Forward Volatility Agreement Valuation: What You Need to Know
Forward Volatility Agreements (FVAs) are a financial instrument used to trade volatility in the market. They are a type of derivative that allows investors to bet on the future movement of volatility. However, FVAs are not as widely known as other derivatives such as options or futures. This article will provide an overview of FVAs, their valuation, and how they can be used in the market.
What are Forward Volatility Agreements?
Forward Volatility Agreements are contracts between two parties to exchange a payment based on the future level of volatility. The parties agree to a specific future date where they will exchange the payment. The payment is based on the difference between the actual level of volatility on that date and a predetermined volatility level.
For example, if the predetermined volatility level is 15%, and the actual level of volatility on the future date is 18%, the holder of the FVA would receive a payment from the counterparty. The payment amount is calculated based on the difference between the predetermined level and the actual level of volatility.
Valuing Forward Volatility Agreements
The valuation of FVAs is complex and requires a deep understanding of volatility modeling. The most common method of valuation is through the Black-Scholes model, which is also used to value options. The model takes into account the strike price, the time to maturity, the underlying asset price, the risk-free rate, and the volatility of the asset.
Another method used to value FVAs is through Monte Carlo simulations. Monte Carlo simulations are used to model the future path of volatility and generate a distribution of potential payout values. This method is preferred for complex FVAs.
Applications of Forward Volatility Agreements
Investors use FVAs as a way to hedge their portfolio against losses due to market volatility. They can also be used to speculate on the future movement of volatility. For example, if an investor expects volatility to increase, they can buy FVAs at a predetermined price. If the level of volatility increases on the future date, the investor can sell the FVA at a higher price and make a profit.
In the past, FVAs were primarily used by institutional investors, but they are now more widely available to retail investors. Some financial firms offer FVA contracts to their clients as a way to protect against market volatility.
Forward Volatility Agreements are a powerful financial instrument used to trade volatility in the market. They allow investors to hedge their portfolio against losses due to market volatility and to speculate on the future movement of volatility. Valuing FVAs requires a deep understanding of volatility modeling, but there are widely accepted methods for valuation. As with any financial instrument, investors should do their due diligence and seek advice from professionals before investing in FVAs.