Chapter 16. Volatility Derivatives


Valere Blair Potter Professor of Management, The Owen Graduate School of Management, Vanderbilt University

Abstract: A relatively new stock index product is the volatility derivative. The Chicago Board Options Exchange (CBOE) contemplated launching trading volatility options as early as 1993. On January 19, 1998, the Deutsche Terminborse (DTB) became the first exchange in the world to list volatility futures. The CBOE launched trading of VIX futures on its CBOE Futures Exchange on March 26, 2004, with contracts on three-month realized variance being launched on May 18, 2004. The CBOE launched VIX options on February 24, 2006. It was not until the Long-Term Capital Management (LTCM) fiasco in late 1998 that the market finally began to recognize the value of trading stock market volatility as a separate asset class.

Keywords: volatility derivatives, volatility swap, realized future volatility, realized volatility derivative contract, variance swap, implied volatility derivatives contract

Volatility derivative contracts are written not only on stock indexes, but also interest rates, currencies, and commodities like crude oil. Prior to the advent of volatility derivatives, stock market volatility risk was managed using options written on the underlying index. The problem with doing so is that it is expensive. Options have two sources of price risk—risk associated with movements in the underlying index level and risk associated with movements ...

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