Volatility risk

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 with appropriate financial instruments.^[2] 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.^[3][4][5] 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.^[6][7]

Option traders often seek to create "vega neutral" positions, typically as part of an options trading strategy.^[8] 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]}

See also

• Financial risk management
• Implied volatility
  • Volatility smile
  • IVX
• Market risk
• Model risk § Uncertainty on volatility
• Value at risk
• Volatility beta
• Volatility risk premium