Derivatives - June 18, 2012

The Benefits of Volatility Derivatives in Equity Portfolio Management

In this paper, we analyse a novel approach in the design of attractive equity solutions with managed volatility, based on mixing a well-diversified equity portfolio with volatility derivatives, as opposed to minimising equity volatility through minimum variance approaches.

The results we obtain suggest that a long volatility position shows a strongly negative correlation with respect to the underlying equity portfolio and that adding a long volatility exposure to an equity portfolio would result in a substantial improvement of the risk-adjusted performance of the portfolio.

The benefits of the long volatility exposure are found to be strongest in market downturns, when they are most needed.

We also compare the performance of the diversified equity portfolios including volatility derivatives with that of global minimum variance (GMV) portfolios that are commonly used in the industry as a benchmark strategy for reducing portfolio risk. We found that the diversified portfolio with long volatility exposure is a more efficient approach for managing risk.

We consider the challenges related to a practical implementation of this strategy by using derivatives instruments futures and options that allow investors direct access to trading volatility.

We consider how increasing allocation to volatility derivatives affects the portfolio performance; we also evaluate transaction costs in each case and discuss the advantages/disadvantages for using each type of instrument. The benefits of adding volatility exposure to equity portfolios are found to be robust with respect to the introduction of trading costs associated with rolling over volatility derivatives contracts.

This research was supported by Eurex Exchange.

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