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Volatility as an Asset Class

Obvious Benefits and Hidden Risks


Juliusz Jabłecki, Ryszard Kokoszczyński, Paweł Sakowski, Robert Ślepaczuk and Piotr Wójcik

Volatility derivatives are an important group of financial instruments and their list is much longer than volatility index futures and options. This book reviews methods used for measurement, estimation and forecasting volatility and presents major classes of volatility derivatives and their possible applications in investment strategies and portfolio optimization. Since volatility is not constant, its term structure and the phenomenon of the volatility risk premium are discussed in view of the permanently instable relation between realized and implied volatility. The study proposes a method to use this information in the process of forecasting future values of volatility.
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2 Overview of volatility derivatives


In this chapter we discuss specific ways in which investors can gain exposure to volatility. We start by explaining the nature of volatility exposure which is an inherent part of any dynamically hedged option. We show that a headger’s profit-and-loss depends on the spread between realized and implied volatility, but also on other market factors. We then present derivative instruments – variance swaps, VIX futures and options – which offer pure exposure to realized or implied volatility.

2.1 Volatility exposure in a delta-hedged option

The simplest way of gaining exposure to volatility is by buying options and dynamically hedging away the unwanted (“delta”) risk of price changes in the underlying instrument. Exposure to volatility arises naturally in delta hedged options positions. To see this, recall some basic delta hedging arithmetic and consider a trader who writes a call option C on an underlying S with implied volatility Σ and hedges away the delta risk by going long (∂C/∂S) units of the underlying instrument (typically a futures contract). Observe that

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