Volatility options: Hedging effectiveness, pricing, and model error

Motivated by the growing literature on volatility options and their imminent introduction in major exchanges, this article addresses two issues. First, the question of whether volatility options are superior to standard options in terms of hedging volatility risk is examined. Second, the comparative pricing and hedging performance of various volatility option pricing models in the presence of model error is investigated. Monte Carlo simulations within a stochastic volatility setup are employed to address these questions. Alternative dynamic hedging schemes are compared, and various option‐pricing models are considered. It is found that volatility options are not better hedging instruments than plain‐vanilla options. Furthermore, the most naïve volatility option‐pricing model can be reliably used for pricing and hedging purposes. © 2006 Wiley Periodicals, Inc. Jrl Fut Mark 26:1–31, 2006