Volatility-of-Volatility Risk

Darien Huang, Christian Schlag, Ivan Shaliastovich and Julian Thimme

Journal of Financial and Quantitative Analysis, 2019, vol. 54, issue 6, 2423-2452

Abstract: We show that market volatility of volatility is a significant risk factor that affects index and volatility index option returns, beyond volatility itself. The volatility and volatility of volatility indices, identified model-free as the VIX and VVIX, respectively, are only weakly related to each other. Delta-hedged index and VIX option returns are negative on average and are more negative for strategies that are more exposed to volatility and volatility-of-volatility risks. Further, volatility and volatility of volatility significantly negatively predict future delta-hedged option payoffs. The evidence suggests that volatility and volatility-of-volatility risks are jointly priced and have negative market prices of risk.

Date: 2019
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