Volatility risk

{{Financial risk types}}

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.Menachem Brenner, Ernest Y. Ou, Jin E. Zhang (2006). [https://pages.stern.nyu.edu/~mbrenner/research/HV_paper_in_JBF.pdf "Hedging volatility risk"]. Journal of Banking & Finance 30 (2006) 811–821 It is also relevant to portfolios of basic assets, and to foreign currency trading.

Volatility risk can be managed by hedging with appropriate financial instruments.{{Cite journal |last1=Avellaneda |first1=M. |last2=Levy |first2=A. |last3=Parás |first3=A. |year=1995 |title=Pricing and hedging derivative securities in markets with uncertain volatilities |journal=Applied Mathematical Finance |volume=2 |issue=2 |pages=73–88 |doi=10.1080/13504869500000005}} 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.{{Cite book |last=Neftci |first=Salih N. |url=https://books.google.com/books?id=TB8ZIFDlKSwC&dq=finance+vega+volatility&pg=PA430 |title=Principles of Financial Engineering |publisher=Academic Press |year=2004 |isbn=978-0-12-515394-2 |series=Academic Press Advanced Finance Series |location=San Diego, CA and London |pages=430–431 |language=en |authorlink=Salih Neftci}}{{Cite book |last1=Xekalaki |first1=Evdokia |url=https://books.google.com/books?id=_FZHKyuXOEwC&dq=vix+volatility+index&pg=PA342 |title=ARCH Models for Financial Applications |last2=Degiannakis |first2=Stavros |publisher=John Wiley & Sons |year=2010 |isbn=978-0-470-68802-1 |location=Chichester, UK |pages=341–343 |language=en}}Andrew Lesniewski (2015). [https://mfe.baruch.cuny.edu/wp-content/uploads/2015/06/VolWork6-Andrew.pdf Managing interest rate volatility risk] 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.{{Cite book |last=Ploeg |first=Antoine Petrus Cornelius van der |url=https://books.google.com/books?id=yP0UwMU1RvUC&dq=finance+vega+volatility&pg=PA25 |title=Stochastic Volatility and the Pricing of Financial Derivatives |publisher=Rozenberg Publishers |year=2006 |isbn=978-90-5170-577-5 |series=Tinbergen Institute Research Series |location=Amsterdam, Netherlands |pages=25–26 |language=en}}{{Cite book |last=Huang |first=Declan Chih-Yen |title=Forecasting Volatility in the Financial Markets |publisher=Butterworth-Heinemann |year=2002 |isbn=978-0-7506-5515-6 |editor-last=Knight |editor-first=John L. |series=Butterworth - Heinemann Finance |location=Oxford and Woburn, MA |pages=375–376 |language=en |chapter=The Information Content of the FTSE100 Index Option Implied Volatility and Its Structural Changes With Links to Loss Aversion |orig-year=1998 |editor-last2=Satchell |editor-first2=Stephen |chapter-url=https://books.google.com/books?id=pc3K-nVn09wC&dq=finance+vega+volatility&pg=PA376}}

Option traders often seek to create "vega neutral" positions, typically as part of an options trading strategy.See, e.g., [https://www.macroption.com/vega-neutral-option-strategies/ Vega Neutral Option Strategies] 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|date=March 2025|reason=unclear in what context the 'here' refers to}}