Alternative Investing

Embracing Downside Risk

Topics - Alternative Investing

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Embracing Downside Risk

This paper shows that downside risk tends to be the main source of long-run returns in equities and other asset classes, and argues that long-term investors may be better off embracing downside risk in certain cases.

  • It is well-known that investors have asymmetric preferences when it comes to bearing downside risk versus participating in the upside.
  • Options arguably provide the most direct downside hedge, but at a significant cost reflecting investor preferences. This cost, commonly referred to as the volatility risk premium and measured by the difference between the option’s implied volatility and its underlying asset’s realized volatility, is paid by option buyers to sellers for bearing undesirable downside risk. Options markets therefore provide a useful and intuitive way to quantify these asymmetric preferences by way of the returns associated with being on the other side.
  • We show this using equity index options, and find that most of the empirical equity risk premium reflects compensation for downside risk — in fact, upside participation earned hardly any reward in the long run, reflecting an asymmetry that might be surprising to some investors.
  • We extend this analysis to other asset classes (bonds, gold and crude-oil futures, and credit) to show similar (though in some cases weaker) results.
  • Data and economic theory suggest that investors who attempt to deal with downside risk by being long options should expect to underperform.

To many, it may sound risky to actively seek out concentrated downside exposure. Yet, for example, the insurance industry is seemingly devoted to accepting the risk of potentially significant loss for profits that are capped at moderately sized insurance premiums. Although it may appear rather unconventional to do so in financial markets, we show that downside exposure has the potential to offer greater rewards than does the highly sought-after upside participation.

Published In

The Journal of Alternative Investments

This document is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein.

 

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This material is not research and should not be treated as research. This paper does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR. The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein. 

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