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Hedging Volatility Risk: The Effectiveness Of Volatility Options

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  • YUNBI AN

    (Odette School of Business, University of Windsor, Windsor, Ontario, Canada, N9B 3P4, Canada)

  • ATA ASSAF

    (Odette School of Business, University of Windsor, Windsor, Ontario, Canada, N9B 3P4, Canada)

  • JUN YANG

    (Manning School of Business Administration, Acadia University, Wolfville, N.S., Canada, B4P 2R6, Canada)

Abstract

In this paper we focus on the performance of volatility options as hedging instruments for hedging volatility risk. We investigate (a) the relative hedging performance of volatility and European options, (b) the relative hedging performance of volatility index and straddle options, and (c) the impact of model misspecification on hedging effectiveness. Our focus is on exotic options as the options to be hedged, because they are more sensitive to volatility risk and model risk and practically more relevant when the effectiveness of different hedging strategies is examined. Using a Monte Carlo simulation, we find that volatility options are especially useful for hedging options with a severe exotic feature and there is no significant difference between the performances of volatility index and straddle options. Furthermore, our results indicate that model misspecification has an important impact on the hedging performance.

Suggested Citation

  • Yunbi An & Ata Assaf & Jun Yang, 2007. "Hedging Volatility Risk: The Effectiveness Of Volatility Options," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 10(03), pages 517-534.
    • Handle: RePEc:wsi:ijtafx:v:10:y:2007:i:03:n:s0219024907004317
    DOI: 10.1142/S0219024907004317
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    References listed on IDEAS

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    1. Rong Fan & Anurag Gupta & Peter Ritchken, 2003. "Hedging in the Possible Presence of Unspanned Stochastic Volatility: Evidence from Swaption Markets," Journal of Finance, American Finance Association, vol. 58(5), pages 2219-2248, October.
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    Cited by:

    1. Konstantinos D. Melas & Photis M. Panayides & Dimitris A. Tsouknidis, 2022. "Dynamic volatility spillovers and investor sentiment components across freight-shipping markets," Maritime Economics & Logistics, Palgrave Macmillan;International Association of Maritime Economists (IAME), vol. 24(2), pages 368-394, June.
    2. Valeriane Jokhadze & Wolfgang M. Schmidt, 2020. "Measuring Model Risk In Financial Risk Management And Pricing," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 23(02), pages 1-37, April.
    3. Kozarski, R., 2013. "Pricing and hedging in the VIX derivative market," Other publications TiSEM 221fefe0-241e-4914-b6bd-c, Tilburg University, School of Economics and Management.
    4. Liu, Tangyong & Gong, Xu, 2020. "Analyzing time-varying volatility spillovers between the crude oil markets using a new method," Energy Economics, Elsevier, vol. 87(C).

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