Harvesting Volatility Risk Premium as Volatility Starts to Turn

Bernhard Brunner from Allianz Global Solutions and Abhinandan Deb from Bank of America Merrill Lynch teamed up for the second presentation session at the 4th Annual CBOE Risk Management Conference in Europe.

Some highlights from Deb’s portion of this session –

  • The ultra low volatility environment appears to have come to an end and we should experience a ‘higher floor’ for volatility going forward
  • He noted that emerging markets now represent 39% of global GDP up from 20% in the year 2000
  • The biggest visible risk to sentiment is a loss of confidence in the Central Bank Put
  • He uses the term ‘tantrums’ for increased volatility and notes that these moves can be exacerbated by regulation induced illiquidity
  • After discussing his outlook for volatility he notes that harvesting volatility in this higher vol environment can be challenging (but not impossible)
  • In higher volatility regimes call overwriting has outperformed and resulted in great risk reduction
  • Volatility risk premium as defined by variance less subsequent realized has been consistent across periods of both low and high volatility
  • He finished up noting that we all like to trade the mean reversion of volatility and short volatility exposure, if scaled up (carefully – his word) it may improve risk adjusted returns and time to recover from drawdowns

Some highlights from Brunner’s portion of the session –

  • He begins noting that the volatility risk premium is favorable when compared to equity risk premium using the last 15 years for this analysis
  • As a warning he shows that the distribution of volatility risk premium is skewed
  • Differences between equity and volatility risk premium – with equities you get exposure to equity returns interest rates, and possibility dividends with volatility you have exposure to implied volatility and realized volatility
  • He goes on to note that volatility risk premium is on average quite stable over different terms which is different than the term structure of implied volatility
  • He also looked at the volatility risk premium for FX, Gold and Oil and noted that it has been consistent across asset classes
  • To end this part of the session he notes three generalities about volatility 1) it mean reverts, 2) we have jumps and 3) it forms (high and low) regimes – jumps have a negative impact on the volatility risk premium
  • He noted that volatility is a good diversifier in all fixed income markets and works best in a rising rate environment
  • His final thought regarding volatility is that using it as an asset class can improve risk/return characteristics of a portfolio

To give some context to this presentation I have included a chart showing the range for VIX by year.

VIX Long Term