the leveraged and unleveraged funds in relation to each other and therefore suggest an arbitrage relation that could prove useful for traders and risk-managers.