Using the Volatility Risk Premium to Mitigate the Next Financial Crisis

Abstract

Ten years have passed since the trough of the Global Financial Crisis, and the US equity market has experienced one of the longest stretches of ascent in history. Some investors have started questioning whether the US stock market is overvalued and if a recession is on the way. It is usually impossible to predict the next financial crisis. An investor’s best course of action may be to adjust the investment portfolio to be resilient against potential market headwinds. This article argues for utilizing the volatility risk premium (VRP), specifically option-selling VRP strategies, to mitigate the losses the portfolio may suffer from a future financial crisis. Such a VRP strategy, if implemented with out-of-the-money equity index options, can help investors cushion the losses from an equity market crash and recover more quickly than the broad equity market. Investors can utilize the VRP by itself or combine it with traditional equity to construct the most suitable investment strategies. This article further examines implementation choices of such strategies and stress tests their performance with four representative crises from the past three decades. <b>TOPICS:</b>Analysis of individual factors/risk premia, financial crises and financial market history, performance measurement <b>Key Findings</b> • The US equity market may be overvalued after the decade-old rally, and an investor’s best approach may be portfolio adjustment against potential market headwinds. • The volatility risk premium (VRP), specifically option-selling VRP strategies, can help investors mitigate losses the portfolio may suffer from a future financial crisis. • Two mechanisms help overlay VRP strategies: low delta options only initiate payouts after the index fall below strike prices; higher implied volatility (IV) translates into higher premium collection in crisis times.