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Please use this identifier to cite or link to this item:
http://hdl.handle.net/2451/26883
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| Title: | HEDGING VOLATILITY RISK |
| Authors: | Brenner, Menachem
Ou, Ernest Y.
Zhang, Jin E. |
| Keywords: | Straddle
Compound Options
Stochastic Volatility |
| Issue Date: | Nov-2000 |
| Series/Report no.: | S-DRP-01-04 |
| Abstract: | Volatility risk has played a major role in several financial debacles
(for example, Barings Bank, Long Term Capital Management). This risk
could have been managed using options on volatility which were proposed
in the past but were never offered for trading mainly due to the lack of
a tradable underlying asset. The objective of this paper is to introduce
a new volatility instrument, an option on a straddle, which can be used
to hedge volatility risk. The design and valuation of such an instrument
are the basic ingredients of a successful financial product. Unlike the
proposed volatility index option, the underlying of this proposed
contract is a traded atthe-money-forward straddle, which should be more
appealing to potential participants. In order to value these options, we
combine the approaches of compound options and stochastic volatility. We
use the lognormal process for the underlying asset, the
Orenstein-Uhlenbeck process for volatility, and assume that the two
Brownian motions are independent. Our numerical results show that the
straddle option price is very sensitive to the changes in volatility
which means that the proposed contract is indeed a very powerful
instrument to hedge volatility risk. |
| URI: | http://hdl.handle.net/2451/26883 |
| Appears in Collections: | Derivatives Research
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