Forward volatility agreement definition: Understanding the concept
Forward volatility agreement (FVA) is a derivative instrument used to hedge against volatility. Volatility is the degree of variation of price of an asset or financial instrument over time. This variation can be measured using standard deviation, which calculates the dispersion of a set of data from its average. Investors can use FVA to protect their investment from the adverse effects of volatility.
FVA is an agreement between two parties. The first party is the buyer, who is the investor seeking to protect their investment from volatility. The second party is the seller, who is typically a financial institution or dealer. Under the FVA, the buyer agrees to pay the seller a predetermined premium in exchange for the seller`s promise to compensate the buyer for losses resulting from the volatility of the underlying asset.
The underlying asset in an FVA can be anything that is subject to price fluctuations, such as stocks, currencies, commodities, interest rates, and market indices. The FVA can be customized to meet the specific needs of the investor and may include various terms and conditions, such as the volatility level, the duration of the agreement, and the method of payment.
FVA is a useful tool for investors who wish to limit their exposure to volatility and protect their investment. However, it is important to note that FVA is a derivative instrument, and as such, it involves a considerable amount of risk. Investors must be aware of the risks associated with FVA, such as the possibility of the other party defaulting on the agreement or the price of the underlying asset moving in an unpredictable manner.
In conclusion, forward volatility agreement definition can be described as a financial instrument used to hedge against volatility in the price of an underlying asset. It is an agreement between two parties, the buyer and the seller, and can be customized to meet the needs of the investor. FVA is a useful tool for investors who wish to limit their exposure to volatility; however, it involves significant risk, and investors must be cautious when using this instrument.