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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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4 Volatility Derivatives in Portfolio Optimization


4.1 Introduction

Over the past decade or so a new class of derivatives has emerged that enable investors to gain direct exposure to volatility. At first glance, the value added of such contracts might seem ambiguous. After all, even plain vanilla options expose investors to volatility as we have already shown. As shown by Black and Scholes (1973) as well as Merton (1973), volatility – i.e. dispersion of the rates of return on a certain underlying instrument – is the key parameter determining the value of an option giving the right to buy (call) or sell (put) that underlying on a certain expiration date. Intuitively, the value of an option to buy a certain stock should be the greater, the greater is the volatility of that stock, since higher volatility means the stock has greater chance of being higher in the money at expiration. The novelty of volatility derivatives, however, is that volatility determines not only the theoretical value of the instrument – as in vanilla options – but also its payoff. Thus, volatility becomes in a sense a new underlying, an asset class in its own right.

This raises three obvious questions. First, how should direct exposure to volatility be understood and why should investors care about obtaining it? Second, assuming some nontrivial advantages of investing in volatility can indeed be identified, how can exposure to volatility be set up in practice? In other words, what are the theoretical underpinnings of the most popular volatility derivatives and...

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