Principles of Financial Engineering, 2nd Edition

CHAPTER 9

Engineering Convexity Positions

1. Introduction

How can anyone trade volatility? Stocks, yes. Bonds, yes. But volatility is not even an asset. Several difficulties are associated with defining precisely what volatility is. For example, from a technical point of view, should we define volatility in terms of the estimate of the conditional standard deviation of an asset price S_t?

(1)

Or should we define it as the average absolute deviation?

(2)

There is no clear answer, and these two definitions of statistical volatility will yield different ...