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Ahead of the Curve: Time to embrace downside risk

The attractions of equity put options as way to reduce a portfolio’s downside risk exposure can make it an expensive play, write Roni Israelov and Lars Nielsen. But offering call options canprovide higher long-term returns 

Many investors turn to buying equity index put options in an effort to reduce the downside risk exposure of their existing equity portfolios, while still maintaining their upside participation. 

This approach certainly sounds appealing – as we all would like to avoid the discomfort felt during market downdrafts – but sadly, it is not so easy. Because so many investors want to avoid that discomfort, the price of doing so is high – to the point of eliminating the upside. This presents an opportunity for investors with a long-term view willing to embrace that downside risk. 

For those seeking to protect their portfolios, options arguably provide the most direct downside hedge. The cost of that protection, commonly referred to as the volatility-risk premium, is measured by the difference between the option’s implied volatility and its underlying asset’s realised volatility. This is the compensation that option buyers pay to sellers for bearing undesirable downside risk. 

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The size of the volatility-risk premium is related to investors’ desire to avoid downside risk. Rather than measure the volatility-risk premium as a volatility spread, we may instead use option prices to quantify the returns earned, respectively, for upside and downside risk exposures. In this way, we present the same information through a different lens to provide an intuitive measurement of the return impact of acting on one’s risk preferences.

Comparison of compounded returns of equities, covered call and long call strategies

We find that most of the empirical equity risk premium reflects compensation for downside risk because of the historical magnitude of the volatility-risk premium. 

In fact, our research shows that owning upside participation via long call options or an S&P 500 allocation coupled with protective put options earned hardly any reward in the long run, reflecting an asymmetry that might be surprising to some investors. This result suggests that demand for upside participation is strong and tolerance for downside risk is weak. 

As a result, long-term investors might be better off embracing the downside because hedging it would potentially remove much, if not all, of the long-term returns. However, those investors willing to bear that downside risk exposure by selling options have the potential to outperform over the long  term. This idea extends beyond stocks. We find that other asset classes, including fixed income, commodities, and credit, show similar results. 

To many, it may sound risky to actively seek out downside-risk exposure. Yet, for example, the insurance industry is seemingly devoted to accepting the risk of potentially significant loss for profits that are capped at moderately-sized insurance premiums. And, while it might appear rather unconventional to do so in financial markets, the downside exposure associated with underwriting financial insurance offers potentially greater rewards than does the sought-after upside participation.

 Economic theory and empirical evidence support the idea that investors should be compensated for bearing downside risk. Therefore, insurance that seeks to mitigate this risk should rationally come at a cost – which we find to be the case in multiple asset classes, historically.

What could this mean for investor portfolios? In general, if the downside risk inherent in a given asset class is too much to bear, it may be better to simply reduce the allocation to that asset class (that is, to de-risk) rather than buy insurance through options. 

Some investors might instead seek to be on the ‘other side’ of those paying for insurance, and thus capture the volatility risk premium (for example, through covered calls). These financial insurance underwriters are more likely to earn higher long-term risk-adjusted returns.

Roni Israelov is a vice-president and Lars Nielsen is a principal at AQR Capital Management

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