HEDGING VOLATILITY RISK: THE EFFECTIVENESS OF VOLATILITY OPTIONS

In this paper we focus on the performance of volatility options as hedging instruments for hedging volatility risk. We investigate (a) the relative hedging performance of volatility and European options, (b) the relative hedging performance of volatility index and straddle options, and (c) the impact of model misspecification on hedging effectiveness. Our focus is on exotic options as the options to be hedged, because they are more sensitive to volatility risk and model risk and practically more relevant when the effectiveness of different hedging strategies is examined. Using a Monte Carlo simulation, we find that volatility options are especially useful for hedging options with a severe exotic feature and there is no significant difference between the performances of volatility index and straddle options. Furthermore, our results indicate that model misspecification has an important impact on the hedging performance.