HEDGING VOLATILITY RISK: THE EFFECTIVENESS OF VOLATILITY OPTIONS

Yunbi An (), Ata Assaf and Jun Yang
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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

International Journal of Theoretical and Applied Finance (IJTAF), 2007, vol. 10, issue 03, 517-534

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.

Keywords: Volatility risk; volatility options; hedging; Monte Carlo simulation (search for similar items in EconPapers)
Date: 2007
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Citations: View citations in EconPapers (4)

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DOI: 10.1142/S0219024907004317

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