Question

Describe the simplest vanilla option structure that isolates exposure to 3-month volatility 3 months forward.

Suppose you are long that structure, and spot drifts down 5% over the next week. How will your risk exposures change if you have not rebalanced the position?

Answer 1

Volatility is a statistical measure of the dispersion of returns for a given security or market index. In most cases, the higher the volatility, the riskier the security. Volatility is often measured as either the standard deviation or variance between returns from that same security or market index.

• Volatile assets are often considered riskier than less volatile assets because the price is expected to be less predictable.
• Volatility is an important variable for calculating options prices.
• There is no up-front cost of hedging by forward contracts. In the case of options hedging, however, hedgers should pay the premiums for the contracts up-front. The cost of forward hedging, however, may be realized ex post when the hedger regrets his/her hedging decision.
• Hedging transaction exposure by a forward contract is achieved by selling or buying foreign currency receivables or payables forward. On the other hand, money market hedge is achieved by borrowing or lending the present value of foreign currency receivables or payables, thereby creating offsetting foreign currency positions. If the interest rate parity is holding, the two hedging methods are equivalent.