Practical Applications of Embracing Downside Risk

Abstract

Practical Applications Summary Many investors prefer to focus on maximizing their upside participation, since downside hedge protection can be expensive, and cut into long-term returns. But efforts to hedge out an asset’s downside risk can be expected to also reduce its returns. In Embracing Downside Risk, published in The Journal of Alternative Investments , Roni Israelov, Lars N. Nielsen, and daniel Villalon of AQR Capital Management show how downside risk is the primary basis for long-term rewards in equities and other asset classes. The authors use option prices to evaluate returns for investors in both upside and downside risk exposures. Instead of measuring the volatility risk premium as a volatility spread, they measure the return impact for investors following their asymmetric risk preferences. “The bottom-line: It’s the downside that pays. There’s a reason these things are called risk premia,” says Villalon in an interview with Institutional Investor Journals .