A question arbitrageurs are frequently asked is “why aren’t the pricing inefficiencies arbitraged away?” This is a very legitimate question.
I believe that in some areas of trading and investment, the number of arbitrage opportunity is diminishing. Take, for example, statistical arbitrage; its profitability is decreasing due to the increasing popularity of the method, competition among traders and advancement in information technology. In other areas of trading, opportunities still exist and persist. For example, in option trading, the volatility risk premium seems to persist despite the fact that it has become widely known. Here are some possible explanations for the persistence of the volatility risk premium:
- Due to regulatory pressures, banks have to meet Value-at-Risk requirements and prevent shortfalls. Therefore, they buy out-of-money puts, or OTC variance swaps to hedge the tail risks.
- Asset management firms that want to guarantee a minimum performance and maintain a good Sharpe ratio must buy protective puts.
- The favorite long-shot bias plays a role in inflating the prices of the puts.
- There might be some utility effects that the traditional option pricing models are not capable of taking into account.
- There are difficulties in implementing and executing an investment strategy that exploits the volatility risk premium and that is at the same time within the limits of margin requirements and drawdown tolerance.
We believe, however, that with a good understanding of the sources of cheapness and expensiveness of volatility, a sensible trading plan can be worked out to exploit the volatility risk premium within reasonable risk limits. We love to hear your suggestion.