Exploring the Risk Premium
The risk premium represents the additional return that investors require for holding riskier assets compared to safer ones. We will explore the concept of risk premium, starting with bond risk premiums (BRP) and extending to equity risk premiums and variance risk premiums in options.
One-month U.S. Treasury-bills (T-Bills) are considered one of the lowest-risk assets. When you lend money to the U.S. government, you get back your principal investment plus an embedded return one month later. Since a default on a T-bill is not considered a possible scenario (due to the government’s ability to print dollars to pay back if necessary), what risks should go into the interest rate? At the very least, inflation is a risk that the interest received should compensate for over the one-month period.
If we compare T-bills with 10-year bonds issued by the U.S. government, the risk of default is still considered the same. However, the uncertainty of inflation over 10 years is greater than over the next month. Therefore, investors of 10-year bonds require a greater return than rolling monthly T-bills.
We can take it a step further and introduce credit risk. A bond issued by a corporation for 10 years has a risk of defaulting. To compensate for that risk, investors will demand a higher interest rate than that of a T-bond. This is known as a credit risk premium.
If we increase the risk further, we can consider the possibility that the timing and amounts of cash flows received is not scheduled as they are with bonds. Furthermore, these are the remaining cash flows after paying debt holders first. Although they are still corporate cash flows, they are clearly more risky than corporate bonds. These are equities, and the additional return required is the equity risk premium.
As we can see below these different assets have delivered returns overtime consistent with a risk premium for risker assets.
The second chart illustrates that although investors can expect greater compensation over the long run for investing in riskier assets, there are periods in which these assets will underperform. In fact, during bad times, riskier assets tend to perform the worst, which aligns with the rational theory that investors require higher risk premia for assets that tend to suffer during difficult periods.
The risk premium cannot be arbitraged away since it requires taking on risk to earn it. This is precisely what makes risk premiums a more sustainable source of returns.
Risk premiums cannot be arbitraged away because arbitrage exploits and eliminates inefficiencies, whereas risk premiums exist as a natural compensation for taking on risk. Risk premiums are a fundamental aspect of investing, as investors require higher returns for taking on additional risk.
Risk premiums are sustainable sources of returns because they reflect the relationship between risk and reward in the market. As long as investors demand compensation for taking on risk, risk premiums will persist. This differs from arbitrage opportunities, which tend to disappear as market participants identify and exploit them.
While the study discussed above is limited to U.S. markets, the fundamental nature of risk premiums holds up globally, as shown below.
Risk Premium in Options
In a risk-neutral world, investors are indifferent to risk and focus solely on expected returns when making investment decisions. They do not seek or avoid risk, and therefore do not require any additional compensation (risk premium) for taking on risky investments. This concept is often used to value financial derivatives or in option pricing models, such as the Black-Scholes model.
The risk-neutral world is a theoretical construct. As demonstrated previously, investors are generally risk-averse in the real world. This means that they require a higher return to compensate for the additional risk they take on.
Implied volatility is a parameter that derives from the market prices of options, and it reflects the market’s expectations regarding the future volatility of the underlying asset. In a risk-neutral world, implied volatility would only reflect the market’s expectations of volatility, as risk preferences would not factor into pricing. However, in the real world, implied volatility often incorporates not only the market’s expectations of future volatility but also risk premia. As a result, the implied volatility observed in the real world is often higher than what would be expected in a purely risk-neutral environment.
Who are the different actors in the option space, and what is important to them from a risk standpoint?
Puts
Buyers of puts on risky underlying assets tend to resemble insurance buyers. Buying puts against something like the S&P500 is a form of portfolio insurance. Even paying 2% a year to buy put options would still generate an average annualized return of 7.64%, which is 1% more than corporate bonds, but with less volatility than the unhedged portfolio. The return is likely greater than the “annual average return minus premiums cost” because put options provide liquidity to the holder during bad times, and that liquidity can be invested into the underlying asset at a lower cost basis, which boosts future returns. We saw earlier that investors are willing to pay more (accept lower expected returns, or lower risk premia) for assets that tend to do well in bad times. Safe haven assets that perform exceptionally well in bad times warrant a negative risk premium.
Consider the recent crash in ETH, illustrated in the chart below. Typically, during a market crash, investors may want to capitalize on undervalued assets. However, their portfolios might already be tied up in other assets that have also plummeted. This is particularly the case in markets with strong correlations, like crypto. Here, put options can serve as a liquidity source, allowing investors to purchase undervalued assets during downturns.
Here are some trades that took place on Rysk during the crash. As we can see buying puts was a profitable strategy providing liquidity during the market crash.
