Volatility risk: Difference between revisions

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{{Financial risk types}}
{{Financial risk types}}
'''Volatility risk''' is [[financial risk|the risk of]] an adverse change of price, due to changes in the [[volatility (finance)|volatility]] of a [[risk factor (finance)|factor affecting that price]]. It usually applies to [[derivative (finance)|derivative instruments]], and their portfolios, where the volatility of the [[Underlying|underlying asset]] is a [[Valuation_of_options#Other_factors_affecting_premium|major influencer]] of [[option pricing|option prices]].<ref name="Brenner et al">[[Menachem Brenner]], Ernest Y. Ou, Jin E. Zhang (2006). [https://pages.stern.nyu.edu/~mbrenner/research/HV_paper_in_JBF.pdf "Hedging volatility risk"]. ''Journal of Banking & Finance'' 30 (2006) 811–821</ref> It is also relevant to portfolios of basic assets, and to foreign currency trading.<ref name="Brenner et al" />
'''Volatility risk''' is [[financial risk|the risk of]] an adverse change of price, due to changes in the [[volatility (finance)|volatility]] of a [[risk factor (finance)|factor affecting that price]]. It usually applies to [[derivative (finance)|derivative instruments]], and their portfolios, where the volatility of the [[Underlying|underlying asset]] is a [[Valuation of options#Other factors affecting premium|major influencer]] of [[option pricing|option prices]].<ref name="Brenner et al">[[Menachem Brenner]], Ernest Y. Ou, Jin E. Zhang (2006). [https://pages.stern.nyu.edu/~mbrenner/research/HV_paper_in_JBF.pdf "Hedging volatility risk"]. ''Journal of Banking & Finance'' 30 (2006) 811–821</ref> It is also relevant to portfolios of basic assets, and to foreign currency trading.<ref name="Brenner et al" />


