Advanced Search
MyIDEAS: Login

Hedging (Co)Variance Risk With Variance Swaps

Contents:

Author Info

  • JOSÉ DA FONSECA

    ()
    (Auckland University of Technology, Department of Finance, Private Bag 92006, 1142 Auckland, New Zealand)

  • MARTINO GRASSELLI

    ()
    (Università degli Studi di Padova, Dipartimento di Matematica Pura ed Applicata, Via Trieste 63, Padova, Italy; Ecole Supérieure d'Ingénieurs Léonard de Vinci, Département Mathématiques et Ingénierie Financière, 92916 Paris La Défense, France)

  • FLORIAN IELPO

    ()
    (Lombard Odier Darier Hentsch & Cie, rue de la Corraterie 11, CH-1204 Genève 73, Switzerland)

Abstract

In this paper, we quantify the impact on the representative agent's welfare of the presence of derivative products spanning covariance risk. In an asset allocation framework with stochastic (co)variances, we allow the agent to invest not only in the stocks but also in the associated variance swaps. We solve this optimal portfolio allocation program using the Wishart Affine Stochastic Correlation framework, as introduced in Da Fonseca, Grasselli and Tebaldi (2007): it shares the analytical tractability of the single-asset counterpart represented by the [36] model and it seems to be the natural framework for studying multivariate problems when volatilities as well as correlations are stochastic. What is more, this framework shows how variance swaps can implicitly span the covariance risk. We provide the explicit solution to the portfolio optimization problem and we discuss the structure of the portfolio loadings with respect to model parameters. Using real data on major indexes, we find that the impact of covariance risk on the optimal strategy is huge. It first leads to a portfolio that is mostly driven by the market price of volatility-covolatility risks. It is then strongly leveraged through variance swaps, thus leading to a much higher utility, when compared to the case when investing in such derivatives is not possible.

Download Info

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
File URL: http://www.worldscinet.com/cgi-bin/details.cgi?type=pdf&id=pii:S0219024911006784
Download Restriction: Access to full text is restricted to subscribers.

File URL: http://www.worldscinet.com/cgi-bin/details.cgi?type=html&id=pii:S0219024911006784
Download Restriction: Access to full text is restricted to subscribers.

As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.

Bibliographic Info

Article provided by World Scientific Publishing Co. Pte. Ltd. in its journal International Journal of Theoretical and Applied Finance.

Volume (Year): 14 (2011)
Issue (Month): 06 ()
Pages: 899-943

as in new window
Handle: RePEc:wsi:ijtafx:v:14:y:2011:i:06:p:899-943

Contact details of provider:
Web page: http://www.worldscinet.com/ijtaf/ijtaf.shtml

Order Information:
Email:

Related research

Keywords: Wishart Affine Stochastic Correlation model; complete and incomplete markets; variance swaps; Fourier transform;

References

No references listed on IDEAS
You can help add them by filling out this form.

Citations

Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
as in new window

Cited by:
  1. Schürhoff, Norman & Ziegler, Alexandre, 2011. "Variance risk, financial intermediation, and the cross-section of expected option returns," CEPR Discussion Papers 8268, C.E.P.R. Discussion Papers.
  2. Alessandro Gnoatto & Martino Grasselli, 2011. "The explicit Laplace transform for the Wishart process," Science & Finance (CFM) working paper archive 1107.2748, Science & Finance, Capital Fund Management, revised Aug 2013.
  3. Branger, Nicole & Muck, Matthias, 2012. "Keep on smiling? The pricing of Quanto options when all covariances are stochastic," Journal of Banking & Finance, Elsevier, vol. 36(6), pages 1577-1591.
  4. Giovanni Salvi & Anatoliy V. Swishchuk, 2012. "Modeling and Pricing of Covariance and Correlation Swaps for Financial Markets with Semi-Markov Volatilities," Science & Finance (CFM) working paper archive 1205.5565, Science & Finance, Capital Fund Management.
  5. Alessandro Gnoatto, 2012. "The Wishart short rate model," Science & Finance (CFM) working paper archive 1203.5513, Science & Finance, Capital Fund Management, revised May 2014.
  6. Jan Baldeaux & Eckhard Platen, 2012. "Computing Functionals of Multidimensional Diffusions via Monte Carlo Methods," Science & Finance (CFM) working paper archive 1204.1126, Science & Finance, Capital Fund Management.
  7. Da Fonseca, José & Gnoatto, Alessandro & Grasselli, Martino, 2013. "A flexible matrix Libor model with smiles," Journal of Economic Dynamics and Control, Elsevier, vol. 37(4), pages 774-793.

Lists

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

Statistics

Access and download statistics

Corrections

When requesting a correction, please mention this item's handle: RePEc:wsi:ijtafx:v:14:y:2011:i:06:p:899-943. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Tai Tone Lim).

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.