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 with appropriate financial instruments.
These are volatility swaps, variance swaps, conditional variance swaps, variance options, VIX futures for equities, and (with some construction) [2][3] caps, floors and swaptions for interest rates.
[4]
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.
Here, the measure of sensitivity is vega,
[5][6]
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.
[7]
(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.
^Menachem Brenner, Ernest Y. Ou, Jin E. Zhang (2006). "Hedging volatility risk". Journal of Banking & Finance 30 (2006) 811–821
^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.
^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.
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