Volatility risk

What is Volatility risk?

Volatility risk is the risk of a change of price of a portfolio as a result of changes in the volatility of a risk factor. It usually applies to portfolios of derivatives instruments, where the volatility of its under lyings is a major influencer of prices.

Volatility risk is specifically related to the breadth of the trading range. This is simply the point spread between the most recent high and low price levels at which a stock has traded.

In the stock market, breadth and trading range are what define volatility risk. The greater the breadth, the greater the risk. For traders, who are most likely to focus on short-term price movement, higher volatility means greater profit potential in a short period of time. It also means greater volatility risk. For most traders, the most realistic approach is to focus on the stocks with moderate volatility, thus accepting moderate volatility risk in exchange for potential profits. If volatility is too high based on a self-defined risk tolerance, the stock is not appropriate. If volatility is too low, then traders will be equally disinterested because in exchange for low risks, profits are also unlikely.

Risk volatility ia a measure of the distance between an expected result and its standard deviation. The further this distance, the greater the volatility, and vice versa. For example, expected annual workers compensation losses for ABC Company are $1 million, and the standard deviation is $100,000 (i.e., 10 percent of $1 million). Expected losses for XYZ Company are also $1 million, but the standard deviation is $250,000, or 25 percent of $1 million. Therefore, XYZ Company’s volatility is much higher than ABC’s.

Sensitivity to Volatility

A measure for the sensitivity of a price of a portfolio (or asset) to changes in volatility is vega, the rate of change of the value of the portfolio with respect to the volatility of the underlying asset.

Managing Volatility risk

This kind of risk can be managed using appropriate financial instruments whose price depends on the volatility of a given financial asset (a stock, a commodity, an interest rate, etc.). Examples are Futures contracts such as VIX for equities, or caps, floors and swaptions for interest rates. Risk management is the configuration and identification of analyzing, and or acceptance during investment decision-making. In essence this occurs whenever an investor or portfolio manager evaluates potential losses within an investment. Under certain investment objectives, appropriate solutions (or no solution) will occur to assess the investors goals and standards. Improper risk management can and or will negatively affect companies as well as their individuals. For example, the recession that began in 2008 was largely caused by the loose credit risk management of financial firms.

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