A volatility arbitrage hedge fund generates returns based on what?

Volatility arbitrage hedge funds aim to exploit discrepancies between forecasted volatility—often derived from models or historical data—and implied volatility, which is the market's expectation of future volatility as reflected in the prices of options.

When the forecasted volatility is notably different from the implied volatility, arbitrageurs can engage in trades that capitalize on the potential convergence of these values. For example, if implied volatility is higher than forecasted volatility, the hedge fund might sell overvalued options while simultaneously entering into other options positions that are undervalued, betting that the implied volatility will decrease over time, thus generating profit from this mispricing.

The other options do not directly pertain to the primary strategy of volatility arbitrage. While economic growth can influence market conditions, it does not specifically relate to the core operational mechanism of volatility arbitrage. Similarly, while blue-chip stocks and long-term bond investments can certainly be components of a hedge fund's portfolio, they are not targeted by the volatility arbitrage strategy itself, which focuses specifically on the interplay of implied and forecasted volatilities in the options market.