CBA Copenhagen Business School MSc in EBA Finance & Investment Master Thesis 2017 CONFRONTING THE VOLATILITY RISK PREMIUM ON THE S&P500 INDEX - AN EMPIRICAL STUDY Lea Jochumsen Victor Vogel Jørgensen Supervisor: Agatha Murgoci Time of submission: May 15, 2017 Page numbers and characters: 120 pages, 247,135 characters Confronting the volatility risk premium on the S&P500 index | 2017 Abstract This thesis examines the effectiveness of different short vega option combinations’ ability to capture the volatility risk premium on the S&P500 index. We find evidence that delta neutrality of the option combinations is required to gain factor exposure linked to the volatility risk premium. The short delta-hedged strangle proves to be the most profitable strategy to capture the volatility risk premium. However, neither of the initially tested strategies yields statistically significant returns. Using market timing indicators based on moving averages of the VIX- and CDX index, the returns of the option combinations considered are consistently improved and yield statistically significant returns. When considering transaction costs and margin requirements faced when trying to capture the volatility risk premium, the investment doesn’t seem as attractive, but is perusable when using market timing indicators. 1 ⏐ 144 Table of Contents ABSTRACT ........................................................................................................................................................ 1 CHAPTER 1 - INTRODUCTION .................................................................................................................... 4 1.1 MOTIVATION ............................................................................................................................................................ 5 1.2 RESEARCH QUESTION ............................................................................................................................................. 6 1.3 DELIMITATION ......................................................................................................................................................... 7 1.4 DATA & METHODOLOGY ........................................................................................................................................ 8 1.4.1 Option & index data ........................................................................................................................................ 8 1.4.2 Risk free proxy, factor data & further research ................................................................................. 9 1.4.3 Methodology of option combinations ................................................................................................... 10 1.4.4 Data for delta hedging ................................................................................................................................ 11 CHAPTER 2 - THEORY ................................................................................................................................. 12 2.1 OPTIONS .................................................................................................................................................................. 13 2.2 GREEKS .................................................................................................................................................................... 14 2.2.1 Delta .................................................................................................................................................................... 14 2.2.2 Gamma ............................................................................................................................................................... 15 2.2.3 Theta ................................................................................................................................................................... 15 2.2.4 Vega ..................................................................................................................................................................... 15 2.3 DELTA HEDGING .................................................................................................................................................... 16 2.4 OPTION COMBINATIONS ....................................................................................................................................... 17 2.4.1 Short straddle .................................................................................................................................................. 18 2.4.2 Short strangle ................................................................................................................................................. 19 2.4.3 Long iron butterfly ........................................................................................................................................ 20 2.4.4 Long iron condor ........................................................................................................................................... 20 2.5 VOLATILITY ............................................................................................................................................................ 21 2.6 INDICES USED AS MARKET TIMING INDICATORS .............................................................................................. 22 2.6.1 VIX index ............................................................................................................................................................ 22 2.6.2 Credit default swap indices ....................................................................................................................... 23 2.7 RISK FREE PROXY .................................................................................................................................................. 24 2.8 RETURN CALCULATION ........................................................................................................................................ 25 2.9 MARGIN REQUIREMENTS ..................................................................................................................................... 25 2.10 PERFORMANCE- & RISK MEASUREMENTS ...................................................................................................... 26 2.11 REGRESSION VARIABLES ................................................................................................................................... 28 CHAPTER 3 - ANALYSIS .............................................................................................................................. 30 3.1 VOLATILITY SPREAD IN SAMPLE PERIOD ........................................................................................................... 31 3.1.1 Empirical evidence of volatility spread vs. short straddle return ............................................ 32 3.2 INITIAL DELTA NEUTRAL STRATEGIES ............................................................................................................... 33 3.2.1 Descriptive statistics .................................................................................................................................... 33 3.2.2 Short straddle .................................................................................................................................................. 35 3.2.3 Short strangle ................................................................................................................................................. 36 3.2.4 Long iron butterfly ........................................................................................................................................ 37 3.2.5 Long iron condor ........................................................................................................................................... 38 3.2.6 General comparison of the strategies’ performance measures ................................................. 39 2 ⏐ 144 Confronting the volatility risk premium on the S&P500 index | 2017 3.2.7 Development of delta during trading period .................................................................................... 44 3.3 DELTA-HEDGED STRATEGIES .............................................................................................................................. 46 3.3.1 Descriptive statistics and comparison .................................................................................................. 47 3.3.2 General comparison of the hedged strategies’ performance measures ................................. 53 3.4 REGRESSIONS ......................................................................................................................................................... 59 3.4.1 Regression results .......................................................................................................................................... 61 3.5 MARKET TIMING INDICATOR STRATEGIES ........................................................................................................ 67 3.5.1 Indicators and their statistics .................................................................................................................. 67 3.5.2 General presentation of strategies ......................................................................................................... 69 3.5.3 Descriptive statistics - Best performing