Monday, October 15, 2012

Vol of Vol

I was at this year's OptionMetrics conference and it was a nice overview of 13 different papers. One that stood out was Guido Boltussen's paper (coauthored by Van Bekkum and Van Der Grient of Erasmus U) on Unknown Unknowns: Vol-of-Vol and the Cross Section of Returns. The idea was simple. Instead of sorting by vol, they sorted by vol of vol, and generate a rather large annualized return  difference (10%) between the high vs. low vol-of-vol buckets. It's a bit like the guys at Gillette coming out with 5 blades, applied to volatility. Here's the standard graph with monthly excess returns:

In any case, it's intriguing. I haven't looked too hard at this, but it's a pretty obvious extension of the well-known low vol premium, and plan to investigate further. Clearly vol-of-vol is correlated with vol, so it would be interesting to see how these variables relate to each other in explaining the now well-known low-volatility premium. Perhaps volatility is a poor man's estimate of the 'true' factor, vol-of-vol, or vol-of-vol-of-vol.

There were several interesting papers, and I noticed that as usual, the risk premium (aka 'price of risk) was usually negative. Now, the risk premium should be positive, a premium, but empirically is usually negative; I don't think that word doesn't means what they think it means. I think it's better to say, here are excess returns, controlling for various obvious alternative characteristics we know to be correlated with excess returns. 


Anonymous said...

Hi Eric, In your book If i remember correctly you refer to the shape of the yield curve prior to 1930. What source did you use for the interest rate data? I have learned a great deal from your book. thank you for writing it.

Eric Falkenstein said...

Glad you enjoyed it. There's many mentions, just search under US interest rates 19th century. See

Anonymous said...


What's so surprising or to use your words "stand out" about this paper?

Gee vol of vol is an indicator to returns? Really, YES VIRGINIA, THERE IS A SANTA CLAUS! Are you kidding me? This is "new" information??? Maybe to the authors but not to any decent-to-good option trader. And Def not to any very good risk manager.

As an aside, not 6 years ago I was speaking to a desk head at a big bulge bracket firm, known then for the impeccable reputation of its prop trading group. This gent led one of the group's vol trading desks. I'd shared with him some analysis and a model I'd built to investigate price behavior in equities. When I explained why we undertook to examine kurtosis, the man looked at me over his glasses and said "are you telling me you use kurtosis as an indicator for returns?" His voice was high with indignation. I went on to briefly explain yes and why. Three months later said desk, was gone, said group was lost a cool $2B and said desk head was headless.

He now runs risk for a 3B converts fund. And the bank's prop group is no more- and not due to Volcker rule. It always makes me laugh what passes for intelligence, not to mention numerical acumen on Wall St. All the PhDs in the world don't mean nor beget profits. That incredible sums of money are constantly chasing these pseudo-cum-professional traders is beyond humorous to me. The only thing worse than this particular breed of animal on the Street are the ivory tower set armed with cheap lab help, oodles of time and no p&l constraints who seem to think that publishing 'novel' academic papers on concepts already well mined to professional is a worthy pursuit and budget expenditure.

Mont Blanc

Anonymous said...


off topic

I'm curious if you've done any work on trying to untangle the good performance of low volatility equities and the declining real and nominal interest rates we've enjoyed over the last 30 years. Given the high correlations between low vol equities (particularly utilities) and bond returns I'm concerned that some the juice in low vol equities will evaporate when rates finally turn up. Could you point me to any work on this topic?

By the way, I really enjoyed your book was a very readable mix of ideas that could be put in practice and insightful philosophizing about risk.


Eric Falkenstein said...

Glad you enjoyed the book. The vol effect (higher return for low vol) goes back to 1928 if you look at the CRSP tapes. I did my dissertation on it in 1992, so I didn't have the last 22 years in that, and I documented it there.

Emilio Lizardo said...

Link to the paper mentioned: