Volatility Risk

Volatility risk is defined as the risk of the alteration of monetary value of the portfolio as the result of alterations in the volatility of the risk component. It by and large imposes to the portfolios of derivatives instruments where the volatility of its constitutional has the main impact of prices.

Volatility risk constitutes bonds with engrafted choices. Expected volatility impacts the option cost within the puttable or callable bond. Greater anticipated yield vol yields the more expectant raise in the value of the option.

Callable bonds

As volatility raises up, with all other components accommodating the same, the cost of the option will raise. This cuts down the cost of the bond. The risk is that volatility raises.

Puttable bonds

As volatility diminishes with all other components holding the same, the cost of the option will belittles, which brings down the cost of the bond. The risk here is that volatility derogates.

Price of the Puttable Bond = Price of option-free bond + Price of embedded option

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