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Volatility-of-Volatility Risk

Published online by Cambridge University Press:  05 November 2018

Darien Huang Open the ORCID record for Darien Huang [Opens in a new window] ,
Christian Schlag ,
Ivan Shaliastovich  and
Julian Thimme
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Abstract

We show that market volatility of volatility is a significant risk factor that affects index and volatility index option returns, beyond volatility itself. The volatility and volatility of volatility indices, identified model-free as the VIX and VVIX, 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 that are more exposed to volatility and volatility-of-volatility risks. Further, volatility and volatility of volatility significantly negatively predict future delta-hedged option payoffs. The evidence suggests that volatility and volatility-of-volatility risks are jointly priced and have negative market prices of risk.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 54 , Issue 6 , December 2019 , pp. 2423 - 2452
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2018 

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Footnotes

1

We thank an anonymous referee, Franklin Allen, Luca Benzoni, Hendrik Bessembinder (the editor), João Gomes, Mete Kilic, Krishna Ramaswamy, Scott Richard, Nikolai Roussanov, Anders Trolle, Amir Yaron, and Hao Zhou and seminar participants at the University of Pennsylvania, the 2014 European Finance Association Meeting, the 2014 OptionMetrics Research Conference, and the 2014 Asian Meeting of the Econometric Society for their comments and suggestions. Schlag gratefully acknowledges research and financial support from SAFE, funded by the State of Hessen initiative for research LOEWE. Shaliastovich thanks the Jacobs Levy Equity Management Center for Quantitative Financial Research, the Rodney White Center, and the Cynthia and Bennett Golub Endowment for financial support.

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