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.
[ Menachem Brenner, Ernest Y. Ou, Jin E. Zhang (2006)]
"Hedging volatility risk"
''Journal of Banking & Finance'' 30 (2006) 811–821 It is also relevant to portfolios of basic assets, and to foreign currency trading.
Volatility risk
can be managed by
hedging with appropriate
financial instrument
Financial instruments are monetary contracts between parties. They can be created, traded, modified and settled. They can be cash (currency), evidence of an ownership, interest in an entity or a contractual right to receive or deliver in the form ...
s.
These are
volatility swaps,
variance swaps,
conditional variance swaps,
variance options,
VIX futures for equities, and (with some construction)
caps,
floors and
swaptions for interest rates. Here, the hedge-instrument is sensitive to the same source of volatility as the asset being protected (i.e. the same
stock
Stocks (also capital stock, or sometimes interchangeably, shares) consist of all the Share (finance), shares by which ownership of a corporation or company is divided. A single share of the stock means fractional ownership of the corporatio ...
,
commodity
In economics, a commodity is an economic goods, good, usually a resource, that specifically has full or substantial fungibility: that is, the Market (economics), market treats instances of the good as equivalent or nearly so with no regard to w ...
, or
interest rate
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the 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'', 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. 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.
See also
*
Financial risk management
Financial risk management is the practice of protecting Value (economics), economic value in a business, firm by managing exposure to financial risk - principally credit risk and market risk, with more specific variants as listed aside - as well ...
*
Implied volatility
**
Volatility smile
**
IVX
*
Market risk
Market risk is the risk of losses in positions arising from movements in market variables like prices and volatility.
There is no unique classification as each classification may refer to different aspects of market risk. Nevertheless, the m ...
*
*
Value at risk
*
Volatility beta
*
Volatility risk premium
References
Financial risk
Market risk
Financial risk modeling
Options_(finance)
Derivatives_(finance)