Volatility Arbitrage and Cross-Border Options

Volatility Arbitrage and Cross-Border Options

A new paper, by Adriano Tosi, of the University of Zurich, Switzerland, looks at the mispricing of a cross-section of international option returns, which suggests that there is money to be made (in more decorous language a “positive risk premium” may be “commanded,”) by selling exchange-traded products and buying the corresponding index options.

Volatility hedge funds have generally stuck to the US options scene, not playing the available cross-border opportunities, Tosi finds. That fact has kept this window of opportunity open.

Even much of the scholarly research on the empirical/behavioral realities of options pricing has focused on the US options markets, which likewise has kept the international situation hidden.

The price gap between ETP and index options is “especially pronounced among options with high ex-ante volatility return difference.”

Literature Review

Tosi isn’t the first scholar to look at international options. Fifteen years ago, S.D. Hodges and associates, in a paper on “The Favorite/Longshot Bias in S&P 500 and FTSE 100- Index Futures Options,” found that out of the money put options in both the S&P and FTSE yielded negative returns for the period 1985 – 2002.

More recently Driessen and Maenhout (2013) found that US and UK derivatives are increasingly interdependent.

Other scholars, casting a wider net, have found that the implied volatility and variance risk premium for options is quite generally higher for nations facing political elections, and have drawn the inference that options provide protection for political tail risk.

The European sovereign debt crisis of 2009-13 set off another wave of studies about volatility focusing on the nations directly involved. One of those studies documented what Tosi calls “the profitability of covered call writing across eleven global indexes.” That is: it was in that context generally profitable to sell a hedge against a sovereign default.

There is also a body of literature that studies dispersion trading strategies. In 2009, Peter Carr and Liuren Wu found a negative variance risk premium in index options and a premium of, in effect, zero among 35 equity stock options. But, again, that involved the domestic US options and indexes. Tosi’s own finds complement such literature by going global.

Tosi’s Research Method

Tosi’s paper looks at options over the period 2006 – 2015. For each month in that period he sorts international at-the-money straddles by previous day volatility returns and then assigns those straddles to one of three equally weighted tectile portfolios. Thus, he creates a long-short portfolio that sells the expensive tectile, buys the cheap, and holds the options to maturity. He follows the same procedure to construct domestic portfolios.

The resulting international portfolios outperform the domestic portfolios. The former yielded Sharpe ratios in a range from 1.23 to 2.29.  These portfolios have a positive skew and a neutral exposure to the equity market. The latter, domestic, portfolios constructed on the same plan, on the other hand, yielded Sharpe ratios of from 0.56 to 0.67.

Looking at ex-post vol returns, the international portfolios have between 14.39% and 29.11% on a yearly basis. The equivalent domestic numbers range only from 7.25% to 19.33%.

Three Conclusions and a Footnote

Tosi draws three conclusions. First, “good returns may lay between securities that at first glance are similar but institutionally are not.” Second, looking into exotic contingent claims “may be an interesting path for unknown returns.” Finally, hedge funds in search of alpha from volatility would be well-advised to explore international derivative products.  Tosi also calls on his fellow academics to expand research in this area, because for decades now research has been largely focused on domestic option prices.

In a footnote, Tosi observes that hedge funds (as well as market makers and proprietary trading firms) may gain leverage by virtue of the new portfolio margining rules of the CBOE, as well as the risk-based margining rules of the European and Asian exchanges.

Tosi is also the co-author, with Alexandre Ziegler of a recent study on the timing of options returns. That study suggests that speculators who want to profit from the put option premium should short front-month options only during the final days of the cycle. Investors trying to protect against downside risk on the other hand should use back month options.  

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