What is the primary objective of volatility arbitrage strategies?

• A. A to exploit differences in rates
• B. B to take advantage of high implied volatility
• C. C to hedge against market downturns
• D. D to profit from volatility convergence

Answer: (D)

The primary objective of volatility arbitrage strategies is to profit from volatility convergence. This approach involves identifying discrepancies between implied volatility (the market's forecast of future volatility) and historical volatility (the actual past volatility of an asset). Traders employing volatility arbitrage will take long and short positions in options or other derivatives to capitalize on these mispricings.

When the implied volatility is higher than historical volatility, the strategy may involve selling options, anticipating that the implied volatility will decline and converge with historical levels. Conversely, if implied volatility is lower, a trader might buy options to profit from an expected increase in volatility. The key aspect of this strategy is the belief that volatility will eventually revert to a long-term average, enabling the trader to realize a profit as the market corrects itself.

This focus distinguishes volatility arbitrage from other strategies that may target differences in interest rates or implied volatility due to market conditions, or those aimed solely at hedging against market downturns, which do not primarily seek to exploit mispricings related to volatility itself.