Principles of Financial Engineering, 2nd Edition

CHAPTER 14

Tools for Volatility Engineering, Volatility Swaps, and Volatility Trading

1. Introduction

Liquid instruments that involve pure volatility trades are potentially very useful for market participants who have natural exposure to various volatilities in their balance sheet or trading book. The classical option strategies discussed in Chapter 10 have serious drawbacks in this respect. When a trader takes a position or hedges a risk, he or she expects that the random movements of the underlying would have a known effect on the position. The underlying may be random, but the payoff function of a well-defined contract or a position has to be known. Payoff functions of most classical volatility strategies are not invariant to underlying risks, ...