Swedroe: Volatility As A Strategy

August 02, 2017

Another way to think of this is that investors pay to hedge catastrophic outcomes—they want to transfer the risk of some terrible outcome, like their house burning down or the price of oil going to $200. Thus, they knowingly and willingly pay above fair value to eliminate that risk.

Therefore, the VRP should be considered a unique risk premium that investors with long investment horizons and stable finances can harvest, allowing them to take on cyclical risks that show up in bad times.

Analyzing The VRP

William Fallon, James Park and Danny Yu contribute to the literature on the VRP with their study “Asset Allocation Implications of the Global Volatility Premium,” which appears in the September/October 2015 issue of the CFA Institute’s Financial Analysts Journal.

The purpose of their study was “to provide a comprehensive statistical and economic analysis of the global volatility risk premium, with a special emphasis on its practical role as an institutional holding.”

The authors developed a grand volatility composite portfolio (GVCP), which was derived from a dynamic trading strategy applied to a variety of instruments but mainly derivatives. Their data set consisted of nearly two decades of volatility marks gathered through a variety of options exchanges and investment dealers.

They write: “A strategy-based approach was required because (1) pure volatility returns are not universally available and (2) risks vary among instruments, across asset classes, and over time.” The authors’ results account for transaction costs, which have a material impact on performance.

Their GVCP is an equal-risk-weighted blend of returns on 34 volatility-sensitive instruments in markets across four asset classes: equities (covering 11 markets that make up almost 90% of the MSCI World Index); bonds (covering four 10-year interest rate swaps denominated in U.S. dollars, euros, sterling and yen, which make up approximately 95% of the J.P. Morgan GBI Global Index); currencies (covering nine major currencies, traded against the U.S. dollar, which make up more than three-quarters of non-U.S. global GDP); and commodities (10 contracts covering four major commodity sectors: industrial metals, precious metals, energy and agricultural products, making up more than half of the S&P GSCI).


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