Sunday, October 25, 2015

The global volatility premium - it exists but beware of the skew

There has been an active discussion on the global volatility premium, the difference between implied volatility and subsequent realized volatility, yet the research on how this risk premium would fit within an asset allocation strategy has been lacking. Nevertheless, we now have a better understanding of the benefits and risks with the research by William Fallon, James Park, and Danny Yu in "Asset Allocation Implications of the Global Volatility Premium".  

There is a volatility premium that exists across all major asset classes. The mean difference between implied volatility and realized volatility is positive across equities, fixed income, currencies, and commodities. The size may vary but the volatility premium is global. Selling volatility will added return and have strong positive Sharpe ratios. 

This seems like an easy way to add returns to a portfolio except there are some significant risks. First, there is a crash risk or negative skew with selling volatility. Investors will make good money with selling volatility only to be hit with a strong negative return when there is a volatility spike. This may seem manageable except that the vol spikes come at the wrong time. Volatility spikes when there are "bad times", those periods when equity returns have a significant fall. Hence, there is poor diversification benefit when a volatility premium strategy is employed. Returns will be added, but the cost will be compounded by losses when there is a market downturn. These can be reduced through focusing on liquid markets, but crash and diversification risks are still present. 

Trading volatility premium can be a consistent return enhancer with a Sharpe ratio (close to 1), but there are special risks which will make any investor nervous. Investors who have high loss aversion will find this a difficult risk premium to add to a portfolio. Crash risk at the wrong time will mean that investors will be penalized for this added return.  Volatility premium trading is a useful excess return strategy but the investor has to have a special awareness of these risks.

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