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UNIVERSITY OF AMSTERDAM – BACHELOR THESIS FINANCE – JULI 2009
Sharpening Portfolio Sharpe Ratios
Using Volatility as an Asset Class
Boudewijn Brouwer (Student ID: 5704294)
Abstract:
This paper researches the impact of adding volatility as an asset class to a portfolio of stocks and
bonds within a strategic asset allocation (SAA) framework. Delta‐hedged straddles are used to
capture the magnitude of volatility through the payoff structure. Adding these straddles to the
original portfolio leads to an improvement of portfolio performance when looking at the efficient
frontiers and the Sharpe ratio of the efficient portfolios.
In the past year the worldwide stock markets experienced dramatic losses losing almost 50% of their
high in 2007. Just as in 2002 during the internet bubble, this market crisis was paired with extreme
volatility. The VIX index moving up from twenty points to an all time high of eighty points. With
hindsight many people “expected” this crash although in the search for extreme returns, many
parties did not hedge their position properly and private and institutional investors saw their
invested capital shrink to oblivion. The search for extreme returns led investors to invest irrational
without properly diversifying and hedging. Now, after the credit crunch, investors are reluctant to
invest, not sure of what is going to happen in the future. Arguably, investors should switch to the
traditional way of investing, using the SAA to invest in well diversified portfolios. This way they are
able to diversify away idiosyncratic risk, as sticking to the traditional asset classes in a portfolio might
not fully profit from the dynamics of the stock market (Bodie, Kane and Markus, 2008). The means to
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search for new ways of diversification opened the doors for investigating the possibility of making a
profit from for example the fluctuation in volatility.
The goal of this research is therefore to research the possibility of improving the performance of
traditional portfolios consisting of only stocks and bonds by adding volatility as an asset class. This
paper evaluates adding volatility as a new asset class within a SAA and a mean‐variance framework.
The important assumption behind this is that investors only care about the mean and the variance of
returns. Andrikopoulos (2007) argues that treating volatility as an asset class could be beneficial if
the dynamics of volatility are managed by creating a portfolio of such assets in accordance with
modern portfolio theory. This paper is however only a brief discussion without any empirical
research, meaning there is room for further research such as this one. In addition, Liu and Pan (2003)
explain how derivatives can potentially improve the risk and return tradeoffs in a portfolio previously
limited to stocks and bonds, because of the ability for such instruments to provide exposure to
volatility.
The Barclays Voltaire Index (Barclays Capital, 2007) shows that there is indeed a potential to boost
portfolio performance by adding volatility as an asset class. The strategy behind this index is to find
markets with a discrepancy between implied and realized volatility, and taking short positions on
variance swaps to capture the premium. Coval and Shumway (2000) also find empirical evidence that
supports the profitability of investing in volatility as an asset. In their report they observe market‐
neutral straddles on the S&P500 index receiving average weekly returns of minus three percent per
week and zero‐beta straddles offering returns that significantly differ from the risk‐free rate. This
indicates there is indeed a premium to be obtained from taking a short position in volatility
instruments.
To research the potential improvement in portfolio performance caused by adding volatility as an
asset class, a portfolio of stocks and bonds is constructed within a SAA. Volatility as an asset class is
then added to this original portfolio, and the portfolio performance is again measured using several
performance indicators. Dynamically delta hedged straddles (DDH straddles) are used as a volatility
instrument to gain exposure to pure volatility. Used performance indicators entail the mean and
standard deviation of returns and the Sharpe ratio. In addition, the efficient frontiers are plotted
using a built‐in solver function in Excel to see if there is an upward shift in the case of the added
straddles. Finally, the same is repeated with an added restriction to the solver function, enforcing a
minimum investment of 2.5% of total capital in each of the used stocks. In both the presence as the
absence of the restriction an improvement of the efficient frontier is observed. The maximum
obtainable Sharpe ratio also went up in both cases. This means it is safe to conclude that adding
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volatility as an asset class to portfolios previously limited to stocks and bonds indeed leads to an
improvement in portfolio performance.
