Swedroe: Variance Risk Premium Evidence

April 22, 2019

An insurance policy is a means of risk transfer in which a buyer pays to eliminate the possibility of an extreme, rare, downside event—such as premature death, destruction from an earthquake or hurricane, or in the case of financial assets (including stocks, bonds, currencies and commodities), a sharp increase or decrease in the price.

The price of such a risk transfer decomposes into two parts: an expected payout and a risk premium to compensate the seller for the uncertain nature of any payout, which may be sudden and dramatic. Financial markets are full of strategies that resemble insurance or lotteries.

For example, in options markets, the premium to compensate the seller for the uncertain nature of the payout is called the variance (or volatility) risk premium (VRP). This risk premium is rational for both the buyer and the seller. The buyer willingly pays it to create, or to eliminate, uncertainty. The seller charges it for taking the risk. And the evidence indicates that the more remote the risk, the higher the ratio of risk premium to expected payout.

The bottom line is that, over a large sample size, there is an expected fair value set by the probabilities of outcomes, and options sellers charge a premium to that fair value to compensate themselves for providing a risk-transfer service.

Nature Of The VRP

The VRP refers to the fact that, over time, the option-implied volatility has tended to exceed the realized volatility of the same underlying asset. This has created a profit opportunity for volatility sellers—those willing to write volatility insurance options, collect the premiums and bear the risk that realized volatility will increase by more than implied volatility.

Because the VRP’s risks (specifically, when the sale of options performs poorly) tend to show up in bad times (when risky assets perform poorly), we should expect a significant premium, one that cannot be arbitraged away.

Another way to think of this is that investors pay to hedge catastrophic outcomes; they want to transfer the risk of a terrible outcome.

For example, we buy insurance against our homes burning down. Oil producers (such as Mexico) buy insurance against the price of oil falling, and utilities and other users of energy buy protection against the price of oil and natural gas rising. Farmers buy insurance against the price of their production falling, and companies that use agricultural products buy protection against the prices of their inputs rising. Importers buy protection against the price of currencies they buy from rising, and exporters buy protection against the price of currencies they bill from falling. Borrowers of floating rate debt buy protection against interest rates rising, and owners of longer-term bond lenders buy protection against rates rising.

As a result, the VRP should be considered a unique risk premium that investors with long investment horizons and stable finances can harvest because they have the ability to accept the cyclical risks that show up in bad times.

Stone Ridge Asset Management, sponsor of the All Asset Variance Risk Premium Fund (AVRPX), examined the historical evidence on the VRP across stocks, bonds, commodities and currencies from 2008 (the first year of publicly available data for all asset classes) through 2018.

It measured the VRP as the premium of implied volatility to realized volatility using one-month 25-delta options. Delta represents an option’s sensitivity to the price change of the underlying asset, ranging from -100 to 100. The price of an option with 25 delta will theoretically move $0.25 for every $1 move in the underlying asset. Due to data limitations, German five-year and 10-year rates represent data since 2011. The asset class VRPs are the equal-weighted average of the component parts shown.

Here is what they found:

  • The equity VRP was 15%.
  • The foreign exchange VRP was 13%.
  • The commodity VRP was 9%.
  • The interest rate VRP was 14%.

A large body of evidence demonstrates that the VRP is persistent and pervasive as well as robust to various maturities across asset classes and the around the globe. My ETF.com blog on August 2, 2017 presented the evidence from academic studies on the subject.

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