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Volatility risk is the risk of a change of price of a portfolio as a result of changes in the volatility of a risk factor. It usually applies to portfolios of derivatives instruments, where the volatility of its underlying is a major influencer of prices.

Volatility risk can be managed - i.e. hedged - using appropriate financial instruments. These are volatility swaps, variance swaps, variance options, futures contracts such as VIX for equities, and (with some construction) [1][2] caps, floors and swaptions for interest rates.

Here, the hedging 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 value to the asset, is offset by a change in value in the hedge-instrument.

The number of hedging instruments purchased, will be a function of the relative sensitivity to volatility of the two instruments. Here, the measure of sensitivity is Vega, the rate of change of the value of the portfolio with respect to the volatility of the underlying asset.[3][4]

See also

References

  1. ^ 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.
  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.
  3. ^ 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.
  4. ^ 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.


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