{{Short description|Risk arising from changes in market volatility affecting the value of financial positions}} {{Financial risk types}} '''Volatility risk''' is the risk of an adverse change of price, due to changes in the volatility of a factor affecting that price. It usually applies to derivative instruments, and their portfolios, where the volatility of the underlying asset is a major influencer of option prices.<ref name="Brenner et al">Menachem Brenner, Ernest Y. Ou, Jin E. Zhang (2006). [https://pages.stern.nyu.edu/~mbrenner/research/HV_paper_in_JBF.pdf "Hedging volatility risk"]. ''Journal of Banking & Finance'' 30 (2006) 811–821</ref> It is also relevant to portfolios of basic assets, and to foreign currency trading.<ref name="Brenner et al" />

Volatility risk can be managed by hedging<ref name="Downey"/> with appropriate financial instruments.<ref name="AvellanedaParas">{{Cite journal |last1=Avellaneda |first1=M. |last2=Levy |first2=A. |last3=Parás |first3=A. |year=1995 |title=Pricing and hedging derivative securities in markets with uncertain volatilities |journal=Applied Mathematical Finance |volume=2 |issue=2 |pages=73–88 |doi=10.1080/13504869500000005}}</ref> These are volatility swaps, variance swaps, conditional variance swaps, variance options, VIX futures for equities, and (with some construction) caps, floors and swaptions for interest rates.<ref>{{Cite book |last=Neftci |first=Salih N. |url=https://books.google.com/books?id=TB8ZIFDlKSwC&dq=finance+vega+volatility&pg=PA430 |title=Principles of Financial Engineering |publisher=Academic Press |year=2004 |isbn=978-0-12-515394-2 |series=Academic Press Advanced Finance Series |location=San Diego, CA and London |pages=430–431 |language=en |authorlink=Salih Neftci}}</ref><ref>{{Cite book |last1=Xekalaki |first1=Evdokia |url=https://books.google.com/books?id=_FZHKyuXOEwC&dq=vix+volatility+index&pg=PA342 |title=ARCH Models for Financial Applications |last2=Degiannakis |first2=Stavros |publisher=John Wiley & Sons |year=2010 |isbn=978-0-470-68802-1 |location=Chichester, UK |pages=341–343 |language=en}}</ref><ref>Andrew Lesniewski (2015). [https://mfe.baruch.cuny.edu/wp-content/uploads/2015/06/VolWork6-Andrew.pdf Managing interest rate volatility risk]</ref> Here, the hedge-instrument is sensitive to the same source of volatility as the asset being protected (i.e. the same stock, commodity, or interest rate etc.). The position is then established such that a change in the value of the protected-asset, is offset by a change in value of the hedge-instrument. The number of hedge-instruments purchased, will be a function of the relative sensitivity to volatility of the two: the measure of sensitivity is ''vega'', the rate of change of the value of the option, or option-portfolio, with respect to the volatility of the underlying asset.<ref>{{Cite book |last=Ploeg |first=Antoine Petrus Cornelius van der |url=https://books.google.com/books?id=yP0UwMU1RvUC&dq=finance+vega+volatility&pg=PA25 |title=Stochastic Volatility and the Pricing of Financial Derivatives |publisher=Rozenberg Publishers |year=2006 |isbn=978-90-5170-577-5 |series=Tinbergen Institute Research Series |location=Amsterdam, Netherlands |pages=25–26 |language=en}}</ref><ref>{{Cite book |last=Huang |first=Declan Chih-Yen |title=Forecasting Volatility in the Financial Markets |publisher=Butterworth-Heinemann |year=2002 |isbn=978-0-7506-5515-6 |editor-last=Knight |editor-first=John L. |series=Butterworth - Heinemann Finance |location=Oxford and Woburn, MA |pages=375–376 |language=en |chapter=The Information Content of the FTSE100 Index Option Implied Volatility and Its Structural Changes With Links to Loss Aversion |orig-year=1998 |editor-last2=Satchell |editor-first2=Stephen |chapter-url=https://books.google.com/books?id=pc3K-nVn09wC&dq=finance+vega+volatility&pg=PA376}}</ref>

Option traders often seek to create "vega neutral" positions, typically as part of an options trading strategy.<ref>See, e.g., [https://www.macroption.com/vega-neutral-option-strategies/ Vega Neutral Option Strategies]</ref> The value of an at-the-money straddle, for example, is extremely dependent on changes to volatility. Once neutrality is established, the total vega of the position is (near) zero — i.e. the impact of implied volatility is negated — allowing the trader to gain exposure to the specific opportunity, without concern for changing volatility.<ref>Sarah Saves (2024). [https://tiblio.com/glossary/vega-neutral-finance-explained/ "Vega Neutral"], tiblio.com</ref> <ref name="Downey">Lucas Downey (2022). [https://www.investopedia.com/terms/v/vega-neutral.asp "Vega Neutral"], Investopedia</ref>

==See also== *Financial risk management *Implied volatility **Volatility smile **IVX *Market risk *{{section link|Model risk#Uncertainty on volatility}} *Value at risk *Volatility beta *Volatility risk premium

==References== {{Reflist}} {{Financial risk}}

<!-- not directly relevant Risk management is the configuration and identification of analyzing, and or acceptance during investment decision-making. In essence this occurs whenever an investor or portfolio manager evaluates potential losses within an investment. Under certain investment objectives, appropriate solutions (or no solution) will occur to assess the investors goals and standards.<ref>{{Cite book|chapter-url=https://books.google.com/books?id=7LOD1CmBD-cC&dq=vix+volatility+index&pg=PA198|title=Handbook of Finance, Financial Markets and Instruments|last=Whaley|first=Robert|publisher=John Wiley & Sons|year=2008|isbn=978-0-470-39107-5|editor-last=Fabozzi|editor-first=Frank J.|location=Hoboken, NJ|pages=193–194|language=en|chapter=Volatility Derivatives}}</ref> -->

<!-- not directly relevant Improper risk management can and or will negatively affect companies as well as their individuals. For example, the recession that began in 2008 was largely caused by the loose credit risk management of financial firms.<ref>{{Cite book|url=https://books.google.com/books?id=Rr_6y9evvowC&q=financial+crisis+2008+credit+risk+management|title=Credit Risk Management In and Out of the Financial Crisis: New Approaches to Value at Risk and Other Paradigms|last1=Saunders|first1=Anthony|last2=Allen|first2=Linda|publisher=John Wiley & Sons|year=2010|isbn=978-0-470-62236-0|location=Hoboken, NJ|pages=3–4|language=en}}</ref><ref>{{Cite journal|last1=Mačerinskienė|first1=Irena|last2=Ivaškevičiūtė|first2=Laura|last3=Railienė|first3=Ginta|date=2014|title=The Financial Crisis Impact on Credit Risk Management in Commercial Banks|journal=KSI Transactions on KNOWLEDGE SOCIETY|volume=7|issue=1|pages=5–15|s2cid=53977152}}</ref> -->

{{DEFAULTSORT:Volatility Risk}} Category:Financial risk Category:Market risk Category:Financial risk modeling Category:Options (finance) Category:Derivatives (finance)

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