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The Eurex Research Chair on "Volatility as an Asset Class" at EDHEC-Risk Institute

Release date: 31 May 2012 | Eurex Group

The Eurex Research Chair on "Volatility as an Asset Class" at EDHEC-Risk Institute

"The Benefits of Volatility Derivatives in Equity Portfolio Management" by Renata Guobuzaite and Lionel Martellini

This paper provides a formal analysis of the benefits of volatility derivatives in equity portfolio management from the perspective of a European investor. Our main contribution is to compare the risk/return characteristic of equity portfolios combined with long volatility exposure to those of a global minimum variance (GMV) portfolio, the conventional approach to managing equity volatility. We confirm that the correlation between the return on volatility indexes and the return on equity indexes is strongly negative, with an absolute level of correlation that increases in recessions and/or high volatility regimes. We also show that even a relatively modest allocation to volatility derivatives, consistent with a reasonable level of expected performance, can allow an investor to generate equity portfolios that have more attractive downside risk properties compared to global minimum variance portfolios, with a substantial reduction in maximum drawdown levels. These findings are robust with respect to the introduction of trading costs associated with rolling over volatility derivatives contracts so as to generate the target level of long volatility exposure.