Lesson 2

📘 Harvesting the Equity Volatility Risk Premium

The market-implied volatility of equities tends to exceed the subsequent realized volatility. This discrepancy, known as the volatility risk premium (VRP), offers a strategic opportunity for yield through shorting variance swaps on equity indexes. Given the challenges of traditional income sources like bonds due to central bank tightening, VRP has become more appealing.

🎯 Understanding the Volatility Risk Premium

VRP represents the compensation required by option sellers to provide downside protection. It is the difference between implied and realized volatility, typically measured using indices like the VIX against actual S&P 500 returns. Historically, this premium averages around 4–5 volatility points.

🔧 How to Harvest the VRP

Strategies to monetize VRP include writing options and engaging in swap-based instruments such as variance swaps. Among these, variance swaps provide the most direct and efficient exposure due to their linear relation to variance (the square of volatility) and transparent pricing.

📈 Variance Swaps Explained

A variance swap is a contract that pays based on the difference between realized and implied variance. For example, if you sell a 1-month variance swap with a strike at 20% and the realized volatility ends at 19%, the payoff approximates a small gain. These contracts are valued using option prices across multiple strikes and are particularly useful for their simplicity and consistency in execution.

📉 Reducing Drawdown Sensitivity

One risk of VRP strategies is drawdowns during volatility spikes, such as in 2008 or 2020. Tactics to manage this include using short-dated contracts and replication methods that limit exposure to large market moves. Weekly variance swaps often show smaller losses and faster recovery during spikes compared to monthly swaps.

🧩 Replication Strategy Insights

Variance replication through option portfolios mimics variance swaps using out-of-the-money (OTM) puts and calls. Adjusting the range and delta of these options can customize exposure and reduce risks. Narrower strike widths harvest less VRP but tend to perform better during sharp market drops.

📊 Portfolio Integration

Short variance swaps can diversify a traditional portfolio. They have a positive correlation to equities and credit but can improve overall returns when financed appropriately. Allocating from both equities and bonds can enhance performance more than replacing one asset class alone.

📝 Final Considerations

Systematic implementation of VRP strategies, particularly with shorter tenors and variance replication, offers an alternative yield mechanism in today’s market. Despite their risks, especially during crises, such strategies remain relevant for sophisticated investors aiming to diversify income sources.