Volatility risk [[financial risk management|can be managed]] by [[hedge (finance)|hedging]] with appropriate [[financial instrument]]s.<ref name="AvellanedaParas">{{Cite journal |last1=Avellaneda |first1=M. |last2=Levy |first2=A. |last3=Parás |first3=A. |year=1995 |title=Pricing and hedging derivative securities in markets with uncertain volatilities |journal=Applied Mathematical Finance |volume=2 |issue=2 |pages=73–88 |doi=10.1080/13504869500000005}}</ref> These are [[volatility swap]]s, [[variance swap]]s, [[conditional variance swap]]s, [[Option on realized variance|variance options]], [[VIX]] [[futures contract|futures]] for equities, and (with some construction) [[Interest rate cap and floor|caps]], [[Interest rate cap and floor|floors]] and [[swaptions]] for interest rates.<ref>{{Cite book |last=Neftci |first=Salih N. |url=https://books.google.com/books?id=TB8ZIFDlKSwC&dq=finance+vega+volatility&pg=PA430 |title=Principles of Financial Engineering |publisher=Academic Press |year=2004 |isbn=978-0-12-515394-2 |series=Academic Press Advanced Finance Series |location=San Diego, CA and London |pages=430–431 |language=en |authorlink=Salih Neftci}}</ref><ref>{{Cite book |last1=Xekalaki |first1=Evdokia |url=https://books.google.com/books?id=_FZHKyuXOEwC&dq=vix+volatility+index&pg=PA342 |title=ARCH Models for Financial Applications |last2=Degiannakis |first2=Stavros |publisher=John Wiley & Sons |year=2010 |isbn=978-0-470-68802-1 |location=Chichester, UK |pages=341–343 |language=en}}</ref><ref>Andrew Lesniewski (2015). [https://mfe.baruch.cuny.edu/wp-content/uploads/2015/06/VolWork6-Andrew.pdf Managing interest rate volatility risk]</ref> 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 [[Option_(finance)#Risks|a function of]] the relative sensitivity to volatility of the two: the measure of sensitivity is [[Greeks_(finance)#Vega|''vega'']], the rate of change of the value of the option, or option-portfolio, with respect to the volatility of the underlying asset.<ref>{{Cite book |last=Ploeg |first=Antoine Petrus Cornelius van der |url=https://books.google.com/books?id=yP0UwMU1RvUC&dq=finance+vega+volatility&pg=PA25 |title=Stochastic Volatility and the Pricing of Financial Derivatives |publisher=Rozenberg Publishers |year=2006 |isbn=978-90-5170-577-5 |series=Tinbergen Institute Research Series |location=Amsterdam, Netherlands |pages=25–26 |language=en}}</ref><ref>{{Cite book |last=Huang |first=Declan Chih-Yen |title=Forecasting Volatility in the Financial Markets |publisher=Butterworth-Heinemann |year=2002 |isbn=978-0-7506-5515-6 |editor-last=Knight |editor-first=John L. |series=Butterworth - Heinemann Finance |location=Oxford and Woburn, MA |pages=375–376 |language=en |chapter=The Information Content of the FTSE100 Index Option Implied Volatility and Its Structural Changes With Links to Loss Aversion |orig-year=1998 |editor-last2=Satchell |editor-first2=Stephen |chapter-url=https://books.google.com/books?id=pc3K-nVn09wC&dq=finance+vega+volatility&pg=PA376}}</ref>
Volatility risk [[financial risk management|can be managed]] by [[hedge (finance)|hedging]]<ref name="Downey"/> with appropriate [[financial instrument]]s.<ref name="AvellanedaParas">{{Cite journal |last1=Avellaneda |first1=M. |last2=Levy |first2=A. |last3=Parás |first3=A. |year=1995 |title=Pricing and hedging derivative securities in markets with uncertain volatilities |journal=Applied Mathematical Finance |volume=2 |issue=2 |pages=73–88 |doi=10.1080/13504869500000005}}</ref> These are [[volatility swap]]s, [[variance swap]]s, [[conditional variance swap]]s, [[Option on realized variance|variance options]], [[VIX]] [[futures contract|futures]] for equities, and (with some construction) [[Interest rate cap and floor|caps]], [[Interest rate cap and floor|floors]] and [[swaptions]] for interest rates.<ref>{{Cite book |last=Neftci |first=Salih N. |url=https://books.google.com/books?id=TB8ZIFDlKSwC&dq=finance+vega+volatility&pg=PA430 |title=Principles of Financial Engineering |publisher=Academic Press |year=2004 |isbn=978-0-12-515394-2 |series=Academic Press Advanced Finance Series |location=San Diego, CA and London |pages=430–431 |language=en |authorlink=Salih Neftci}}</ref><ref>{{Cite book |last1=Xekalaki |first1=Evdokia |url=https://books.google.com/books?id=_FZHKyuXOEwC&dq=vix+volatility+index&pg=PA342 |title=ARCH Models for Financial Applications |last2=Degiannakis |first2=Stavros |publisher=John Wiley & Sons |year=2010 |isbn=978-0-470-68802-1 |location=Chichester, UK |pages=341–343 |language=en}}</ref><ref>Andrew Lesniewski (2015). [https://mfe.baruch.cuny.edu/wp-content/uploads/2015/06/VolWork6-Andrew.pdf Managing interest rate volatility risk]</ref> 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 [[Option (finance)#Risks|a function of]] the relative sensitivity to volatility of the two: the measure of sensitivity is [[Greeks (finance)#Vega|''vega'']], the rate of change of the value of the option, or option-portfolio, with respect to the volatility of the underlying asset.<ref>{{Cite book |last=Ploeg |first=Antoine Petrus Cornelius van der |url=https://books.google.com/books?id=yP0UwMU1RvUC&dq=finance+vega+volatility&pg=PA25 |title=Stochastic Volatility and the Pricing of Financial Derivatives |publisher=Rozenberg Publishers |year=2006 |isbn=978-90-5170-577-5 |series=Tinbergen Institute Research Series |location=Amsterdam, Netherlands |pages=25–26 |language=en}}</ref><ref>{{Cite book |last=Huang |first=Declan Chih-Yen |title=Forecasting Volatility in the Financial Markets |publisher=Butterworth-Heinemann |year=2002 |isbn=978-0-7506-5515-6 |editor-last=Knight |editor-first=John L. |series=Butterworth - Heinemann Finance |location=Oxford and Woburn, MA |pages=375–376 |language=en |chapter=The Information Content of the FTSE100 Index Option Implied Volatility and Its Structural Changes With Links to Loss Aversion |orig-year=1998 |editor-last2=Satchell |editor-first2=Stephen |chapter-url=https://books.google.com/books?id=pc3K-nVn09wC&dq=finance+vega+volatility&pg=PA376}}</ref>


Option traders often seek to create "vega neutral" positions, typically as part of an [[Options strategy|options trading strategy]].<ref>See, e.g., [https://www.macroption.com/vega-neutral-option-strategies/ Vega Neutral Option Strategies]</ref> 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.{{Citation needed|date=March 2025|reason=unclear in what context the 'here' refers to}}
Option traders often seek to create "vega neutral" positions, typically as part of an [[Options strategy|options trading strategy]].<ref>See, e.g., [https://www.macroption.com/vega-neutral-option-strategies/ Vega Neutral Option Strategies]</ref> The value of an at-the-money [[straddle]], for example, is extremely dependent on changes to volatility. Once neutrality is established, 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.<ref>Sarah Saves (2024).
[https://tiblio.com/glossary/vega-neutral-finance-explained/ "Vega Neutral"], tiblio.com</ref>
<ref name="Downey">Lucas Downey (2022). [https://www.investopedia.com/terms/v/vega-neutral.asp "Vega Neutral"], [[Investopedia]]</ref>


