Pricing methods and hedging strategies for volatility derivatives. Working Paper

In this paper we investigate the behaviour and hedging of discretely observed volatil-ity derivatives. We begin by comparing the effects of variations in the contract design, such as the differences between specifying log returns or actual returns, taking into con-sideration the impact of possible jumps in the underlying asset. We then focus on the difficulties associated with hedging these products. Naive delta-hedging strategies are ineffective for hedging volatility derivatives since they require very frequent rebalancing and have limited ability to protect the writer against possible jumps in the underlying asset. We investigate the performance of a hedging strategy for volatility swaps that establishes small, fixed positions in straddles and out-of-the-money strangles at each volatility observation.