To understand better how this research is performed, section 1 of the paper is set out to explain the
theoretical background on the used models and frameworks. Because investing in volatility supplies
the foundation of this research, section 2 is allotted to give a summary of the theories that explain
why investing in volatility is potentially beneficial. In particular the theoretical justifications of the
existence of the variance risk premium (VRP) found in current literature are discussed. Section 3 then
explains how this VRP can be exploited using volatility instruments. As this research uses dynamically
delta hedged straddles as a volatility instrument, these will be discussed in detail. Section 4 will
explain what data is used and show where it is gathered from. The methods used to carry out the
research are discussed in section 5, and the results are analyzed in section 6. Finally, the conclusion
of the research is given and its shortcomings are discussed, in section 7 and 8 respectively.
1 Theoretical Background on Models and Framework
In the following section the theoretical groundings of this project will be reviewed. Because the
Black‐Scholes Model (BSM) is used for pricing the used derivative securities, it provides a starting
point for explaining how implied volatility is derived and captured. This will enhance the
understanding of the behavior of volatility and why it will prove to be profitable in a diversified
portfolio as an extra asset class when constructing an optimal SAA. Secondly, the mechanics behind
implied volatility will be explained to give a clear view on some of the shortcomings inherent in the
BSM.
1.1 The Black and Scholes Model
Understanding the concept of investing in volatility requires understanding the components making
up the extrinsic value (market price – intrinsic value) of a standard option contract. This is the money
an investor pays for risk factors other than the price of the underlying stock. As explained by Dash,
Srikant and Moran (2005) this extrinsic value is priced into the option premium using the BSM. Other
factors that are incorporated in the BSM are the time to expiration, the strike price, the prevailing
interest rate, the current price of the underlying security, and an estimate of the implied volatility.
Due to the simplicity and its ability to explicitly model the relationship between all factors that make
up for the option price, the BSM is still most frequently used to price options.
By principle, the value of an option will depend most directly on the price of the underlying asset,
because that determines how far in‐ or out of the money the position is giving the current market.
The sensitivity to directional changes in the price of the underlying asset is called the delta of an
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option. By minimizing the influence of delta, it is in effect possible to isolate IV as the only source of
value to pricing the option. This means that the second greatest factor that determines the price of
an option comes from the IV (which is in effect the probability of an option to move into the money),
which is priced as part of the extrinsic value of the option. The formula as given by Hull (2006) shows
mathematically how the BSM prices options:
with P and C as the price of a call‐ and put option and
St is the price of the underlying stock for t=0
is the cumulative distribution function of a standard normal variable
r is the risk free rate
T is the time to maturity in years
K is the strike‐ or exercise price
To incorporate dividends into the Black Scholes Models, the stock price St must be adjusted for the
present value of dividends:
where pv(D) represents the present value of the dividends to be paid out before expiration of the
option. This will be incorporated into (1.1) and (1.2) so that the returns on the used option structures
do account for dividends:
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The BSM assumes that interest rates are constant and known, volatility is constant and returns
normally distributed. These are strong assumptions which in practice do not hold. There is no such
thing as a risk free asset, although 3M US T‐bills are usually used to represent this. When dealing
with complex option structures designed to have exposure only to volatility the assumption of
normally distributed returns can become a problem as well. The following section will explain why
the assumption of constant volatility in practice does not hold.
1.2 Implied Volatility
One interpretation of implied volatility (IV) is known as the market’s expectation for future volatility
and is calculated using the Black Scholes formula (formula 1.1 and 1.2). Market prices of options are
inserted in the formula together with the other factors incorporated in the BSM. IV gives an
indication of the probable magnitude of movement of the stock price in either direction. When an
option has a high IV, there is a greater probability that the price of the underlying will move in your
favor. Conversely, an option with a low IV has a more stagnant underlying stock and the probability
will be smaller that its price will move in your favor (that is, if you are expecting a price movement).
This means there is a positive relation between the price of an option and its IV.
The relationship between IV and time to maturity and moneyness of an option is more complicated.
The further out‐of‐the‐money (OTM) or in‐the‐money (ITM) the option is, the higher the IV of the
option in comparison to an at‐the‐money (ATM) option. This relationship is known as the volatility
surface (see Figure 1), and is commonly seen when extracting volatilities from a wide variety of
options. As pointed out by Rouah and Vainberg (2007) this smile‐shaped pattern provides evidence
against the constant volatility assumption inherent in the BSM.
Figure 1: The Implied Volatility Surface. Moneyness across the x‐axis shows a smile pattern called the volatility
smile. This indicates that the implied volatility increases when the option is further in‐or‐out of the money. This
is the third‐degree moment of skewness that is not captured by the BSM, which assumes constant volatility.