==See also==
==See also==
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**[[IVX]]
**[[IVX]]
*[[Market risk]]
*[[Market risk]]
*{{slink|Model risk#Uncertainty on volatility}}
*{{section link|Model risk#Uncertainty on volatility}}
*[[Value at risk]]
*[[Value at risk]]
*[[Volatility beta]]
*[[Volatility beta]]
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{{Reflist}}
{{Reflist}}
{{Financial risk}}
{{Financial risk}}
{{DEFAULTSORT:Volatility Risk}}
[[Category:Financial risk]]
[[Category:Market risk]]
[[Category:Financial risk modeling]]
[[Category:Options_(finance)]]
[[Category:Derivatives_(finance)]]
{{Investment-stub}}


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Improper risk management can and or will negatively affect companies as well as their individuals. For example, the [[Financial crisis of 2007–08|recession that began in 2008]] was largely caused by the loose credit risk management of financial firms.<ref>{{Cite book|url=https://books.google.com/books?id=Rr_6y9evvowC&q=financial+crisis+2008+credit+risk+management|title=Credit Risk Management In and Out of the Financial Crisis: New Approaches to Value at Risk and Other Paradigms|last1=Saunders|first1=Anthony|last2=Allen|first2=Linda|publisher=John Wiley & Sons|year=2010|isbn=978-0-470-62236-0|location=Hoboken, NJ|pages=3–4|language=en}}</ref><ref>{{Cite journal|last1=Mačerinskienė|first1=Irena|last2=Ivaškevičiūtė|first2=Laura|last3=Railienė|first3=Ginta|date=2014|title=The Financial Crisis Impact on Credit Risk Management in Commercial Banks|journal=KSI Transactions on KNOWLEDGE SOCIETY|volume=7|issue=1|pages=5–15|s2cid=53977152}}</ref>  
Improper risk management can and or will negatively affect companies as well as their individuals. For example, the [[Financial crisis of 2007–08|recession that began in 2008]] was largely caused by the loose credit risk management of financial firms.<ref>{{Cite book|url=https://books.google.com/books?id=Rr_6y9evvowC&q=financial+crisis+2008+credit+risk+management|title=Credit Risk Management In and Out of the Financial Crisis: New Approaches to Value at Risk and Other Paradigms|last1=Saunders|first1=Anthony|last2=Allen|first2=Linda|publisher=John Wiley & Sons|year=2010|isbn=978-0-470-62236-0|location=Hoboken, NJ|pages=3–4|language=en}}</ref><ref>{{Cite journal|last1=Mačerinskienė|first1=Irena|last2=Ivaškevičiūtė|first2=Laura|last3=Railienė|first3=Ginta|date=2014|title=The Financial Crisis Impact on Credit Risk Management in Commercial Banks|journal=KSI Transactions on KNOWLEDGE SOCIETY|volume=7|issue=1|pages=5–15|s2cid=53977152}}</ref>  
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{{DEFAULTSORT:Volatility Risk}}
[[Category:Financial risk]]
[[Category:Market risk]]
[[Category:Financial risk modeling]]
[[Category:Options (finance)]]
[[Category:Derivatives (finance)]]
{{Investment-stub}}

Latest revision as of 05:02, 5 September 2025

Template:Financial risk types 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.[1] It is also relevant to portfolios of basic assets, and to foreign currency trading.[1]

Volatility risk can be managed by hedging[2] with appropriate financial instruments.[3] 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.[4][5][6] 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, the rate of change of the value of the option, or option-portfolio, with respect to the volatility of the underlying asset.[7][8]

Option traders often seek to create "vega neutral" positions, typically as part of an options trading strategy.[9] The value of an at-the-money straddle, for example, is extremely dependent on changes to volatility. Once neutrality is established, 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.[10] [2]

See also

References

<templatestyles src="Reflist/styles.css" />

  1. ↑ a b Menachem Brenner, Ernest Y. Ou, Jin E. Zhang (2006). "Hedging volatility risk". Journal of Banking & Finance 30 (2006) 811–821
  2. ↑ a b Lucas Downey (2022). "Vega Neutral", Investopedia
  3. ↑ Script error: No such module "Citation/CS1".
  4. ↑ Script error: No such module "citation/CS1".
  5. ↑ Script error: No such module "citation/CS1".
  6. ↑ Andrew Lesniewski (2015). Managing interest rate volatility risk
  7. ↑ Script error: No such module "citation/CS1".
  8. ↑ Script error: No such module "citation/CS1".
  9. ↑ See, e.g., Vega Neutral Option Strategies
  10. ↑ Sarah Saves (2024). "Vega Neutral", tiblio.com

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