Alternative Risk Premia (ARP) provide investors with an additional source of return. Numerous types of ARP exist, such as carry, value, momentum and volatility. The volatility premium is a well-studied premium and the principles behind its existence plus methods of how it can be harvested by investors are covered here.
This article is written by Tim Sterk and Fares Ben Ghachem, Investment Strategists at Aegon Asset Management.
The principle of an insurance premium
In an insurance contract, one party wants to protect itself against the consequences a potential future event. That party is willing to pay a price, called premium, for an insurance agreement which will reimburse him if the event occurs. Consequently, there is another party willing to sell such an insurance contract and hence who is willingly taking over the risk.
No insurance providers would exist if their received compensation for selling the insurance was insufficient on average to cover the reimbursement costs that they make. In fact, insurance takers effectively overpay for the protection, i.e. they pay more than they should expect on average to receive from the insurance, hence the name "premium".
This generic insurance principle can also be extended to financial markets. Some market participants would like to protect themselves against the effects of certain events occurring. Financial instruments that facilitate this, such as options, therefore tend to trade at a premium as well. Moreover, the price of options in financial markets is partly determined by the volatility market participants expect to happen: the implied volatility. The more volatility they expect, the more they are willing to pay for the insurance in the form of options. The volatility risk premium is the observation that the level of volatility that is deduced from the price of insurance contracts such as options, called the implied volatility, tends to be higher than the average realized market volatility. This mismatch provides a systemic opportunity for investors to harvest the volatility premium.
Figure 1 shows that the realized volatility on the US S&P 500 index historically tends to be lower than the price that was priced in by market participants, namely the implied volatility. Hence, this clearly shows that the market provides the opportunity for investors to act as insurance providers and hence to harvest these premia in a systemic matter.
Figure 1: The implied versus realized volatility on the S&P 500 equity Index. Source: Bloomberg and Aegon Asset Management
Higher implied volatility, higher option prices
In their seminal 1973 paper, finance experts Black, Scholes and Merton demonstrated how the price of a financial option can be calculated on the basis of five input parameters. Interestingly, four of those five parameters can be readily observed in the market place: the price of the underlying, the strike price of the option, the time to maturity and the level of interest rates. The last input parameter is the implied volatility, which is not directly observable. Theoretically it is the level of volatility that, when entered into the option pricing formula, results in the tradable price of the option in the market.
A positive relationship exists between this implied volatility and the price of an option: when investors are worried, they are willing to pay more for insurance in the form of options and hence the higher the implied volatility needs to be in order to make the equation produce the correct and observable option price. Stated differently: financial unrest causes the implied volatility to rise and consequently increases the price of options.
The VIX index: a measure for implied volatility
The relationship between implied volatility and option prices has led to the development of the VIX index. The VIX index represents the implied volatility of options on the SP 500 index that expire in 30 days. Figure 1 depicts the VIX index graphically. Historically, we see that this measure tends to go up during periods in which markets experience stress, such as in the last quarter of 2018 or during the global financial crisis one decade ago.
Figure 2: The VIX index. Source: Bloomberg, Aegon Asset Management
Harvesting the implied volatility premium in practice
Numerous financial instruments are linked to the value of the VIX index and hence, effectively provide investors the opportunity to expose themselves to the implied market volatility premium. There are however many more methods via which investors can expose themselves to the implied volatility premium in the market. All the presented strategies entail effectively being seller of a given market's implied volatility and this requires robust risk management procedures, since losses can be unlimited in theory.
- The most common and straightforward way to have exposure to the implied volatility premium is to sell options on a given equity index (for instance: S&P500, Euro Stoxx 50). The investor should follow some rules in a systematic manner in order to be successful in capturing the premium (e.g. which options to sell).
- Benefits: easily applicable to any equity index that has listed and liquid options and represents the "purest" way of capturing the implied volatility premium.
- Drawbacks: requires a systematic approach and a lot of trading which usually entails high transaction fees.
- An alternative for trading the options directly in order to capture the volatility premium is to invest in an ETF replicating a "short implied volatility" strategy.
- Benefits: easily tradable and the ETF manager trades the required securities on behalf of the investor.
- Drawbacks: the underlying can be a "black box" for investors and ETFs are only available on US indices.
- Another alternative via which an investor can have access to the implied volatility premium consists in selling derivative contracts on the VIX index (as presented above). These derivatives are futures, are traded on transparent markets and are fairly liquid.
- Benefits: easily tradable and doesn't require a lot of trading.
- Drawbacks: these futures don't exist for a lot of equity markets and trading them requires a deep understanding of the dynamics of the underlying financial instruments (for example: term structure of the futures).
At Aegon Asset Management we analyze the existence of alternative risk premia in detail and capture them in numerous funds. Future articles will provide additional information on Alternative Risk Premia.