Volatility Risk
Market volatility is often considered to be the same as risk. It is also a popular way of expressing, understanding, and measuring the risk of investments. However, it is also believed that volatility can underestimate the actual risk because it does not consider extreme events.
What Is Volatility Risk?
It is the likelihood that the stockholder will suffer losses due to changes in market volatility - a financial indicator that defines the degree of variation of a trading price series. The Volatility Risk typically applies to portfolios of derivatives, where the volatility of its underlying assets, such as futures and options, greatly influences the prices. For short term traders, higher volatility means greater profit potential during a short time period, but it also means greater risk. A more balanced approach is to focus on stocks with moderate volatility and moderate profits.
Let's take currency pairs as an example. The investor must be able to determine all sorts of factors that affect the currency exchange rate. Studying all of these factors will allow them to define the likelihood of an unfavorable exchange rate fluctuation for a currency pair in the short term. If there are many negative factors, the VR is considered unacceptable, and the investor begins to look for other, safer investment opportunities.
Unacceptably high volatility risk has a negative impact on the entire financial market. It can provoke a fall in international trade, affecting the activities of many companies like a domino effect. When prices rapidly change, consumers reduce their costs and thus minimize company revenues. This is why companies have recently started to invest heavily in risk management, hoping to reduce the likelihood of unexpectedly high market volatility.
Protection Against Volatility Risk
To protect your portfolio from VR, it is important that you get used to an environment with higher
volatility. It will help you to seek out new ways to diversify your portfolio, in order to both generate returns and hedge the risks pertaining to traditional assets such as equities and bonds.
There are several ways to protect your portfolio against sudden market uncertainties. However, it is difficult to dynamically manage your exposure to risky assets in order to limit the fluctuations in your portfolio's value.
Multi-Asset Solutions
Specific multi-asset solutions have both a return and a volatility target. They help reduce the risk profile of a diversified portfolio and provide an extra source of return. Many of these solutions tap into the renewed volatility that often comes with greater dispersion and thus has more investment opportunities. They have a predefined risk budget and thus are a good alternative.
Volatility Risk Premium
The VR premium compensates investors for taking VR. It is based on the difference between the implied and expected volatility. In equity markets, this premium is mostly positive, fluctuating over time depending on the market's willingness to pay for protection against future changes in volatility. In practice, measuring premium overtime is challenging, especially because the expected volatility is not known. However, the tradeoff between timeliness and noise ratio of recent price changes and the long term mean reversion of volatility can become a realistic estimate.
Summary
Volatility risk refers to the probability that the stockholder will suffer losses because of changes in market volatility (price fluctuations). It is often considered to be the same as risk. VR typically applies to portfolios of derivatives. The unacceptably high volatility levels can negatively influence the entire financial market and even provoke a fall in international trade. Multi-asset solutions and VR premiums are some of the ways to hedge an investment portfolio against VR.
