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Volatility Trading: What Is the Role of the Long-Run Volatility Component?

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  • Zhou, Guofu
  • Zhu, Yingzi

Abstract

We study an investor’s asset allocation problem with a recursive utility and with tradable volatility that follows a 2-factor stochastic volatility model. Consistent with previous findings under the additive utility, we show that the investor can benefit substantially from volatility trading due to hedging demand. Unlike existing studies, we find that the impact of elasticity of intertemporal substitution (EIS) on investment decisions is of 1st-order importance. Moreover, the investor can incur significant economic losses due to model and/or parameter misspecifications where the EIS better captures the investor’s attitude toward risk than the risk aversion parameter.

Suggested Citation

  • Zhou, Guofu & Zhu, Yingzi, 2012. "Volatility Trading: What Is the Role of the Long-Run Volatility Component?," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 47(02), pages 273-307, June.
  • Handle: RePEc:cup:jfinqa:v:47:y:2012:i:02:p:273-307_00
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    Cited by:

    1. Song, Zhaogang & Xiu, Dacheng, 2016. "A tale of two option markets: Pricing kernels and volatility risk," Journal of Econometrics, Elsevier, vol. 190(1), pages 176-196.
    2. Warren Bailey & Lin Zheng & Yinggang Zhou, 2012. "What Makes the VIX Tick?," Working Papers 222012, Hong Kong Institute for Monetary Research.
    3. Dew-Becker, Ian & Giglio, Stefano & Le, Anh & Rodriguez, Marius, 2017. "The price of variance risk," Journal of Financial Economics, Elsevier, vol. 123(2), pages 225-250.

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