Across the axis labeled TTM (time to maturity), the volatility increases linearly as time to maturity decreases.
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As Figure 1 shows, the volatility surface is indeed not flat and implied volatility is not constant over
moneyness of options. Fleming’s (1998) findings are consistent with this notion and explain that the
BSM leads to valution errors. While volatility depends on both moneyness maturity, smiles are
shown on the moneyness axis only. This means that the effect of maturity on volatility is linear only,
which can also be concluded from looking at the volatility surface. The fact that volatility smiles
appear means that investors that are buying options are willing to pay a bigger premium for options
that are further in‐or‐out of the money.
2 Investing in Volatility
This section expands on the research goal and discusses the benefits of investing in volatility, and
discusses the theoretical justifications for the existence of a variance risk premium. This will provide
the foundation of the research project for it will show why it is potentially beneficial to invest in
volatility.
2.1 Benefits of Investing in Volatility
There are a number of benefits of using volatility as an investment vehicle for the institutional as well
as the private investor. The first benefit of investing in volatility instruments is that it allows the
investor to take a position on the magnitude of volatility without having to consider what will happen
to the price of the underlying asset. Speculating on the magnitude of volatility narrows the question
down to how volatile the price will move, eliminating the need to gather information on what will
happen to the price of the specific stock during the life volatility instrument.
Another major advantage originates from the negative correlation between volatility and stock index
returns, which has been pointed out by Carr, Pieter and Wu (2008) in their research. For a portfolio
consisting of stocks, adding volatility as an asset class would result in an adapted source of
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diversification. The investment strategy of the Barclays Voltaire Index (Barclays Capital, 2007) is to go
short on variance swaps, effectively having exposure solely to volatility. As shown in Figure 2, the
correlation between the Voltaire Index and traditional asset classes is quite low, backing up these
results of the research of Carr, Pieter and Wu (2008).
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Figure 2: Correlation between Voltaire Index and Traditional Asset Classes. Correlation of the Voltaire Index
with traditional asset classes is quite low, indicating that investing in volatility may provide an adapted source
of diversification in the context of a portfolio of stocks and
bonds.
Furthermore, the paper of Carr, Pieter and Wu (2008) shows that volatility is more pronounced in
times of market downturns than market upturns. Hafner and Wallmeier (2007) label this the
“leverage effect”, or “down market effect” and explain it as the stronger response of volatility to
negative stock returns than to positive returns. In addition, Avellaneda and Lee (2008) point out the
mean‐reversion tendencies of volatility, indicating that a period of relatively high volatility is likely to
be followed by a decrease in the level of volatility. This means that speculating on volatility can
provide a protective hedge position during the greatest time of need.
Lastly, volatility investing has the potential to capture excess returns through the variance risk
premium, which will be discussed in further detail in the following paragraph.
2.2 Variance Risk Premium
The general understanding of this negative premium is that investors are willing to pay a price for the
hedge against large potential movements in volatility; comparable to a premium payment on
insurance to guard against the potential losses from a large shift in prices. However, there is still
much debate in current literature on how the VRP must be derived. Consistent with the use of the
BSM for option pricing, all theory will be discussed within a Black Scholes world. This includes the
assumption of no arbitrage and the original motivation of the BSM, the Capital Asset Pricing Model
(CAPM).
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2.2.1 Arbitragefree VRP
As shown in Figure 3, taken from the Barclays Voltaire Index (Barclays Capital, 2007), the value of
implied volatility on the VIX is persistently higher than the realized volatility. This phenomenon gives
ample evidence of the existence of a VRP. The strategy of the Barclays Voltaire Index is based on
exploiting this by going short on variance swaps, and by doing so is able to generate impressive
returns.
Figure 3: Persistent Positive Volatility Differentials on a Historical Basis. Historically, implied volatility (the
dark blue line) has been persistently higher than realized volatility (the light blue line) for the Dow Jones
EuroStoxx 50, the S&P 500, the Nikkei 225 and the FTSE
100.
