Article by: Emil S. F. Stamp, Thomas F. Thorsen
Published by: Department of Business Studies, Aarhus University
Date: Aug 2011
“Volatility has always been considered a key measure within the field of finance. Financial markets have changed significantly over the last century and the recent financial crises have reshaped the markets in such a way that the role of volatility has become even more pronounced than it was before. The concept finds its use within important areas such as risk management, valuation and asset pricing in general, trading and many more.
“Increased market complexity have historically spurred the demand for more exotic derivatives for directional trading and hedging. In the 1990s a new asset class arose which provided the investor with the opportunity to take a direct position, not in the underlying itself, but in its volatility. With this new derivative class, volatility is no longer viewed as side product inherent in other derivatives, but as an independent asset class of its own. Variance and volatility swaps were the first and most fundamental products to be introduced in this asset class and ever since their introduction, the market for them has exploded. The products are in nature forward contracts which at maturity exchange the difference between a fixed strike and realized variance/volatility, scaled by a predetermined notional. Both are traded OTC which makes it difficult to assess the true market size but recent estimates indicate daily trading volumes of more than $35 million notional. Both market and academic interest for these products has increased in line with demand and much research has recently been devoted to develop efficient pricing methods.”
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