| Volatility Risk Premium 101 |
|
|
| 24.06.2007 | |
|
Anne Sanciaume, senior vice president of volatility strategy, and Saeed Amen, analyst in quantitative strategy at Lehman Brothers, answer this week's questions on Volatility Risk Premium. 1. What is Volatility Risk Premium? Volatility risk premium is generally defined as the difference between implied and realised volatility for a given maturity. These two quantities are intrinsically very different. Realised volatility is backward looking (computed from past spot returns) while implied volatility is forward looking (an estimate of realised volatility for the days or months to come used for trading purposes). It is easy to show empirically that, on average, the volatility risk premium will be positive for all currency pairs provided the observation window used is long enough. This positive volatility risk premium makes intuitive sense as a long option position can be viewed as an insurance against extreme moves incurred in the underlying asset. Hence, the option buyer should be willing to pay an insurance premium to get protection against exchange rates uncertainty and conversely, market makers need to charge a premium to account for the uncertainty related to their estimate of volatility. 2. How do such strategies perform in the current environment? Returns from such strategies tend to be similar to that of carry trades, ie. gradual increases interupted by losses during times of risk aversion (when vol tends to spike upwards). In the current low volatility environment the volatility risk premium has been compressed and hence these volatility strategies do not perform as well. One way to take advantage of the volatility risk premium is to sell vol. Without transaction costs, if done on a systematic basis, this is profitable. However, with the inclusion of transaction costs, we need to be more selective when to sell vol, for example only selling vol when implieds are very high. On the flipside, vols might be high for a good reason (eg. expectations of a risk event). 3. Where in the currency markets should investors try to capture the Volatility Risk Premium? We would point to the USD/CAD. Since the beginning of 2007, 1-week implied volatility has averaged 6.40 against 5.44 for realised. Implied is near its high so far for the year, whereas realised volatiltiy is now coming off as spot seems to have bottomed out. It is a good place to try and capture the Volatility Risk Premium. |
|
© bfinance. Alle Rechte vorbehalten. Das Vervielfältigen und Verbreiten über bfinance veröffentlichter Inhalte oder das Speichern in Datenbanken außerhalb der Grenzen des Urhebergesetzes ohne Zustimmung von bfinance ist verboten. Diese E-Mail-Adresse ist gegen Spam Bots geschützt, Sie müssen JavaScript aktivieren, damit Sie es sehen können