Explain the cash flow of the volatility, Financial Management

Assignment Help:

1. Let's look at the cash flow of the volatility (variance) spread swap:

-(σ2Nasdaq- σ2S&P500)N2

It is noticeable from this expression that investor actually takes a long position on the S&P500 variance and a short position on the NASDAQ variance. This trade is able to be put in place by simultaneously entering into a long S&P500 variance swap and a short NASDAQ variance swap.

Pricing here is to conclude the initial variance swap spread which makes the initial value of the swap between the two indices have a value of zero. This price is specified as 21% in the question.

2. Of course we need the correlation between the two markets. If the correlation is high close to one in absolute value among these markets then this implies that most of the time volatility will move in both markets in the same direction which in return indicates that volatility (variance) spread is relatively tight in the long run this makes the position mentioned in the query reasonable. Consequently the fixed leg of the spread has to be set (relatively) higher.

If the correlation is low near to zero in absolute value which implies that these two markets move more or less independently from every other then there is no reason to believe that the volatility spread between the markets should get narrower.

It is less probable that the investor who holds a long position will end up with a positive payoff. In order to make the initial value of the swap equal to zero the fixed leg of the spread requires to be set at a lower level.

3. The smile effect is significant. Nevertheless in this present case the trade concerns realized volatility and not the Black-Scholes implied volatility.

This signifies that the pricing of the swap will make no use of the smile in any direct way. Indirectly the smile is able to be useful to calibrate a model on the other hand.

4. If the position is taken by utilizing volatility (variance) swaps then this may be less risky compared to the other ways of taking the same position. As well the pricing of the instrument may be easier.

The major risk involved here is related to the assumption that the long run dynamics of the volatility spread is stationary. If this underlying supposition is violated then the position may lose.


Related Discussions:- Explain the cash flow of the volatility

#titleEvaluate alternative hedging strategies, Peak Inc. needs to order Can...

Peak Inc. needs to order Canadian raw materials to use in its production process. The Canadian exporter typically invoices Peak in Canadian dollars. Assume that the current exchang

Just-in-time inventory management processes, Q. Just-in-time inventory mana...

Q. Just-in-time inventory management processes? Just-in-time (JIT) inventory management processes seek to eliminate any waste that arises in the manufacturing process as a resu

Certified public accountant, Certified Public Accountant (CPA) - ACCOUNTANT...

Certified Public Accountant (CPA) - ACCOUNTANT who has satisfied education, experience and examination requirements of her or his jurisdiction essential to be certified as a public

Statement showing working capital requirement, Current Assets:- Stoc...

Current Assets:- Stock of Raw-Materials :- [(Cost of yearly consumption Of raw material)*{ (Average Inventory holding period (weeks/months))}/(52 weeks / 12 months)]=

What is suspension of payments, Is it possible for a company with a positiv...

Is it possible for a company with a positive net income and which does not distribute dividends to find itself in suspension of payments?  Yes. A lot of companies which entered

Prevention of risk - method of risk management, Prevention of Risk - Method...

Prevention of Risk - Method of risk management In case of this method, the business avoids risk by taking appropriate steps for prevention of business risk or avoiding loss, su

Calculate cost of equity, 1. Why do you think you are asked to perform valu...

1. Why do you think you are asked to perform valuation given an array of discount rates? a. Would it not be more accurate to utilize, for example, CAPM to calculate cost of equi

Cost of capital, what is the cost of capital and advantages of it?

what is the cost of capital and advantages of it?

International monetary system, what is the criteria for a good internationa...

what is the criteria for a good international financial system

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd