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

Statement of total comprehensive income, At 31 July 2010 this instrument me...

At 31 July 2010 this instrument meets the definition of a derivative: Small or no initial investment. Its value is dependent on an underlying economic item; exchange ra

Stripped mortgage-backed securities , These securities aid in unpacki...

These securities aid in unpacking the cash flows from a pass-through. The most uncomplicated stripped mortgage-backed securities are the PO-IO-security. Unlike a

Method to find seasonal variation in time series, Method to Identify the Co...

Method to Identify the Component of Seasonal Variation in a Time Series This technique is called as Ratio to Moving Average Method. In this technique, we construct an index wh

Illustrate report on net present value, Q. Illustrate report on net present...

Q. Illustrate report on net present value? The NPV of a project is a positive $56000. This point to that using our cost of capital 10% as our discount rate the project is we

Forward contracts, Forward Contracts: The origin of forward contracts i...

Forward Contracts: The origin of forward contracts is lost in history. Some authors suggest that, it was India where these contracts took birth, while some others suggest that

Define correlation coefficient for two variables is -1, What does it mean w...

What does it mean when we say that the correlation coefficient for two variables is -1? What does it mean if this value were zero? What does it mean if it were +1? Correlation is

Determine about the shareholders, Determine about the Shareholders Shar...

Determine about the Shareholders Shareholders, being the owners of the company, elect board of directors and vote on major issues that affect functioning and long term plans of

Calculation of weighted average cost of capital, Calculation of Weighted Av...

Calculation of Weighted Average Cost of Capital The calculation of weighted cost of capital involves the following steps: (i) Calculate the cost of each source of funds.

Financial analysis and interpretation , You have been to carry out the foll...

You have been to carry out the following work: To provide a financial analysis and interpretation of one London stock Exchange registered company. The senior Partner has

How is finance related to accounting and economics, How is finance related ...

How is finance related to the disciplines of accounting and economics? Financial management is fundamentally a combination of economics and accounting. First financial managers

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