Death, Taxes and VRP? Not So Fast!

Shortly after the U.S. Constitution was ratified (June 1788) and months before Benjamin Franklin passed away (April 1790), he wrote a letter saying, "Our new Constitution is now established, and has an appearance that promises permanency; but in this world nothing can be said to be certain, except death and taxes." Others have attributed the idiom to Christopher Bullock and/or Daniel Defoe, but in this context, it’s important that none of them mentioned volatility risk premium (VRP) in their list of inevitabilities.

Benjamin Franklin was an American historical giant, a polymath, a master of everything from electricity and ocean currents to chess and population studies. In 1752, he helped establish the first insurance company in the U.S. (Philadelphia Contributionship for the Insurance of Houses from Loss by Fire). They inspected properties and established rates based on a risk assessment.

Options traders, particularly those in search of potential alternative sources of yield, often evaluate risk like an actuarial type. AQR Capital Management has done meaningful research on the topic, and defines volatility risk premium as a representation of the "compensation that investors earn for providing protection against unexpected market volatility."

The term "compensation" does not imply a guarantee that the amount is sufficient to offset the amorphous nature of future volatility (or lack thereof). Insurance companies and options traders must make assumptions about the likelihood of adverse events over a given time frame. These expectations are informed by a wealth of historical data, but by definition, forecasts are imperfect.

Glenmede Investment Management, Nomura, Parametric, PIMCO and others have also done considerable research on VRP. There are links to some of the work below, but a simple search for VRP research will produce more than enough fodder for "somewhat interesting" holiday party conversation.

Inside Volatility Trading 10-30 1
Source: Macro Risk Advisors, Bloomberg

Key VRP Takeaways:

  • Potential unique source of returns (All)
  • There is "unique risk involved" (Parametric
  • VRP is persistent across a variety of asset classes with "high frequency of positive returns" (Glenmede – see visual above)
  • Various means of potential implementation (Nomura); often through (short) index options and/or volatility products
  • Behavioral biases: risk aversion (Nomura)

Last month, IPS Strategic Capital published a piece titled, Is Selling Options Still Worth the Risk? It contends that VRP has narrowed in recent years as more capital has been allocated to these types of strategies. Further, the IPS research posits that managers have added leverage to their strategies in the hopes of outperforming a benchmark.

Leverage is a risk unto itself. It can be a critical part of an important process. Consider the internal combustion engine—fuel meets an oxidizer to create a force that makes the pistons move and transforms chemical energy into mechanical energy. Leverage can be considered a fuel. In other situations (macro volatility), leverage can be the oxidizer (air) that picks up and turns a small fire into one much more difficult to control.

Potential sources of yield/alpha must not be evaluated in a vacuum. A decade of persistently low yields from sovereign and corporate debt issuances have arguably incentivized leverage and capital to move in new directions.

Benjamin Franklin knew there were precious few guarantees in life, and there are precisely none in capital markets. There’s inherent risk in every market at every moment. The relative degrees of risk will ebb and flow like the currents of the ocean or the power in lightning … which Franklin also studied.

Inside Volatility Trading 10-30 2
Source: Philadelphia Museum of Art

Risk is omnipresent, whereas VRP is mostly present, but not always. Both concepts need to be understood and respected.

Cboe Global Markets® hosts Risk Management Conferences (RMC), where VRP is always a topic of discussion. RMC brings together sophisticated investors and asset managers who implement strategies in an effort to protect and grow capital. Here’s an Allianz presentation from the 2015 conference in Geneva, Switzerland on VRP. The next RMC events will be in Tel Aviv, Israel (Dec, 4-5, 2019) and Bonita Springs, Florida (March 2-4, 2020).

Aegon Asset Management: The Volatility Risk Premium
Glenmede: Expanding the Efficient Frontier by Capturing the Volatility Risk Premium
Nomura: "Seling Vol" or Earning a Risk Premium?
Maxwell Grinacoff, CFA: "End of an Era?" Part 1: Taking the Pulse of the Great Short Volatility Trade
Parametric: Non-traditional Alpha


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NOTABLE TRADES

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EVENTS

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Cboe Will Be Attending:
October 29-31, FIA Expo in Chicago, IL

November 4-7, Schwab IMPACT in San Diego, CA
November 6, Capstone Global Volatility Summit in Tokyo, Japan
November 16, FOW Dubai in Dubai, UAE

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