Volatility risk

Volatility risk is the risk of an adverse change of price, due to changes in the volatility of a factor affecting that price. It usually applies to derivative instruments, and their portfolios, where the volatility of the underlying asset is a major influencer of option prices. It is also ^[1] relevant to portfolios of basic assets, and to foreign currency trading.

Volatility risk can be managed by hedging ^[2] with appropriate financial instruments. These are volatility swaps, variance swaps, conditional variance swaps, variance options, VIX futures for equities, and (with some construction) ^[3]^[4] caps, floors and swaptions for interest rates. ^[5] Here, the hedge-instrument is sensitive to the same source of volatility as the asset being protected (i.e. the same stock, commodity, or interest rate etc.). The position is then established such that a change in the value of the protected-asset, is offset by a change in value of the hedge-instrument. The number of hedge-instruments purchased, will be a function of the relative sensitivity to volatility of the two: the measure of sensitivity is vega, ^[6] ^[7] the rate of change of the value of the option, or option-portfolio, with respect to the volatility of the underlying asset.

Option traders often seek to create "vega neutral" positions, typically as part of an options trading strategy. ^[8] (The value of an at-the-money straddle, for example, is extremely dependent on changes to volatility.) Here the total vega of the position is (near) zero — i.e. the impact of implied volatility is negated — allowing the trader to gain exposure to the specific opportunity, without concern for changing volatility.

References

^ Menachem Brenner, Ernest Y. Ou, Jin E. Zhang (2006). "Hedging volatility risk". Journal of Banking & Finance 30 (2006) 811–821
^ Avellaneda, M.; Levy, A.; Parás, A. (1995). "Pricing and hedging derivative securities in markets with uncertain volatilities". Applied Mathematical Finance. 2 (2): 73–88. doi:10.1080/13504869500000005.
^ Neftci, Salih N. (2004). Principles of Financial Engineering. Academic Press Advanced Finance Series. San Diego, CA and London: Academic Press. pp. 430–431. ISBN 978-0-12-515394-2.
^ Xekalaki, Evdokia; Degiannakis, Stavros (2010). ARCH Models for Financial Applications. Chichester, UK: John Wiley & Sons. pp. 341–343. ISBN 978-0-470-68802-1.
^ Andrew Lesniewski (2015). Managing interest rate volatility risk
^ Ploeg, Antoine Petrus Cornelius van der (2006). Stochastic Volatility and the Pricing of Financial Derivatives. Tinbergen Institute Research Series. Amsterdam, Netherlands: Rozenberg Publishers. pp. 25–26. ISBN 978-90-5170-577-5.
^ Huang, Declan Chih-Yen (2002) [1998]. "The Information Content of the FTSE100 Index Option Implied Volatility and Its Structural Changes With Links to Loss Aversion". In Knight, John L.; Satchell, Stephen (eds.). Forecasting Volatility in the Financial Markets. Butterworth - Heinemann Finance. Oxford and Woburn, MA: Butterworth-Heinemann. pp. 375–376. ISBN 978-0-7506-5515-6.
^ See, e.g., Vega Neutral Option Strategies

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[Brenner_et_al-1] Menachem Brenner, Ernest Y. Ou, Jin E. Zhang (2006). "Hedging volatility risk". Journal of Banking & Finance 30 (2006) 811–821

[AvellanedaParas-2] Avellaneda, M.; Levy, A.; Parás, A. (1995). "Pricing and hedging derivative securities in markets with uncertain volatilities". Applied Mathematical Finance. 2 (2): 73–88. doi:10.1080/13504869500000005.

[3] Neftci, Salih N. (2004). Principles of Financial Engineering. Academic Press Advanced Finance Series. San Diego, CA and London: Academic Press. pp. 430–431. ISBN 978-0-12-515394-2.

[4] Xekalaki, Evdokia; Degiannakis, Stavros (2010). ARCH Models for Financial Applications. Chichester, UK: John Wiley & Sons. pp. 341–343. ISBN 978-0-470-68802-1.

[5] Andrew Lesniewski (2015). Managing interest rate volatility risk

[6] Ploeg, Antoine Petrus Cornelius van der (2006). Stochastic Volatility and the Pricing of Financial Derivatives. Tinbergen Institute Research Series. Amsterdam, Netherlands: Rozenberg Publishers. pp. 25–26. ISBN 978-90-5170-577-5.

[7] Huang, Declan Chih-Yen (2002) [1998]. "The Information Content of the FTSE100 Index Option Implied Volatility and Its Structural Changes With Links to Loss Aversion". In Knight, John L.; Satchell, Stephen (eds.). Forecasting Volatility in the Financial Markets. Butterworth - Heinemann Finance. Oxford and Woburn, MA: Butterworth-Heinemann. pp. 375–376. ISBN 978-0-7506-5515-6.

[8] See, e.g., Vega Neutral Option Strategies

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See also

References