Scribd
Upload
13 views2 pages

Volatility

Vol

Uploaded by

Rosa
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
13 views2 pages

Volatility

Vol

Uploaded by

Rosa
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 2

Finance Derivatives

Course: 3445
Volatility

Understanding Volatility in the Context of Derivatives

Introduction to Volatility

Volatility represents the degree of variation of a trading price series over time, usually
measured by the standard deviation of logarithmic returns. In simpler terms, it is a statistical
measure of the dispersion of returns for a given security or market index. In the context of
derivatives, volatility is a key input in pricing models and is a critical factor in the trading and
risk management of these financial instruments.

Volatility and Derivatives Pricing

Impact on Pricing: Volatility is one of the most influential factors in the pricing of options and
other derivatives. Higher volatility increases the potential range of movement for the price of
the underlying asset, which can increase the value of options.
Implied Volatility: This is the market's forecast of a likely movement in a security's price and is
derived from the market price of a market-traded derivative (like an option). Implied volatility is
directly influenced by supply and demand in the market and by traders' expectations of future
price movements.
Historical Volatility: Also known as statistical volatility, this measure looks at the fluctuations of
the underlying asset in the past and is calculated from historical prices.
Volatility and Option Strategies

Hedging: Options can be used to hedge against volatility. For instance, purchasing put options
can protect against downward price movements.
Speculating: Traders can speculate on the future volatility of an asset by using strategies such as
straddles or strangles, which allow one to profit from large price swings in either direction.
Income Strategies: When volatility is expected to decrease or remain low, traders might sell
options to collect the premium, a strategy often seen in the writing of covered calls.
Volatility and Risk Management

Risk Measurement: Volatility is a crucial component in risk management models, such as Value
at Risk (VaR), which estimates how much a set of investments might lose, given normal market
conditions, in a set time period such as a day.
Portfolio Hedging: Derivatives can be used to create a 'delta-neutral' portfolio – one that is not
sensitive to small movements in the underlying asset price, thus managing volatility risk.
Dynamic Hedging: This involves frequently adjusting the amounts of the underlying asset and
derivatives held, in response to price changes in the underlying asset.
The Greeks and Volatility
Delta: Measures the sensitivity of an option’s price to changes in the price of the underlying
asset.
Vega: Unlike other Greeks, Vega measures the sensitivity of an option’s price to changes in
volatility. An increase in volatility will increase the price of options, all else being equal, and vice
versa.
Volatility Skew

This phenomenon occurs when different strike prices on options for the same underlying asset
with the same expiration date have different implied volatilities. Skew can indicate market
sentiment for an asset, where out-of-the-money puts or calls are in greater demand, usually in
anticipation of a downturn or upturn.
Volatility Smiles and Smirks

A volatility smile is a pattern in which at-the-money options have lower implied volatility than
in- or out-of-the-money options. This pattern can indicate that the market expects the
underlying asset to be more volatile in extreme price scenarios.
A volatility smirk is a variation where the implied volatility is higher on one side of the strike
price spectrum, reflecting asymmetric market expectations.
Conclusion

Volatility is a complex but essential concept in the world of derivatives. It influences pricing,
hedging strategies, and risk management practices. Derivative traders must have a firm grasp of
volatility and its implications to navigate the markets effectively. Understanding how to
measure and respond to volatility can significantly impact the performance of a derivatives
portfolio.

You might also like