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

Published online by Cambridge University Press:  20 January 2012

Guofu Zhou  and
Yingzi Zhu
Guofu Zhou
Affiliation:
Olin School of Business, Washington University, 1 Brookings Dr., St. Louis, MO 63130. zhou@wustl.edu
Yingzi Zhu
Affiliation:
School of Economics and Management, Tsinghua University, Beijing 100084, China. zhuyz@sem.tsinghua.edu.cn
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Abstract

We study an investor’s asset allocation problem with a recursive utility and with tradable volatility that follows a 2-factor stochastic volatility model. Consistent with previous findings under the additive utility, we show that the investor can benefit substantially from volatility trading due to hedging demand. Unlike existing studies, we find that the impact of elasticity of intertemporal substitution (EIS) on investment decisions is of 1st-order importance. Moreover, the investor can incur significant economic losses due to model and/or parameter misspecifications where the EIS better captures the investor’s attitude toward risk than the risk aversion parameter.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 47 , Issue 2 , April 2012 , pp. 273 - 307
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2012

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