Another interesting piece of evidence is reported by Coval and Shumway (2000). They observed
market‐neutral straddles on the S&P500 index receiving average weekly returns of minus three
percent per week and zero‐beta straddles offering returns that significantly differ from the risk‐free
rate. These findings conflict with the theoretical argument inherent in the CAPM that the fair value
expected return on an option that is zero‐beta should equal the risk‐free rate. Also, the BSM and
Arbitrage Pricing Theory (APT) state that the excess return on a zero‐beta security should be equal to
zero. However, clearly the buyer of these securities is willing to pay a premium for something that is
unaccounted for in these models. As explained by Carr and Wu (2000) the existence of this
observable risk premium means that either the market for index variance is inefficient or that the
classic risk factors do no fully account for the negative VRP.
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The two major theories on asset pricing, the APT and the CAPM, provide the basis for understanding
the existence of this VRP. Under APT the market does not allow a guaranteed payoff on any
securities. Rather, it allows for a locked‐in positive expected payoff. Any mispricing will be quickly
consumed and the current prices will change to again match the expected price. Pricing is based on
identifying all factors that affect stock prices, measuring the sensitivity to each factor and then
producing an expected return that corresponds with the input. Because the challenge of identifying
and quantifying these factors tends to become overwhelming, the more practical CAPM has taken
over as the industry standard for pricing stocks. As explained in Bodie, Kane and Markus (2008), the
only factor in the CAPM explaining the expected return of a stock is the risk of a stock relative to the
market, called beta.
2.2.2 Variance Beta
Extending from the explanation of the CAPM to calculate expected returns using the beta of a stock,
a more recent factor was identified as the variance beta of a stock. The variance beta is specifically
applied to volatility instruments. Here, the main justification for a VRP follows that variation of
excess returns between assets is completely captured by the different betas, as stated by Carr and
Lee (2007). Furthermore, they argue that the variance beta has a negative correlation with the
negative VRP, meaning that stocks with a higher variance beta have a more negative VRP. Tying this
back to the CAPM, it means that just as the stock beta determines excess returns in proportion to the
market, the variance risk premium comes from the variance swap’s correlation to the market
portfolio. Carr and Wu (2008) find however that the variance beta might not in fact fully account for
the variance risk premium. The main point to illustrate here though, is that it is possible to justify the
existence of the VRP using the basic foundations of asset pricing. Therefore it makes sense to
research how this VRP can be added to portfolios of stocks and bonds to improve portfolio
performance.
3 Volatility Instruments
Trading on volatility requires volatility instruments. In this research delta hedged straddles are used
to capture volatility exposure. These are complex option structures that only have exposure to
volatility. To understand the way delta hedged straddles are constructed it is important to first
understand what simple straddles are.
3.1 Simple Straddles
A straddle is a volatility investment vehicle composed of a call‐ and put option of the same amount
with identical maturity and strike price (with strike price nearest to current price of the underlying
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asset). The payoff of a simple straddle is equal to the payoff of the put‐ and the call option added up
(see Figure 4 and Figure 5). By going long on the straddle the investor benefits from large price
movements in either direction. Shorting the straddle generates profit when there are little or no
changes in price, hence benefiting from the negative volatility premium. Although the straddle has
exposure to volatility it is still highly influenced by price of the underlying stock. In order to have a
straddle which has less exposure to changes in price of the underlying, it must be delta hedged. This
way the effect of IV is isolated.
Figure 4: Payoff‐ and Profit Graph for Basic Call‐ and Put Options. With put options, the buyer can protect
itself from a loss of the underlying, while still benefiting from a gain. The reverse is true for call options. The
writer of an option has unlimited loss potential, while only benefiting from the premium (the cost of the option
contract).
Figure 5: Payoff‐ and Profit Graphs for Long‐ and Short Straddles. The buyer of a straddle profits from large
price movements of the underlying stock in either direction. Conversely, if the underlying stock does not move
outside the bounds, the loss is limited to the cost of the call and put option to construct the straddle. The profit
of a short position is limited to the premiums of the call and the put (the cost of the option contracts), while
the potential loss is
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unlimited.
3.2 Delta Hedged Straddles
The same principles that apply to the simple straddle, apply to the delta hedged straddle as well. In
this form however, the straddle is constructed with unequal amounts of call‐ and put options. The
relative number of call‐ (θ) and put options (θ‐1) is calculated to have a position that is delta neutral.
Delta is the sensitivity of an option’s change in price to changes of its underlying asset. Having a delta
neutral position means that delta equals 0 and the position is unaffected by (small) changes in price
of the underlying (Hull 2006). However, because the delta for an option is a monotonically increasing
function of the underlier’s price, the delta position still varies over time. To remain delta hedged you
would theoretically need to adjust your position constantly (this is called dynamic delta hedging). In
this research dynamically delta hedged straddles are used as a volatility instrument. This means that
at the beginning of each month a delta neutral straddle is set up and rebalanced daily by buying or
selling futures. Because futures have no transaction costs this will imply a more realistic view. This
means that when the price of the underlier goes up futures are sold and when the price of the
underlier goes down they are bought. The opposite is true when shorting a straddle, then futures are
bought when the price of the underlier goes up and futures are sold when the price of the underlier
goes down.
4 Method
The main idea behind this investment strategy is to derive a payoff from option positions that have
no exposure to the change in price of the underlying asset (this means they are delta hedged). By
doing this we are trading solely on volatility. There are two ways to trade on volatility, either by
taking a position on future expected volatility (for instance by the use of variance swaps) or by
trading on the difference between implied and realized volatility. This research will be focused on the
former of the two, because the price of a straddle generates the implied volatility the market expects
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(through the Black Scholes formula). If an investor expects volatility to go down, he can speculate on
this decrease by buying a straddle.
As discussed earlier in this report, the financial literature supports the finding that implied volatility
in general exceeds realized volatility, despite the conflict with asset pricing theory and fair market
value. Therefore, taking a short position on volatility instruments allows for obtaining the variance
risk premium that investors are willing to pay for volatility protection.
4.1 Building the Investment Portfolios
First, the optimal weights for a SAA with only stocks and bonds are determined. Eight stocks taken
from the Dow Jones Industrial Average and US T‐bills are used to construct the initial portfolio. As
described in Bodie, Kane and Markus (2008), a solver function built in Excel is used to optimize
weights within the SAA. For each level of monthly portfolio return the solver optimizes a portfolio
that has the lowest possible risk. Plotting the monthly portfolio return against the risk of the portfolio
into a graph shows the well known curve that is called the efficient frontier. Afterwards, the same is
done for an SAA with stocks, bonds and dynamically delta hedged straddles. The goal is to see an
upward shift of the efficient frontier, indicating an improvement in portfolio performance. As
performance indicators for the mean variance framework used in this research, the portfolio mean,
the portfolio variance and the Sharpe ratio of the efficient portfolio (the portfolio with the highest
Sharpe ratio) are included.
In addition, the above will be repeated while adding a restriction to the solver function. The
restriction used is that a minimum of 2.5% must be invested in each stock at any given time. This is
done to give a more realistic view, as portfolio managers aim to have a well diversified portfolio of
assets.
In this project there are assumed to be no transaction costs and no margin costs. A mid‐price is of the
assets is taken, meaning that no bid‐ask spread is taken into account.
5 Data
To simulate a well diversified portfolio of stocks one company was chosen from each of the eight
sectors (basic materials, conglomerates, consumer goods, financial, healthcare, industrial goods,
services and technology) defined within the Dow Jones Industrial Average. From each sector the
company with the biggest market capitalization was chosen. This process led to the following eight
companies: Exxon Mobil (XOM), General Electric (GE), Procter & Gamble (PG), JPMorgan Chase
(JPM), Johnson & Johnson (JNJ), Boeing (BA), Wal‐Mart (WMT) and Microsoft (MSFT). From these
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companies historical stock prices were collected over a period of approximately eight years from July
2000 until July 2008. This time period is comparable to the performance period used in the literature
gathered on simulating volatility investments, and also incorporates two periods of market upturns
and downturns. The used stock price are adjusted for stock splits and paid out dividends. Three‐
Month U.S. Treasury Bills were used to calculate the monthly risk free rate (RF) used in the SAA
framework. Lastly, daily option data with the S&P 500 as the underlying asset was gathered from
Bloomberg to construct the dynamically delta hedged straddles (DDH straddles).
6 Empirical Findings
This section is set out to present the results of the research project. First, the return statistics of the
different assets used in the project will be discussed. Afterwards, the results of the different SAA’s
are given. Finally, the performance indicators of the different SAA’s will be analyzed by looking at the
maximum obtainable Sharpe ratio (the efficient portfolio).
