Volatility Arbitrage Strategies

Volatility arbitrage strategies take positions in fixed-income security options that are deemed to have mispriced volatility. In other words, the volatility implied in the option is either too high or too low relative to the "correct" volatility as determined by the manager's proprietary option pricing model. If the implied volatility is too low (cheap volatility), the manager takes a long position in the option. If the implied volatility is too high (expensive volatility), the manager takes a short position in the option. Managers thus seek to profit from the level of and changes in volatilities of underlying fixed-income instruments by taking long and short option positions as appropriate. Mispriced volatility tends to occur just after market shocks, when volatility is high and increasing. During such periods, volatility becomes expensive relative to historical and observed future volatility.

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