Ralph Elliott: The Pervasiveness of the Variance Risk Premium Across Global Asset Classes
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This is a draft of the third article. I will continue to refine and add more details as I write the other articles.
The Pervasiveness of the Variance Risk Premium Across Global Asset Classes
The variance risk premium (VRP) is not a phenomenon confined to the U.S. equity market. A growing body of academic research and empirical evidence demonstrates that the VRP is a pervasive feature of global financial markets, present across a wide range of asset classes, including international equities, fixed income, currencies, and commodities. This pervasiveness has significant implications for institutional investors, as it suggests that a diversified, multi-asset class approach to VRP harvesting can offer a more robust and consistent source of return.
Theoretical Underpinnings of a Pervasive VRP
The economic rationale for the existence of the VRP in the U.S. equity market—namely, the structural demand for protection against volatility—can be extended to other asset classes. Investors in all markets have a natural aversion to risk and are willing to pay a premium to hedge against adverse price movements. This demand for insurance is not limited to equity investors; it is also present among bond investors concerned about interest rate volatility, currency traders hedging against exchange rate fluctuations, and commodity producers and consumers managing price risk.
Empirical Evidence from International Markets
Numerous studies have documented the existence of a positive and statistically significant VRP in major international equity markets. For example, a study by Carr and Wu (2009) found evidence of a significant VRP in the equity indexes of the G7 countries. The following table summarizes the average annualized VRP for several major international equity indexes from 2000 to 2008:
| Index | Average Annualized VRP |
|---|---|
| S&P 500 (USA) | 0.034 |
| FTSE 100 (UK) | 0.029 |
| DAX (Germany) | 0.031 |
| CAC 40 (France) | 0.033 |
| Nikkei 225 (Japan) | 0.025 |
Source: Carr and Wu (2009)
The VRP in Other Asset Classes
The VRP is not limited to equity markets. It has also been documented in:
- Fixed Income: The VRP is present in the market for interest rate options, where implied volatility on interest rate swaps and government bonds tends to be higher than realized volatility.
- Currencies: The VRP is a feature of the foreign exchange market, where options on major currency pairs exhibit a persistent premium.
- Commodities: The VRP has been identified in the markets for a wide range of commodities, including crude oil, natural gas, and agricultural products.
Actionable Example: A Diversified VRP Harvesting Strategy
An institutional investor could construct a diversified VRP harvesting strategy by systematically selling volatility across a range of global asset classes. For example, the investor could allocate a portion of their portfolio to selling straddles on the S&P 500, another portion to selling straddles on the Euro Stoxx 50, and another portion to selling straddles on the USD/JPY exchange rate. This diversified approach would help to mitigate the impact of a volatility spike in any single asset class and could lead to a more stable and consistent stream of returns.
By diversifying across asset classes, investors can take advantage of the low correlation between the VRP in different markets. For example, a spike in equity market volatility may not be accompanied by a corresponding spike in currency market volatility. This low correlation can help to smooth the returns of a VRP harvesting strategy and reduce its overall risk profile.