Volatility Trading: What is the Role of the Long-Run Volatility Component?

49 Pages Posted: 28 Apr 2010 Last revised: 14 Dec 2010

See all articles by Guofu Zhou

Guofu Zhou

Washington University in St. Louis - John M. Olin Business School; China Academy of Financial Research (CAFR)

Yingzi Zhu

Tsinghua University - School of Economics & Management

Date Written: December 6, 2010

Abstract

In this paper, we study an investor's asset allocation problem with a recursive utility and with tradable volatility that follows a two-factor stochastic volatility model. Consistent with Liu and Pan (2003) and Egloff, Leippold, and Wu's (2009) finding under the additive utility, we show that volatility trading generates substantial hedging demand, and so the investor can benefit substantially from volatility trading. However, unlike existing studies, we find that the impact of elasticity of intertemporal substitution on investment decisions is of first-order importance in the two-factor stochastic volatility model when the investor has access to the derivatives market to optimally hedge the persistent component of the volatility shocks. Moreover, we study the economic impact of model and parameter misspecifications and find that an investor can incur substantial economic losses if he uses an incorrect one-factor model instead of the two-factor model or if he incorrectly estimates one of the key parameters in the two-factor model. In addition, we find that the elasticity of intertemporal substitution is a more sensible description of an investor's attitude toward model and parameter misspecifications than the risk aversion parameter.

Keywords: Volatility Trading, Asset Allocation, Long-run Volatility

JEL Classification: G11, G12

Suggested Citation

Zhou, Guofu and Zhu, Yingzi, Volatility Trading: What is the Role of the Long-Run Volatility Component? (December 6, 2010). Available at SSRN: https://ssrn.com/abstract=1596987 or http://dx.doi.org/10.2139/ssrn.1596987

Guofu Zhou (Contact Author)

Washington University in St. Louis - John M. Olin Business School ( email )

Washington University
Campus Box 1133
St. Louis, MO 63130-4899
United States
314-935-6384 (Phone)
314-658-6359 (Fax)

HOME PAGE: http://apps.olin.wustl.edu/faculty/zhou/

China Academy of Financial Research (CAFR)

Shanghai Advanced Institute of Finance
Shanghai P.R.China, 200030
China

Yingzi Zhu

Tsinghua University - School of Economics & Management ( email )

Beijing, 100084
China
+86-10-62786041 (Phone)

Register to save articles to
your library

Register

Paper statistics

Downloads
542
Abstract Views
2,586
rank
50,908
PlumX Metrics