Swedroe: Volatility As A Strategy

August 02, 2017

Historical Evidence

In the paper “Option Markets and Implied Volatility: Past Versus Present,” published in the November 2009 issue of the Journal of Financial Economics, Scott Mixon shows the results of his hand-collected data set from newspapers published between 1873 and 1875.

He calculated implied and subsequently realized volatility and found that option prices reflected a persistent, large and positive spread between implied and realized volatility of 11.8% for the most liquid options. That’s a huge risk premium. Today, markets are more liquid, more transparent and more efficient. Thus, we should not expect to see such a large premium.

Additionally, 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. The firm’s researchers found a persistent and stable premium.

Similar Patterns

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

In international markets, just like in the U.S., more short-dated and more out-of-the-money options have higher expected VRP returns in both single-stock and index options. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Stone Ridge funds in the construction of client portfolios.)

In his November 2011 paper, “The Variance Risk Premium Around the World,” (a Federal Reserve System Board of Governors International Finance Discussion Paper) Juan Londono reported similar results for the VRP. The VRP has been well documented, and is thus best known in U.S. equities.

For example, the implied volatility of S&P 500 Index options has exceeded the realized index volatility 85% of the time from January 1990 to September 2014. And options historically have traded about 4.4 percentage points above subsequent realized volatility.


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