Hedging (Co)Variance Risk with Variance Swaps

46 Pages Posted: 4 Mar 2008 Last revised: 26 Nov 2008

See all articles by José Da Fonseca

José Da Fonseca

Auckland University of Technology - Faculty of Business & Law

Martino Grasselli

University of Padova - Department of Mathematics; Léonard de Vinci Pôle Universitaire, Research Center

Florian Ielpo

Université Paris I Panthéon-Sorbonne - Centre d'Economie de la Sorbonne (CES)

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Date Written: November 17, 2008

Abstract

In this paper we introduce a new criterion in order to measure the variance and covariance risks in financial markets. Unlike past literature, we quantify the (co)variance risk by comparing the spread between the initial wealths required to obtain the same final utility in an incomplete and completed market case. We provide explicit solutions for both cases in a stochastic correlation framework where the market is completed by introducing volatility products, namely Variance Swaps. Using real data on major indexes, we find that this criterion provides a better measure of the market risks with respect to the (misleading) traditional approach based on the hedging demand.

Keywords: Wishart Affine Stochastic Correlation model, complete and incomplete markets, variance swaps, optimal portfolio choice

JEL Classification: G11, G12

Suggested Citation

Da Fonseca, José and Grasselli, Martino and Ielpo, Florian, Hedging (Co)Variance Risk with Variance Swaps (November 17, 2008). 21st Australasian Finance and Banking Conference 2008 Paper, Available at SSRN: https://ssrn.com/abstract=1102521 or http://dx.doi.org/10.2139/ssrn.1102521

José Da Fonseca

Auckland University of Technology - Faculty of Business & Law ( email )

3 Wakefield Street
Private Bag 92006
Auckland Central 1020, Auckland 1010
New Zealand
64 9 921 9999 5063 (Phone)

Martino Grasselli

University of Padova - Department of Mathematics ( email )

Via Trieste 63
Padova, Padova
Italy

Léonard de Vinci Pôle Universitaire, Research Center ( email )

Paris La Défense
France

Florian Ielpo (Contact Author)

Université Paris I Panthéon-Sorbonne - Centre d'Economie de la Sorbonne (CES) ( email )

106-112 Boulevard de l'hopital
106-112 Boulevard de l'Hôpital
Paris Cedex 13, 75647
France

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