Hedging volatility risk

Menachem Brenner

doi:10.1016/j.jbankfin.2005.07.015

Hedging volatility risk

2006-03-01

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DOI：10.1016/j.jbankfin.2005.07.015

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Abstract

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Volatility risk plays an important role in the management of portfolios of derivative assets as well as portfolios of basic assets. This risk is currently managed by volatility swaps or futures. However, this risk could be managed more efficiently using options on volatility that were proposed in the past but were never introduced mainly due to the lack of a cost efficient tradable underlying asset. The objective of this paper is to introduce a new volatility instrument, an option on a straddle, which can be used to hedge volatility risk. The design and valuation of such an instrument are the basic ingredients of a successful financial product. In order to value these options, we combine the approaches of compound options and stochastic volatility. Our numerical results show that the straddle option is a powerful instrument to hedge volatility risk. An additional benefit of such an innovation is that it will provide a direct estimate of the market price for volatility risk. (c) 2005 Elsevier B.V. All rights reserved.

Keywords:

volatility options

compound options

stochastic volatility

risk management

volatility index

Hedging volatility risk

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