Volatility risk

Volatility risk is the risk of a change of price of a portfolio as a result of changes in the volatility of a risk factor. It usually applies to portfolios of derivatives instruments, where the volatility of its underlying is a major influencer of prices.

Sensitivity to volatility

A measure for the sensitivity of a price of a portfolio (or asset) to changes in volatility is vega, the rate of change of the value of the portfolio with respect to the volatility of the underlying asset.[1][2]

Risk management

This kind of risk can be managed using appropriate financial instruments whose price depends on the volatility of a given financial asset (a stock, a commodity, an interest rate, etc.). Examples are Futures contracts such as VIX for equities, or caps, floors and swaptions for interest rates.[3][4]

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.[5]

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.[6][7]

See also

• Derivative
• Implied volatility
• Market risk
• Risk management
• Standard deviation
• Value at risk method
• Volatility risk premium

References

1. Ploeg, Antoine Petrus Cornelius van der (2006). Stochastic Volatility and the Pricing of Financial Derivatives. Tinbergen Institute Research Series. Amsterdam, Netherlands: Rozenberg Publishers. pp. 25–26. ISBN 978-90-5170-577-5.
2. Huang, Declan Chih-Yen (2002) [1998]. "The Information Content of the FTSE100 Index Option Implied Volatility and Its Structural Changes With Links to Loss Aversion". In Knight, John L.; Satchell, Stephen (eds.). Forecasting Volatility in the Financial Markets. Butterworth - Heinemann Finance. Oxford and Woburn, MA: Butterworth-Heinemann. pp. 375–376. ISBN 978-0-7506-5515-6.
3. Neftci, Salih N. (2004). Principles of Financial Engineering. Academic Press Advanced Finance Series. San Diego, CA and London: Academic Press. pp. 430–431. ISBN 978-0-12-515394-2.
4. Xekalaki, Evdokia; Degiannakis, Stavros (2010). ARCH Models for Financial Applications. Chichester, UK: John Wiley & Sons. pp. 341–343. ISBN 978-0-470-68802-1.
5. Whaley, Robert (2008). "Volatility Derivatives". In Fabozzi, Frank J. (ed.). Handbook of Finance, Financial Markets and Instruments. Hoboken, NJ: John Wiley & Sons. pp. 193–194. ISBN 978-0-470-39107-5.
6. Saunders, Anthony; Allen, Linda (2010). Credit Risk Management In and Out of the Financial Crisis: New Approaches to Value at Risk and Other Paradigms. Hoboken, NJ: John Wiley & Sons. pp. 3–4. ISBN 978-0-470-62236-0.
7. Mačerinskienė, Irena; Ivaškevičiūtė, Laura; Railienė, Ginta (2014). "The Financial Crisis Impact on Credit Risk Management in Commercial Banks". KSI Transactions on KNOWLEDGE SOCIETY. 7 (1): 5–15. S2CID 53977152.