(January 14, 2014) — Interest rate instability can provide a way of generating alpha returns, thanks to a gap between implied and actual levels of volatility, according to Nomura.
The investment bank assessed how the volatility risk premia (VRP)—the gap between the implied interest rate volatility levels (which tend to be higher) and the actual rates—behave in today’s environment, and discovered VRP strategies performed well, even when volatility levels fell.
“Another way to think about VRP exposure is that it is like providing insurance and deserves compensation,” Nomura said.
“One earns small, frequent rewards, while being exposed to large, infrequent losses. The catch is that these losses are likely to occur when other markets are also experiencing increased volatility. Hence, this kind of insurance has systematic risk, and deserves extra compensation.”
In the current environment, where expectations of recovery and rate rises are growing, long-only bond positions are returning poorly, but VRP plays do the opposite, Nomura said.
What’s more, the VRP positive returns were found in three different currencies: the yen, the US dollar, and sterling.
“This result may appear somewhat counterintuitive,” Nomura wrote. “Investors might expect volatility to be particularly high in a rising rate environment. But the reality is that implied volatility rises to such an extent that systematically selling it provides good returns.
“In other words, while volatility may go up, the gap between implied and realised volatility goes up even more. And this implied/realised volatility gap is what really matters for VRP returns.”
In addition, Nomura’s data analysis found the strategy even worked when volatility levels were low. This is because the VRP performance doesn’t rely on the absolute level of volatility, instead it relies on the difference between implied and actual levels.
Nomura then measured the VRP returns when varying selling frequencies, option expiries, and swap tenors for major swaption markets—USD, EUR, and JPY—and examined how these factors influenced the level of VRP.
Among the manager’s findings were that implied risk levels rise in the run up to major economic announcements, such as the US non-farm payroll figures, driven by investors demanding protection and/or fewer investors being willing to supply protection before data releases.
By only initiating VRP exposure on a daily basis for the week starting on the last business day of the month, the returns beat both daily trades and monthly trades in terms of both the Sharpe ratio and Calmar ratio.
No investment strategy is without downside risk, but Nomura believes that a simple stability mechanism neutralises some of it—by only selling swaption straddles when either implied volatility is declining or implied volatility is modestly increasing, provided there is also a rising risk premium.
“Mention the word ‘derivative’ or ‘volatility’ and many investors instinctively recoil. But when a product is so unloved, it may represent good value,” Nomura said.
“Given recent regulatory changes, the attractiveness of VRP exposure seems even greater. There are fewer sellers of optionality and more buyers. When there are fewer sellers of insurance in a market place, it usually pays to be one of them.
“Given the real prospect of higher interest rates in the years to come, it is especially important that interest rate investors consider other ways to make returns. Just being long bonds may not be good enough anymore. VRP exposure may be one of the most scalable ways to earn good returns going forward.”
The full paper can be found here.
Related Content: NYSE LIFFE Launches 30-Year Gilt Future in UK and Who Knows Best about Hedging?