Swedroe: Volatility Risk Endures

September 29, 2017

There are a multitude of alternative investments for investors to consider, largely because Wall Street is exceptionally good at creating products, and at creating demand for those products, even when there shouldn’t be. However, among the many alternatives from which to choose, there are really only a few you should contemplate.

They …

  • Are supported by the academic literature, meaning they have provided premiums that have been both persistent and pervasive, come with intuitive risk-based or behavioral-based explanations, and survive implementation costs.
  • Can be implemented using products under SEC regulation.
  • Tend to have low correlation with the returns of traditional portfolio assets.
  • May not necessarily be cheap by index fund or ETF standards, but don’t come with the typical “2-and-20” hedge fund fees.

Among the few that meet these criteria is the variance risk premium (VRP). The VRP refers to the fact that, over time, option-implied volatility has tended to exceed realized volatility of the same underlying asset. (Note that the popular VIX is a measure of implied volatility.)

VRP has been well-documented, and is best known in U.S. stocks. For example, Stone Ridge Asset Management examined the VRP for the 10 largest stocks for the period 1996 through 2012. Breaking down the period into three subperiods, they found a persistent and stable premium.

From 1996 through 1999, the VRP was 4.3%. From 2000 through 2009, it was 3.9%. And from 2010 through 2012, it was 4.1%. Researchers at Stone Ridge also found strikingly similar patterns in the implied volatility curves around the world.

Global Trend

In a November 2011 paper, “The Variance Risk Premium Around the World” (Federal Reserve System Board of Governors International Finance Discussion Paper), Juan Londono found similar results for VRP.

Research into VRP in U.S. stocks has found not only that options have traded about 4 percentage points above subsequent realized volatility, but also that, from January 1990 through September 2014, the implied volatility of S&P 500 Index options has exceeded realized index volatility 85% of the time—the premium is highly persistent.

It’s important to understand that this should not be interpreted to mean the option market tends to overestimate future volatility. Instead, the more likely explanation is that option prices incorporate a risk—or insurance—premium. Most investors are risk-averse, and so are willing to pay a premium to hedge downside risk. Buying volatility insurance options provides that hedge, or insurance.

Profit Opportunity

The large premium also exists because of a supply and demand imbalance: There likely are far more natural buyers of volatility insurance options than sellers. 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.

Investors are willing to pay a premium because risky assets, such as equities, tend to perform poorly when volatility increases. In other words, markets tend to crash down, not up. Thus, the VRP isn’t an anomaly investors should expect to be arbitraged away.

And because the risks of the VRP (the sale of options performs poorly) tend to show up in bad times (when risky assets are performing poorly), investors should expect a significant premium.

Another way to think about this is that investors pay to hedge catastrophic outcomes. They want to transfer the risk of a terrible outcome, like their house burning down or the price of oil climbing to $200 a barrel. So, they knowingly and willingly pay above fair value to eliminate it.

Thus, VRP should be considered a unique risk premium that investors with long horizons and who are financially stable (which allows them to take on cyclical risks that show up in bad times) can harvest.


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