6.1 Returns of the Assets
Table 1 of the Appendix shows the monthly return statistics of the used assets over the period of July
2000 to July 2008. A summary of the return statistics of the stocks is as follows: Boeing had a mean
return of 1.06% and a standard deviation of 8.29%, Exxon Mobil had a mean of 1.17% and a standard
deviation of 5.34%, General Electric had a mean of 0.17% and a standard deviation of 5.96%,
Johnson & Johnson had a mean of 0.64% and a standard deviation of 4.41%, JPMorgan Chase had a
mean of 0.57% and a standard deviation of 9.16%, Microsoft had a mean of 0.36% and a standard
deviation of 9.18%, Proctor & Gamble had a mean of 1.16% and a standard deviation of 4.41% and
Wal‐Mart had a mean of 0.3% and a standard deviation of 5.74%. By looking at these statistics it can
be concluded that some of the stocks will not be a part of the optimal portfolio because they are
dominated by other stocks or even have a negative return such as General Electric. For instance,
stocks as Microsoft and JPMorgan have a lower mean of returns but a higher standard deviation
compared to the stock of Exxon Mobil. Of course this is not the case when the restriction is applied
to the SAA.
The mean of monthly return of the US 3M T‐bills is 0.26% and the standard deviation is 0.3%. It
makes sense that both these values are very low because these T‐bills are used to mimic a risk free
investment. The dynamically delta hedged straddles have a mean of monthly return of 6.26% and a
standard deviation of 21.17%. This higher mean suggest that adding it to the original portfolio will
lead to improvements of portfolio performance.
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6.2 SAA Results and Efficient Frontiers
Figure 6 shows the efficient frontiers of the portfolios with stocks and T‐bills only and with stocks, T‐
bills and dynamically delta hedged straddles. There is a significant increase is steepness of the
efficient frontier of the top half of the original SAA (OSAA) after adding the straddles to the portfolio.
This indicates that for this part of the OSAA there is an improved portfolio performance after adding
the straddles. This means that for any given level of monthly portfolio return a decreased level of risk
is obtained. In addition, the OSAA with added straddles is able to generate higher returns as the
maximum monthly return of the OSAA is just under 12%. The efficient portfolios (the portfolios with
the highest possible Sharpe ratio) of the OSAA and the OSAA with straddles are highlighted in the
graph. These portfolios will be discussed later in this section.
Figure 6: Efficient Frontiers without Restriction. In red the efficient frontier of the OSAA (the original SAA with
only the eight used stocks and T‐bills) is shown with the efficient portfolio shown in purple. The blue line shows
the efficient frontier of the OSAA with dynamically delta hedged straddles and the yellow dot highlights the
efficient portfolio. A significant increase in steepness of the top part of the efficient frontier of the OSAA is
shown after adding the volatility
instrument.
The efficient frontiers after adding the restriction of a minimum investment of 2.5% in each stock is
shown in Figure 7. In this case, an upward shift of the entire efficient frontier of the OSAA is shown
after adding the straddles. This indicates an increase in portfolio performance as for any given level
of monthly portfolio return a decreased level of risk is obtained. Again, the efficient portfolios of the
OSAA and the OSAA with straddles are highlighted in the graph. The portfolio with the highest Sharpe
ratio of the OSAA is also the portfolio with the highest possible monthly portfolio return. It is not
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possible to generate higher monthly returns using the OSAA with added restriction. This maximum
monthly return lies at approximately 10.3% (see Table 1).
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Figure 7: Efficient Frontiers with Restriction. In red the efficient frontier of the OSAA (the original SAA with
only the eight used stocks and T‐bills) with the added restriction is shown. The efficient portfolio is shown in
purple. The blue line shows the efficient frontier of the OSAA with dynamically delta hedged straddles with the
added restriction. The yellow dot highlights the efficient portfolio for the OSAA with straddles. An upward shift
of the efficient frontier of the OSAA is shown adding the volatility instrument. The restriction is a minimum
investment of 2.5% in each of the stocks used to construct the
portfolios.
6.3 Sharpe Efficient Portfolios
Table 2 of the appendix shows the weights of each of the used assets within the efficient portfolios.
The efficient portfolio of the OSAA only has capital invested in Exxon Mobil, JPMorgan, Proctor &
Gamble, Wal‐Mart and the T‐bills. The rest of the stocks are dominated by one or more of the stocks
in the portfolio and are therefore not added in the efficient portfolio. The same stocks that are not
included in the portfolio of the OSAA are also not included in the OSAA with added straddles. In
addition, there now also is no capital invested in the stock of JPMorgan. The most striking difference
is that the percentage invested in the risk free asset (the T‐bills) is significantly bigger in the efficient
portfolio of the OSAA with added straddles. This makes sense because the DDH straddles have a
relatively high risk and reward and to compensate there is more capital invested in the T‐bills.
