Volatility as an Asset Class: European Evidence

Abstract

Volatility movements are known to be negatively correlated with stock index returns. Hence, investing in volatility appears to be attractive for investors seeking risk diversification. The most common instruments for investing in pure volatility are variance swaps, which now enjoy an active over-the-counter market. This paper investigates the risk-return tradeoff of variance swaps on the Deutscher Aktienindex (DAX) and EuroStoxx50 index (ESX) over the time period of 1995 to 2004. We synthetically derive variance swap rates from the smile in option prices. Using quotes from two large investment banks over two months, we validate that the synthetic values are close to OTC market prices. Our objective is to analyze the relationship between index and variance swap returns, including extreme events like September 11, 2001. We find that the variance swap return pattern shows a pronounced kink at zero index return. This not only highlights the importance of differentiating between up and down markets but also sheds new light on the leverage effect. Due to the option-like profile of returns it is crucial to account for the non-normality of returns in measuring the performance of variance swap investments. Based on the empirical analysis, we finally draw conclusions for investors. Our backtests result in significant short volatility positions in optimal portfolios during the sample period. Typically, the stock index weight is also negative, since the diversification gain exceeds the loss in expected return.