Adding the volatility risk premium to an investment portfolio makes sense in many respects. Firstly, it is not correlated with the performance of equities and fixed-income markets. This means that volatility risk premiums generate income irrespective of price movements in equities and bond markets and of the prevailing level of interest rates. Furthermore, the addition of this asset class improves the risk–return profile of a portfolio over the long term.
This is an economic and intuitive illustration of what a volatility risk premium is, what its characteristics are and how the trading process to capture the risk premium works. Watch our RP Crest Academy video ‘An alternative asset class – the volatility risk premium’, or simply read on.
Why does the volatility risk premium exist?
Every time an option is bought and sold, the counterparties effectively enter into an insurance relationship with one another. The seller of the option becomes the insurance provider to the option buyer, the latter of whom is now insured as by buying the option he passes on the risk of price fluctuations (e.g. the risk of adverse volatility) to the option seller.
In order for this insurance service to be remunerated, the implied volatility used to value options must on average trade higher than the realised volatility. This is no different from the traditional insurance business, where the premium of an insurance policy is also calculated on the basis of estimated loss ratios (implied volatility) that are well above the loss ratios actually expected (realised volatility).
How to capture the volatility risk premium?
Selling implied volatility and hedging it with realised volatility earns the volatility risk premium.
While it is easy enough to understand how we sell implied volatility, it is generally much more difficult to understand how we can go long (buy) realised volatility. That is precisely what we explain in our film.
To be long realised volatility, the return profile of an option has to be replicated by numerous transactions in the underlying instrument. If you persistently hedge all market direction risks arising from a short options position (the delta) by taking opposing positions in the underlying instrument, the return profile of the option will be replicated at the realised volatility of the hedge portfolio. Thus, you will have effectively bought the realised volatility through your hedge transactions. The P&L of this hedge portfolio will roughly equal the value of the options if they had been traded valued at their effectively realised volatility.
No arbitrage, but a systematic capital market risk premium
The volatility risk premium does not result from the mispricing of options, but is rather the remuneration for a service that is much in demand: the provision of insurance coverage against capital market risks. As such, the probability that the volatility risk premium will remain positive is as likely as the probability that insurance companies will charge an insurance premium for their services that is high enough for them to expect to generate a profit.
The volatility risk premium is not an invention of RP Crest; it has been successfully captured by option sellers, typically banks and hedge funds, since options were introduced – it is a necessity for the options market to function properly.