Article by: Neil Chriss, William Moroko
Published by: New York University
Date: Jul 1999
“The market for volatility swaps at the time of this writing is dominated by longer dated instruments with maturities in the one to five year range (for an overview of the market, see Mehta (1999)). Consequently, risk management is largely a matter of understanding fluctuations in the mark-to-market value of the swap. Recently a number of articles focusing on the pricing and hedging of volatility swaps (see Carr and Madan (1998), Demeter , Derman, Kamal and Zou (1999)) have appeared. These articles demonstrate that it is possible to hedge the payout risk of a variance swap using a combination of a static position in options and a dynamic stock strategy, but say nothing of mark-to-market risk. This article exclusively studies mark-to-market risk. We classify the types of risks the holder of a volatility swap faces, and argue that some of these risks are modelable and while others depend exclusively on the valuation of out-of-the-money options whose values are not available in the market.”
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