The Clifton Group and the Value Added by the Insurance Risk Premium (IRP)

Today Mr. Jay H. Strohmaier, CFA, Senior Portfolio Manager, The Clifton Group, delivered a presentation at the CBOE’s 28th Annual Risk Management Conference (RMC).

Much of Jay’s presentation was focused on the Insurance Risk Premium (IRP), the gap between implied volatility and realized volatility.

  • Options buyers often are “inelastic” – often overpay for options.
  • Option sellers often are very price sensitive.
  • Implied volatility exceeded subsequent realized volatility in 86.7% of the monthly observations since 1990, with a mean difference of 4.4%.
  • Selling options may enable investors to “harvest” the “Insurance Risk Premium.”
  • Covered options enable investors to capitalize on the expensive nature of equity index options.
  • Short call contingently removes portion of underlying equity exposure.
  • Short put contingently adds equity risk to underlying cash holdings.
  • Modern portfolio theory suggests that PUT, BXY and BXM (with lower volatility) should not have higher returns than the S&P 500 over the long run, but the option-based indexes did have higher returns than the S&P 500 over the period from 1990 through 2011.
  • Short strangles also were discussed.

* The Clifton Group has been providing customized risk management solutions to institutional investors for more than 24 years.

Investing in options has certain risks. There is a risk of loss.