R 32 Q#4 ‘‘You are the portfolio manager of a mortgage portfolio. A new junior portfolio manager, Alexander Coffee, wants you to explain risk management strategies for the mortgage portfolio. Mr. Coffee understands that there are several risk exposures associated with the portfolio but is especially interested in knowing how volatility risk can be hedged. Explain to Mr. Coffee how this can be done.’’ Answer: Volatility risk can be managed by buying options or by hedging dynamically. Hedging dynamically is selected when the volatility implied in option prices is high and it is believed that future realized volatility will be lower than implied volatility. When implied volatility is low and it is believed that actual future volatility will be higher than implied volatility, hedging by purchasing options would be the better alternative. Can someone please explain this? Thanks
“Hedging dynamically is selected when the volatility implied in option prices is high and it is believed that future realized volatility will be lower than implied volatility.” = “options prices are ‘rich’ right now and are not justified based on the manager’s view of future volatility” “When implied volatility is low and it is believed that actual future volatility will be higher than implied volatility, hedging by purchasing options would be the better alternative.” = “options are ‘cheap’ and so they make sense as a hedging strategy” Remember, options are valued by the BSM model using implied volatility (that’s what we need to think on June 5th, anyhow).
“options prices are ‘rich’ right now and are not justified based on the manager’s view of future volatility” “options are ‘cheap’ and so they make sense as a hedging strategy” Good way to remember. Thanks Skillionaire.
hs_1811 Wrote: ------------------------------------------------------- > “options prices are ‘rich’ right now and are not > justified based on the manager’s view of future > volatility” > “options are ‘cheap’ and so they make sense as a > hedging strategy” > > Good way to remember. Thanks Skillionaire. My pleasure.