Apart from the obvious there is little change in the general composition of the efficient portfolios.
The dominated stocks, in which no capital was invested in the OSAA and the OSAA with added
straddles, now have the exact minimum of 2.5% of invested capital. There is however one difference
in weights after adding the restriction. This difference is seen in the efficient portfolio of the OSAA
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with added straddles and restriction. Here, the percentage of total capital invested in T‐bills has gone
down and the capital invested in the DDH straddles went up in comparison to the situation where
there is no restriction. This is because due to the added restriction the monthly return of the
portfolio is lower, and to compensate for this effect, there is more invested in the riskier DDH
straddles.
The Sharpe ratios of the efficient portfolios are shown in Table 1. In both the situation without‐ as
the situation with the added restriction there is an increase in the Sharpe ratio after added the DDH
straddles. This means the portfolio performance is increased by invested in volatility as an asset
class. The mean of the monthly portfolio returns is lower in the situations where the DDH straddle is
added and the standard deviation is lower. This makes sense in the absence of the restriction,
because in this situation there is a higher percentage of capital invested in the risk free asset in the
OSAA with added straddles. However, in the case of the added restriction there is invested less
capital in the risk free asset after adding the straddles to the OSAA. This means that in this case the
decrease in portfolio return comes from a change in weights of the stocks, meaning there is less
capital invested in the stocks with a higher return.
Table 1: Performance Indicators of the Efficient Portfolios. There is an increase of the Sharpe ratio after
adding the DDH straddles to the OSAA, in both the absence as the presence of the restriction.
7 Conclusion
This paper researches the possibility of improving the performance of the original portfolio of stocks
and bonds (the OSAA) by adding volatility as an asset class. The OSAA consisted of eight stocks, each
of them being the company with the biggest market capitalization within its sector, and 3M US T‐
bills. To synthesize the option returns for the DDH straddles, the BSM option pricing formula was
applied and monthly returns were recorded. Both the average monthly returns and the standard
deviation of returns of the DDH straddles were a lot higher than that of the stocks.
As indicated by the higher mean and standard deviation of monthly returns, adding DDH straddles to
the OSAA led to an increase in performance. This also was the case when adding a restriction to the
OSAA that ensured a minimum of 2.5% invested capital in each of the stocks. Adding volatility as an
asset to the OSAA led to an improvement of the efficient frontier. The same was true in the case of
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the added restriction. Finally, the highest obtainable Sharpe ratio (the Sharpe ratio of the efficient
portfolio) increased after adding the DDH straddles to the OSAA, in both the presence as the absence
of the restriction. This means it is safe to conclude that adding volatility as an asset class to portfolios
previously limited to stocks and bonds indeed leads to an improvement in portfolio performance.
8 Shortcomings and Future Research
The results presented in this paper are subject to some limitations. This section is set out to shortly
go through them and discuss the possibilities of further research.
Firstly, no transaction‐ or margin costs were incorporated into the research. Adding them might give
a different picture on the effectiveness of adding volatility as an asset class, which is something that
would be interesting for further research.
Secondly, the used models assume returns to be normally distributed. In the case of volatility
instruments this poses a problem because the CAPM does not account for the skewness observed in
the volatility smile. The CAPM assumes an investor cares solely about the mean and variance of
returns, and does not care about what contributed to the variance. Further research can be focused
on overcoming this problem by using different performance measures that do not have the same
shortcomings. It would be interesting to see if these performance measures give the same results.
Models that can be used to research this are the Power Utility and the Sortino ratio, which both in
their own way account for skewness in the volatility smile.
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Appendix
Table 1: Returns of the Assets
This table shows a summary of statistics on monthly returns of the different assets used in the SAA: average,
standard deviation, minimum and maximum. Adjusted closing prices were sampled monthly between July 2000
and July 2008. The data is gathered from Yahoo Finance.
Table 2: Weights of Assets within the Efficient Portfolios
This table shows the weights of assets used within the four different SAA’s of the market efficient portfolios:
The original SAA, the original SAA with the dynamically delta hedged straddle, the original SAA under a
restriction (at least 2.5% invested in each stock) and the original SAA with the dynamically delta hedged
straddle under the same restriction.
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