Harvesting the S&P500 Volatility Risk Premium

The ultimate goal of an investor should be to identify and exploit attractive risk premia in capital markets. Risk premia and factor exposures have been intensively discussed in academic literature as a framework for decision-making processes in the area of Absolute Return and Hedge Fund investing. However, to practically extract a risk premium and to offer market participants an attractive investment opportunity requires a very structured approach. This article provides an insight on how to efficiently harvest the volatility risk premium in the US stock market (S&P500) through a regulated (UCITS IV) investment vehicle (OptoFlex I - ISIN: LU0834815101).

We define the attractiveness of a risk premium by its magnitude, stability and liquidity. Magnitude measured as the expected return implying whether a certain risk should be considered to be taken by an investor to receive a premium. As drawdowns of an investment should be minimised, the stability of a risk premium is important as well. Sufficient trading liquidity of a risk premium is also required to provide flexibility for potential exposure adjustment in case desired. Assuming that an available risk premium combines all three of the above we expect an investor to be adequately paid for taking such a risk in capital markets.

Below we demonstrate that the volatility risk premium in the US stock market (S&P500) is characterised by all three criteria defined above. The return expectation from harvesting the volatility risk premium is not only attractive in terms of the dimension, but also very stable in comparison to other capital market risk premia. Finally, the S&P500 volatility risk premium can be captured very efficiently in the most liquid derivative markets globally.