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What is a Volatility Risk?

Article Details
  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 13 October 2018
  • Copyright Protected:
    2003-2018
    Conjecture Corporation
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Volatility risks are understood to be the amount of threat to a given investment, based on conditions currently taking place in the market. This would include some indication that the value of an underlying security is about to enter into a period of fluctuation that will seriously impact performance of the investment. When deciding whether or not to buy a given option, an investor will normally wish to be made aware of the amount of volatility risk currently associated with the investment.

One of the easiest ways to understand the projection of volatility risk is to examine the risk associated with currency trading. In terms of a volatility risk, the holder of an option would want to understand the nature of the underlying securities that form the basis for the current exchange rate applied to the currency. At the same time, the option holder will want to understand any factors that appear to be changing, and could possibly adversely impact the rate of exchange currently applied to the currency. In essence, the investor will want to know if there is a chance of the currency losing value in the short term. If that is the case, then the volatility risk may be deemed to be unacceptable, and the investor will seek other opportunities.

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When an unacceptable level of volatility risk is present, the phenomenon can have serious implications for not only individual securities, but also for the market as a whole. For example, a high volatility risk could result in a reduced volume of international trading. This could seriously hamper the production and operation of a number of companies and eventually lead to serious repercussions for the economy of one or more nations.

Cash flow among consumers may be minimized, which in turn begins to impact the profit margins for other companies and increases the rate of volatility associated with their stocks. This in turn means that companies must utilize more resources in risk management, which may inhibit other functions within the corporate structure. Unless the risk management strategies are able to contain and reverse the impact of the volatility risk, the impact could continue to spread to other sectors of the economy.

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