CHAPTER 14 - Tools for Volatility Engineering, Volatility Swaps, and Volatility Trading

Abstract

This chapter provides an introduction to a sector that may, in the future, play an even more significant role in financial market strategies. The purpose is to show how one can isolate the volatility of a risk factor from other related risks, and then construct instruments that can be used to trade it. Liquid instruments that involve pure volatility trades are potentially very useful for market participants who have natural exposure to various volatilities in their balance sheet or trading book. When a trader takes a position or hedges a risk, he or she expects that the random movements of the underlying would have a known effect on the position. The underlying may be random, but the payoff function of a well-defined contract or a position has to be known. Payoff functions of most classical volatility strategies are not invariant to underlying risks, and most volatility instruments turn out to be imperfect tools for isolating this risk. Even when traders' anticipations come true, the trader may realize that the underlying volatility payoff functions have changed due to movements in other variables. Hence, classical volatility strategies cannot provide satisfactory hedges for volatility exposures. The reason for this and possible solutions are given in the chapter.