There is growing demand from investors for derivative-based solutions because they can offer greater clarity and control over returns in an uncertain market environment.
In a time of heightened volatility, inflation pressures and unpredictable central bank policy, transparency and the ability to design specific return profiles are especially appealing. As a result, derivatives are increasingly seen as essential tools for achieving more predictable, risk-managed performance when traditional market exposures offer less certainty.
Derivative-based structured investments such as defensive autocalls and buffer ETFs are often described as ways to ‘harvest’ both the equity risk premium and the volatility risk premium. While both product types are anchored in these same underlying risk premia, they harness them in very different magnitudes and through different option exposures.
Understanding these differences is essential for investors evaluating expected returns, risk and product suitability:
* The volatility risk premium measures the difference between implied volatility (expectations of volatility) and realised volatility.
* The equity risk premium represents the additional return investors demand for holding equities instead of a risk-free asset that forgoes the higher volatility and uncertainty of equity markets. The equity risk premium varies over time and between markets and is influenced by many factors, including macroeconomic uncertainty, corporate profitability and investor risk appetite.
“In effect, defensive autocall investors sell downside equity volatility and are compensated for absorbing that risk by earning the volatility and skew premia that markets systematically overprice.
Equity forward contracts
When looking at defensive autocalls, the equity risk premium is embedded within the option package through the pricing implied by the ‘equity forward’ – and, before we go any further, it is important to remind ourselves just what that is.
Equity forward contracts – or ‘futures’ – describe derivative contracts that force a buyer and seller to exchange an asset at a fixed price at a pre-determined time in the future. They reflect the fair, non-arbitrage price of the underlying asset over time and are used widely in financial and commodity markets.
The price of an equity forward reflects two components: interest rates, which represent the cost of waiting rather than holding the equity today; and dividends, which represent the economic benefits earned by holding equities.
Importantly, the equity forward does not include any assumption about future equity growth – even though markets have historically risen by more than the risk-free rate due to the presence of the equity risk premium. As a result, the forward price of an equity index often underestimates that index over time.
While both buffer ETFs and defensive autocall strategies take advantage of the equity risk premium, longer-dated autocalls benefit to a greater extent.
This is because the equity risk premium is more stable over longer time periods due to equity market declines generally being shallower and less common over such periods. This equity risk premium is the main driver of autocall returns above the equivalent bond return and, in addition to the volatility risk premium, largely explains the excess returns of a defensive autocall.
It is important for investors to understand both risk premia and their implications for both buffer ETFs and defensive autocalls. To understand the impact the volatility risk premium can have on the price of defined return investments, we can look more closely at the structure of a defensive autocall.
Read more from Tom May in Alternative thinking: On the buffers (and defensive autocalls)
The downside exposure is created through the sale of knock-in puts – typically struck at or near the money but with deep out-of-the-money barriers. This structure makes the strategy sensitive to both the volatility skew premium (arising from the market’s tendency to overpay for deep downside protection) and the at-the-money volatility risk premium. These premia arise because investors are willing to pay more for downside protection than the statistically fair value of that protection over time.
A similar dynamic is also found in traditional insurance markets. Why do insurers make money? Because providers, such as car or home insurers, typically collect more in premiums than they pay out in claims over time. Likewise, in capital markets, sellers of downside options receive compensation in the form of premiums that often exceed the actual cost of realised losses over time.
In effect, defensive autocall investors sell downside equity volatility and are compensated for absorbing that risk by earning the volatility and skew premia that markets systematically overprice.
While both buffer ETFs and defensive autocall strategies take advantage of the volatility risk premium, defensive autocalls not only take greater advantage by typically being around five times shorter volatility but, as a result of their longer term and further out-of-the-money option selling, they also take advantage of more persistent and richer longer-dated volatility and skew risk premia. This significantly enhances the returns they can offer relative to shorter-dated or more conservatively structured strategies.
Tom May is CEO and CIO at Atlantic House, an asset manager specialising in risk-managed derivative solutions
