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 relevant to portfolios of basic assets, and to foreign currency trading. 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, 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.
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. 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.
See also
- Financial risk management
- Implied volatility
- Volatility smile
- IVX
- Market risk
- Value at risk
- Volatility beta
- Volatility risk premium
References
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Risk management is the configuration and identification of analyzing, and or acceptance during investment decision-making. In essence this occurs whenever an investor or portfolio manager evaluates potential losses within an investment. Under certain investment objectives, appropriate solutions (or no solution) will occur to assess the investors goals and standards.
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Improper risk management can and or will negatively affect companies as well as their individuals. For example, the recession that began in 2008 was largely caused by the loose credit risk management of financial firms.
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