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Volatility-of-volatility risk

Author

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  • Huang, Darien
  • Schlag, Christian
  • Shaliastovich, Ivan
  • Thimme, Julian

Abstract

We show that time-varying volatility of volatility is a significant risk factor which affects the cross-section and the time-series of index and VIX option returns, beyond volatility risk itself. Volatility and volatility-of-volatility measures, identified modelfree from the option price data as the VIX and VVIX indices, respectively, are only weakly related to each other. Delta-hedged index and VIX option returns are negative on average, and are more negative for strategies which are more exposed to volatility and volatility-of-volatility risks. Volatility and volatility of volatility significantly and negatively predict future delta-hedged option payoffs. The evidence is consistent with a no-arbitrage model featuring time-varying market volatility and volatility-of-volatility factors, both of which have negative market price of risk.

Suggested Citation

  • Huang, Darien & Schlag, Christian & Shaliastovich, Ivan & Thimme, Julian, 2018. "Volatility-of-volatility risk," SAFE Working Paper Series 210, Leibniz Institute for Financial Research SAFE.
    • Handle: RePEc:zbw:safewp:210
    DOI: 10.2139/ssrn.3183610
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    2. Giacomo Toscano & Maria Cristina Recchioni, 2020. "Bias optimal vol-of-vol estimation: the role of window overlapping," Papers 2004.04013, arXiv.org, revised Jul 2021.
    3. Kim, Seong-Tae & Kim, Jeong-Hoon, 2020. "Stochastic elasticity of vol-of-vol and pricing of variance swaps," Mathematics and Computers in Simulation (MATCOM), Elsevier, vol. 177(C), pages 420-440.
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    6. Min-Ku Lee & See-Woo Kim & Jeong-Hoon Kim, 2022. "Variance Swaps Under Multiscale Stochastic Volatility of Volatility," Methodology and Computing in Applied Probability, Springer, vol. 24(1), pages 39-64, March.

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    More about this item

    Keywords

    volatility of volatility; hedging errors; risk premiums;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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