Many investors use options to hedge volatility risk in general, or downside risk in particular. For this the other side wants compensation. As a result the implied volatility used to price options is on average larger than the actual realized volatility. E.g. for the S&P500 stock index the difference is about 3%. Hence on average buying options costs money, also known as the negative volatility risk premium. To turn this around, an investor can take on the risk on the other side by writing options. On average such a strategy will make money in say 9 out of 10 years, but then the one year it goes wrong the investor will take a big hit (especially for these moments the buyer of the options is willing to be the premium …).
In a previous internship project we studied in detail the volatility risk premium for equities, government bonds, credits, commodities and currencies. The result of combining these five applications is a very strong volatility risk premium.
In this internship we want to study whether these results can be used to build a new product that is appealing to investors.
First let us stress that we expect an active contribution from you on what are the important questions and which are not. Hence you can help with extending the list of examples below or even replace the examples by topics that are deemed more relevant.
Improving the volatility risk premium
Writing options still leaves several degrees of freedom. Which assets to include, which ones not? Do you delta-hedge the market exposure or not? For delta-hedging: When/how often? If not delta-hedging, should you make the payoff symmetric by selling some stock? Do you write calls and puts or only one of them? Which moneyness and maturities do you sell? How do we diversify optimally over the asset classes? How do all these choices affect the gross returns but especially also the net returns? Net returns is taking into account transaction costs when setting and unwinding the positions, and costs tend to be lower for the most liquid options. Hence for the all the mentioned choices you should take this into account. And perhaps you can use less assets than the 60 in the previous internship to simply reduce the costs but keep sufficient diversification? Finally but not least: Can we predict/avoid the periods were we will take a big hit?
Instead of attempting to avoid the big hits (which may be hard to predict) the new product can also combine the volatility risk premium with other known quantitative strategies for which there is a lot of academic evidence. We think for example about time-series momentum. CTA/trend funds have been highly successful in the past. Academic research shows that the returns of these funds can for a sizeable part be explained by long (look-back) straddles. Whilst for the volatility risk premium we write straddles. A perfect match?
Hurst, Ooi and Pedersen, 2013. Demystifying managed futures. Journal of Investment Management 11, 42-58. https://www.aqr.com/~/media/files/papers/joim-demystifying-managed-futures.pdf
Tilgenkamp and Martens, 2016. The global volatility risk premium. To appear on SSRN soon.