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the following reading deals with another example of how spread positions on volatili 599233

The following reading deals with another example of how spread positions on volatility can be taken. Yet, of interest here are further aspects of volatility positions. In fact, the episode is an example of the use of knock-in and knock-out options in volatility positions.

(a) Suppose the investor sells short-dated (one-month) volatility and buys six-month volatility. In what sense is this a naked volatility position? What are the risks? Explain using volatility swaps as an underlying instrument.

(b) Explain how a one-month break-out clause can hedge this situation.

(c) How would the straddles gain value when the additional premium is triggered?

(d) What are the risks, if any, of the position with break-out clauses?

(e) Is this a pure volatility position?

Sterling volatility is peaking ahead of the introduction of the euro next year. A bank suggests the following strategy to take advantage of the highly inverted volatility curve. Sterling will not join the euro in January and the market expects reduced sterling positions. This view has pushed up one-month ster-ling/Deutsche mark vols to levels of 12.6% early last week. In contrast, six-month vols are languishing at under 9.2%. This suggests selling short-dated vol and buying six-month vols. Customers can buya six-month straddle with a one-month break-out clause added to replicate a short volatilityposition in the one-month maturity. This way they don’t have a naked volatility position. (Based on an article in Derivatives Week.)

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