The Role of Variance Risk Premium in Equity Markets

The variance risk premium is a crucial concept in equity markets. It's the extra return investors demand for taking on the risk of volatility in the market.

Research has shown that the variance risk premium is not a constant, but rather it varies over time. In fact, studies have found that the variance risk premium can be as high as 3-5% per annum in certain periods.

For investors, understanding the variance risk premium can help them make more informed decisions about their portfolios. By recognizing that volatility is a risk that requires a premium, they can adjust their investment strategies accordingly.

Investors have traditionally sought to minimize volatility, but recent research suggests that this approach may not always be the best. By embracing the variance risk premium, investors can potentially increase their returns and better align their portfolios with their risk tolerance.

Intriguing read: Variance (accounting)

The variance risk premium is a concept that describes how implied volatility tends to be greater than the subsequent realized volatility. This phenomenon presents an excellent opportunity for those willing to accept the risk of selling volatility by writing options contracts and collecting premiums.

Implied volatility is often higher than realized volatility, giving sellers of volatility a chance to profit.

Numerous academic studies have shown that the Volatility Risk Premium is persistent, pervasive, and resilient against varying maturities across assets.

The Volatility Risk Premium is not limited to stocks, but also applies to other assets like bonds, commodities, and currencies.

A study in the Financial Analysts Journal found that shorting volatility offered a very high Sharpe ratio: 0.6 in equities, 0.5 in fixed income, and 0.5 in currency.

Even during the turbulent years around September 2008, selling volatility was still profitable, but it came with substantial tail risks.

Diversifying across multiple asset classes helped reduce tail risk while still providing significant performance benefits – improving Sharpe ratios by 31 percent overall.

For another approach, see: Efficient Frontier Sharpe Ratio

Managing variance risk is crucial for traders seeking to harvest the variance risk premium.

The straddle has a less negative Value-at-Risk (VaR) and Conditional Value-at-Risk (CVaR), but a higher maximum loss.

Equal exposure strategies, such as using a model-free measure of convexity (gamma), can provide a more homogeneous picture of variance risk.

The iron condor is a safer strategy for options trading because it's a "defined" risk trade, but it requires traders to spend a portion of their profits on insurance.

Straddles can achieve much higher gammas than other strategies, making them a popular choice for variance risk premium harvesting.

The variance swap has the highest return of all the variance strategies while showing the lowest downside risk for the majority of the risk measures.

Short straddles, iron condors, short puts, and credit spreads are popular options strategies used by traders to harvest the volatility risk premium.

A delta-hedged put involves shorting the index, with only margin requirements, giving it much greater leverage potential compared to a delta-hedged call.

Intriguing read: Popular Community Bank News

The S&P 500 index options provide a unique opportunity to assess variance risk premium strategies empirically, with a data sample ranging from January 1996 to June 2021.

Transaction costs play a crucial role in option trading, with a 25% effective spread of the quoted spread used as the baseline case, reflecting institutional investors' ability to trade at better terms.

Institutional demand for index put options is high, especially in markets with significant market capitalization like the S&P 500, where many investors engage in hedging activities.

The variance risk premium is reasonably consistent in the S&P 500, driven by the fact that buyers of put options receive insurance against potential losses due to declining equity markets, while paying premiums for the protection.

On a similar theme: Cash Out Refinance 500 Credit Score

The S&P 500 index options are a popular choice for traders looking to harvest the variance risk premium. In a study of these options, researchers found that the demand for index puts is evident in the implied volatilities of S&P 500 puts.

Historically, options implied a 13% chance of a 10% drawdown in the index, but the actual probability was 4%. This means that buyers were willing to pay significantly higher prices for added protection against severe drops in stock prices.

For your interest: Cost of Funds Index

A 2-month, 10% out-the-money S&P 500 option costs an average of USD 14.3, but would only cost USD 4.1 if calculated using realized volatility. This is a clear indication that buyers are willing to pay a premium for protection against sharp equity declines.

