Journal of Financial and Quantitative Analysis

Research Articles

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

Guofu Zhoua1 and Yingzi Zhua2

a1 Olin School of Business, Washington University, 1 Brookings Dr., St. Louis, MO 63130. zhou@wustl.edu

a2 School of Economics and Management, Tsinghua University, Beijing 100084, China. zhuyz@sem.tsinghua.edu.cn

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.

(Online publication January 20 2012)

Footnotes

We are grateful to Darrell Duffie, Hong Liu, Kevin Wang, Tan Wang, Jianfeng Yu, Jin Zhang, Hao Zhou, seminar participants in Tsinghua University, and participants of the 2009 China International Conference in Finance for helpful comments, and especially to Turan Bali (the referee) and Stephen Brown (the editor) for many insightful comments that substantially improved the paper. Part of the paper was written during Zhou’s visit to Tsinghua University and Shanghai Advanced Institute of Finance.

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