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| Categories of |
| Financial risk |
|---|
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| Credit risk |
| Market risk |
| Liquidity risk |
| Investment risk |
| Business risk |
| Profit risk |
| Non-financial 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 [2] with appropriate financial instruments.[3] 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.[4][5][6] 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.[7][8]
Option traders often seek to create "vega neutral" positions, typically as part of an options trading strategy.[9] The value of an at-the-money straddle, for example, is extremely dependent on changes to volatility. Once neutrality is established, 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. [10] [2]
