LO 63.3: Assess methods of mitigating volatility risk in a portfolio, and describe

LO 63.3: Assess methods of mitigating volatility risk in a portfolio, and describe challenges that arise when managing volatility risk.
Volatility can be mitigated by investing in less volatile assets. As one would expect, bond returns are less impacted by volatility in equity markets (than equity returns). However, bonds are not necessarily a safe haven. Correlation between changes in the VIX and bond returns was 0.12 (between 1986 and 2011). This means bonds perform better than stocks (with a correlation coefficient of 0.39) when the VIX is rising, but the relationship is not highly positively correlated. For example, during the recent financial crisis, volatility was a factor that caused risky assets, bonds and stocks included, to fall simultaneously. The VIX can also capture uncertainty. Some research indicates that uncertainty risk is different from volatility risk, but the two risks are highly correlated.
Other investment approaches also perform poorly in periods of increased volatility. A number of strategies have a large exposure to volatility risk. For example, currency strategies perform poorly during periods of high volatility. For investors who want to avoid volatility, they can buy put options (i.e., protection against volatility). Out-of-the-money puts, which pay off during periods of high volatility, provide hedges against volatility risk.
In sum, there are two basic approaches to mitigating volatility risk. They are:
Invest in less volatile assets like bonds, understanding that they too can perform poorly during extreme circumstances such as the 20072009 financial crisis.
Buy volatility protection in the derivatives market (e.g., buy out-of-the-money put
options).
Volatility Premiums
Typically, an investor buys an asset, like a stock, and the long position produces a positive expected return. In other words, on average, assets have positive premiums. However, volatility has a negative premium. To collect the volatility premium, one must sell volatility protection (e.g., sell out-of-the money put options). Realized volatilities are lower on average (by approximately 2%3%) than VIX implied volatilities. This means that, on average, options are expensive and investors can collect volatility premiums by shorting volatility strategies.
During normal economic periods, selling volatility provides high, stable payoffs. However, when there is a crash, like the 20072009 financial crisis, sellers of volatility suffer large, negative returns. A volatility (swap) index constructed by Merrill Lynch indicates steadily (with minor blips) increasing cumulative returns between January 1989 and December 2007, until the financial crisis. Between September and November 2008, losses were nearly 70%. Considering the data leading up to the crisis (through December 2007), selling volatility looked like easy money. Considering the whole sample period, including the crisis,
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Topic 63 Cross Reference to GARP Assigned Reading – Ang, Chapter 7
the data indicates negative skewness of 8.26. Without the crisis (i.e., only considering the data up to December 2007) the negative skewness was a mere 0.37.
Professors Note: Selling volatility is like selling insurance. I f you sell auto insurance, you collect stable premiums over time but occasionally face a large payout due to a car accident. The same is true for selling out-ofth e-money put options. The seller collects option premiums for years, then a disaster happens, like the 20072009 financial crisis, and the seller faces massive losses. Option purchasers know in advance what they can lose, the option premium, but sellers do not. Thus, during a market crash, losses could be massive for volatility sellers. Only investors who can tolerate periods o f high volatility, which often coincide with losses (sometimes very large losses), should sell volatility.
Academics have estimated a relationship between the expected market risk premium [E(Rm) Rp] and volatility. The equation is shown as follows:
E ( R m ) ^ F T XcrM
is equal to the variance of the market return and where investors risk aversion. While the coefficient ^ is positive in theory, various studies have estimated it as either positive, negative, or zero. Again, though, whether positive or negative, only those investors who can withstand massive losses during periods of high volatility should sell volatility.
represents the average
D y n a m ic Ris k Fa c t o r s

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