Reducing the Risk of Black Swans by Larry Swedroe & Kevin Grogan

Author:Larry Swedroe & Kevin Grogan
Language: eng
Format: azw3, epub
ISBN: 9780692060742
Publisher: Buckingham
Published: 2018-03-11T05:00:00+00:00

Historical Evidence

Data going back as far as 1873 shows the existence of a VRP. In the paper “Option Markets and Implied Volatility: Past Versus Present,” published in the November 2009 issue of The Journal of Financial Economics, Scott Mixon presented the results from his analysis of data hand-collected from newspapers published between 1873 and 1875. Mixon calculated implied and subsequently realized volatility, and found that options prices reflected a persistent, large and positive spread of 11.8 percentage points between implied and realized volatility for the most liquid options. That is a huge risk premium. Today, markets are more liquid, more transparent and more efficient. Thus, we should not expect to see such a large premium.

Graham Rennison and Niels Pedersen, authors of the September 2012 paper “The Volatility Risk Premium,” studied the period from June 1994 through June 2012 and 14 volatility markets, including markets associated with stocks, bonds, commodities and currencies. They found strong evidence of a variance risk premium, with its magnitude ranging from 0.9 percent in currencies to 2.2 percent in equity indices, 2.9 percent in 10-year interest rate swaptions and 4.4 percent in commodities futures. They concluded that the risk-return trade-off in volatility strategies compares favorably to traditional stock and bond strategies, and that these strategies exhibit low correlation to equities. They also found that Sharpe ratios ranged from 0.7 for currencies to 1.2 for U.S. interest rates and commodity futures. These compare favorably to the historical 0.4 Sharpe ratio for the market beta premium. Thus, the authors recommended that investors consider an allocation to VRP strategies.

Using equity index options, Roni Israelov, Lars Nielsen and Daniel Villalon, authors of the study “Embracing Downside Risk,” which appears in the Winter 2017 issue of The Journal of Alternative Investments, showed that the vast majority of the equity risk premium derives from accepting downside risk versus seeking participation in the upside. They found that, over the period from 1986 through 2014, greater than 80 percent of the equity risk premium was explained by the willingness to accept downside risk. They also discovered that the ex-post VRP was positive 88 percent of the time and averaged 3.4 percent per year.

Israelov, Nielsen and Villalon found a similar result when they examined the upside and downside risk premium in Treasury bonds, with 62 percent of the excess return coming from the downside. The lower percentage they found in bonds should not be surprising because Treasuries have less downside risk than stocks. When they examined gold, the authors found 100 percent of the excess return was from downside risk. They also found strong results when they looked at credit default swaps, with the return for accepting downside risk accounting for more than 100 percent of the excess return.

In addition, Stone Ridge examined the VRP for the 10 largest stocks over the period from 1996 through 2012, breaking down that period into three sub-periods. The firm’s researchers found a persistent and stable premium. From 1996 through 1999, the VRP was 4.3 percent. From 2000 through 2009, the premium was 3.

Download

Copyright Disclaimer:
This site does not store any files on its server. We only index and link to content provided by other sites. Please contact the content providers to delete copyright contents if any and email us, we'll remove relevant links or contents immediately.