On the other side of the equation, option sellers, much like insurance providers, accept premiums with the understanding that they will occasionally face significant payouts. For these sellers, such a payout event materialized during the recent downturn. While these events are anticipated to occur perhaps 1–2 times a year, the cumulative premiums collected over time are projected to surpass the infrequent payouts. This is the fundamental mechanism that makes selling options viable: the steady income from option premiums, gathered during more stable periods, offsets the occasional but substantial liabilities during market crashes.
Calls
Buyers of call options on risky assets often resemble buyers of lottery tickets. Various market factors affect the attractiveness of call options, such as access to leverage. When there are few alternatives for leverage, call volume tends to increase. The convex nature of options provides a good example. Instead of buying call options, one could use a pyramiding strategy, where an investor increases their position as the price rises, essentially “riding the trend.” However, this strategy requires access to leverage in order to margin the increasing equity, needs to be actively managed, and has reversal risk, where an investor can suffer large losses if the price reverses after pyramiding up. These components are expensive on their own. A call option can effectively bundle these components for the buyer, providing embedded leverage, convex upside exposure, and risk limited to the premium they paid for the option.
Option sellers require a risk premium. Strategies that sell lottery tickets or portfolio insurance that pays off in bad times deserve high risk premiums because large losses (spiking volatility) tend to coincide with market crashes. According to finance theory, volatility selling should carry a positive risk premium if its losses tend to coincide with market losses and other bad times.
The tendency for a strategy of selling volatility to lose money in bad times suggests that the risk premium for buyers should be negative (so that selling is profitable in the long run). Indeed, years of options market data have consistently shown that implied volatility has been at a premium to realized volatility.
In the options market, there is a paradox: option sellers consistently receive a positive risk premium, while buyers are willing to accept a negative risk premium. This paradox is resolved by the fact that if option sellers consistently received a negative risk premium, they would go out of business, and the options market would cease to exist. Buyers, on the other hand, can and do accept a negative risk premium because they view options as a form of asset protection, much like home or car insurance. This willingness of buyers to accept a long-run negative risk premium enables option sellers to provide liquidity in the options market, as evidenced by years of continuous options trading activity across multiple assets.
Risk Premium in Crypto
So far, we have focused on traditional fixed-income and equity assets to understand risk premiums. We did this because there is a much longer history to test and draw conclusions from. However, we can still observe some relationships.
Rysk builds within the Ethereum ecosystem and its first vault is based on ETH, so we will use ETH’s historical data. Classifying what type of asset ETH is itself is an interesting and complicated subject beyond the scope of this topic. We will attempt to provide a basic classification for the purpose of evaluating whether risk premium relationships should also apply here.
ETH exhibits properties of a currency (fungibility and transfers), a commodity (gas), and an equity (cash flows from validation). Studies have shown that risk premia are associated with both commodity and currency strategies. Similar to equities, studies have also demonstrated that selling volatility can be profitable in these alternative sectors.
Using our dataset, which goes back to 2017 when ETH started to mature as a crypto asset, we found that its standard deviation of daily returns is 5%, while the S&P’s was 1.3%. Over that same period, ETH had an average annualized return of 42.77%, while the S&P averaged 9.15%. This shows that ETH is riskier based on its historical volatility, but it has compensated investors with an additional 33% per year in returns.
Like other assets, we have shown previously that the Variance Risk Premium also exists in the ETH options market.
Conclusion
Risk premiums are sustainable sources of returns, as they reflect the relationship between risk and reward in the market. The risk premium cannot be arbitraged away since it requires taking on risk to earn it, differentiating it from arbitrage opportunities that tend to disappear as market participants exploit them.
Furthermore, we highlight the importance of risk premiums in various markets. In the options market, option sellers consistently receive a positive risk premium overtime to compensate for occasional losses, while buyers willingly accept a negative risk premium. This is explained by the fact that buyers view options as a form of asset protection, similar to insurance.
What’s Next?
Remember, options trading can be both rewarding and risky. Understanding the intricacies of each strategy is key to making informed decisions and managing your positions effectively. But with a bit of knowledge and a sprinkle of humor, you’ll be navigating the options market like a pro in no time!
Trade options with Rysk 👉 https://app.rysk.finance
Happy trading, and may the options be ever in your favor!
The provided content is for informational purposes only. You should not understand any information or other material as legal, tax, investment, financial, or other advice. Nothing contained in our statements constitutes a solicitation, recommendation, endorsement, or offer by Rysk or any third-party service provider to buy or sell any kind of instrument or to execute any kind of transaction discussed above.
All presented content is information of a general nature and does not address the circumstances of any particular individual or entity. Nothing in the previous statements constitutes professional and/or financial advice, nor does any of the above information integrate a comprehensive or complete statement of the matters discussed or the law relating thereto. You alone assume the sole responsibility of evaluating the merits and risks associated with the use of any information or other content described above before making any decisions based on such information. With the above content, Rysk does not assume any fiduciary duty.
