Stradle Hedge

Hedging

Volatility Risk

The Straddle Option Theory

Karim Sayegh

Banking & Treasury Management

Prof. R. Salomon

25th September, 2013

Executive Summary

Volatility risk has played a major role in several financial debacles. This risk could have been managed using options on volatility, which were proposed in the past but were never offered for trading mainly due to the lack of a tradable underlying asset.

The objective of this paper is to introduce a volatility instrument, an option on a straddle, which can be used to hedge volatility risk. The design and valuation of such an instrument are the basic ingredients of a successful financial product. Unlike the proposed volatility index option, the underlying of this proposed contract is a traded at- the-money-forward straddle, which I think should be more appealing to potential participants.

In order to value these options, the combination of the approaches of compound options and stochastic volatility. With an example in the paper, we can see and further more understand the function, opportunities, and disadvantages of such straddle options.

This paper first explores and explains the importance and significance of the VIX index, then furthermore shows and explains how traders are able to hedge themselves from these volatility risks that are always immanent and there for also can have a high and profitable return.

Hedging

Volatility Risk

What is the VIX? And why do we use it?

The most basic tenet of financial theory is that risk and expected return are related. One widely used measure of risk is volatility. It's well known that unexpected stock market returns are negatively related to the unexpected change in the volatility of stock returns. Greater than expected volatility leads to negative stock returns; investors demand a higher risk premium to compensate them for the greater risk. The result is that the discount rate used to value future cash flows increases (dividend or...