The S&P 500 Variance Risk Premia is fairly significant, with implied volatility (IV) being 9% higher than realized volatility (RV) on average. This premium can be harvested using various options strategies.

Short straddles, iron condors, short puts, and credit spreads are popular options strategies used by traders to capture this premium.

If this caught your attention, see: What Is the Average Medicare Supplement Premium

The S&P 500 Volatility is a crucial aspect of equity market analysis. Index put options are extremely attractive for hedging against market crashes, especially in markets with significant market capitalization like the S&P 500.

The S&P 500 volatility risk premium is reasonably consistent due to institutional demand, making it an attractive option for risk management. Many institutional investors engage in hedging activities, creating a high demand for index puts.

On a similar theme: What Is a Demand Deposit

Buyers of put options receive insurance against potential losses due to declining equity markets, and they're willing to pay premiums for this protection. The premiums are small compared to potential losses from a sharp drop in stock prices.

The implied volatilities of S&P 500 puts reveal a significant demand for added protection against severe drops in stock prices. Historically, options implied a 13% chance of a 10% drawdown in the index, but the actual probability was 4%.

Buyers are willing to pay 3x times more than fair value pricing for put options to insure themselves against risks associated with sharp equity decline. This is evident in the prices of 2-month, 10% out-the-money S&P 500 options, which cost USD 14.3 on average.

The S&P500 Variance Risk Premia is fairly significant, with IV being, on average, 9% higher than RV. This means that buyers are willing to pay a premium for the added protection against volatility.

On a similar theme: Ubs Stock Forecast

The Law of One Price in Equity Markets is a fundamental concept that's not always followed in equity volatility markets. It's a concept that's hard to wrap your head around, but essentially, it states that the price of something should be the same everywhere.

Surprisingly, VIX futures prices often deviate from their option-implied upper bounds, which are calculated by taking the square root of variance swap forward rates. This is a problem, as it means that the law of one price is being violated.

These deviations can be quite significant and get even wider during times of market stress. In fact, research has shown that these deviations can actually predict the returns of VIX futures. It's a bit like trying to solve a math problem that's just beyond your grasp - the equity volatility market seems to struggle with taking a square root at times.

The New York Fed's Liberty Street Economics blog has done some great work on this topic, highlighting the importance of understanding the law of one price in equity markets.

Related reading: Temenos Group Ag Share Price

The U.S. bond market has been experiencing occasional abrupt regime changes since the 1960s. This is according to an empirical analysis of the market.

These regime changes can have a significant impact on the bond market, leading to fluctuations in bond risk premia. The model for bond risk premia and the macroeconomy suggests that these changes are not uncommon.

An empirical analysis of the U.S. bond market since the 1960s emphasizes the importance of understanding these regime changes. This can help investors make more informed decisions.

The U.S. bond market has been subject to significant changes in the past, and it's essential to consider these when evaluating bond risk premia.

Related reading: Maximizing Return on Investment by Selling Mortgage Loans on the Secondary Market

Further research has provided more evidence of the variance risk premium's pervasiveness. The study "Credit Variance Risk Premiums" by Manuel Ammann and Mathis Moerke found that the CVP was significantly profitable after transaction costs, with very high T-stats.

Their research extended the study to credit markets, using options written on the CDX North America Investment Grade 5 Year Index from March 2012 to September 2018. They synthetically constructed the variance swap rate from out-of-the-money payer and receiver swaptions.

The high return found by the authors is not entirely realistic, as it's based on a variance swap that doesn't trade in reality. Returns to a straddle are a more reasonable proxy.

The data sample ends just before a particularly difficult time for credit risk, from the fourth quarter of 2018 through the start of 2019. This means the premium found may overstate the realizable premium.

Transaction costs are likely understated, as they can be high unless you're a patient trader who sells liquidity to the market, not takes it from the market.

A unique perspective: Equity Market Risk