have an account?【sign in】Volatility Skew in Sensibull: Understanding and Managing Volatility Skew in the Marketplace
crespoauthorVolatility skew is a highly complex and intriguing aspect of the financial markets that has been gaining increasing attention from both academicians and practitioners. It is a measure of the differential impact of volatility on the prices of various assets, and its importance in risk management and portfolio construction has been widely recognized. This article aims to provide an in-depth understanding of volatility skew, its causes, and potential strategies to manage it in the marketplace.
What is Volatility Skew?
Volatility skew, also known as volatility dispersion or volatility heteroskedasticity, refers to the difference in the volatility of various assets or portfolios. It is measured by the coefficient of variance (CV) or the covariance-weighted volatility of asset returns. A positive volatility skew indicates that the volatility of one asset is higher than that of other assets, while a negative skew indicates the opposite.
Causes of Volatility Skew
There are several factors that can cause volatility skew, some of which are:
1. Time variation of risk aversion: As market participants become more risk-averse, the demand for risk-free assets like Treasury bills increases, leading to a decrease in the volatility of these assets and an increase in the volatility of more volatile assets like stocks.
2. News and events: Important news or events can have a significant impact on the volatility of various assets. For example, an interest rate announcement or a company earnings release can lead to differential changes in volatility among assets.
3. Inefficiencies in the market: Market inefficiencies, such as mispricing or poor risk management, can lead to skewed volatility. For instance, a company with poor risk management may have a higher volatility than the market average, leading to a negative skew in its stock price.
4. Diversification: The diversification benefits of a well-diversified portfolio can lead to a skewed volatility. For example, a portfolio with a high allocation to low-volatility assets like bonds may have a lower volatility than the market average, leading to a positive skew in the portfolio's volatility.
Strategies to Manage Volatility Skew
Understanding the causes of volatility skew and its implications for portfolio construction and risk management is crucial in creating effective strategies to manage it. Some potential strategies include:
1. Diversification: As mentioned earlier, a well-diversified portfolio can help mitigate volatility skew. By incorporating assets with different volatility profiles, an investor can create a portfolio with a more stable volatility.
2. Rebalancing: Regular rebalancing of a portfolio to its target allocation can help maintain the desired volatility level and mitigate skew. As the portfolio moves away from its target allocation due to market fluctuations, rebalancing can help bring it back to its original volatility level.
3. Exploiting skew: Volatility skew can be a valuable information source for investors. By using skew as a predictor of future volatility, an investor can make more informed decisions about when to buy or sell assets and create investment opportunities.
4. Leveraging skew: Investors can use volatility skew in derivatives markets, such as options contracts, to create leverage and income opportunities. For example, selling puts on an asset with a high volatility skew can generate income when the skew increases, while buying calls on an asset with a low volatility skew can provide income when the skew decreases.
Volatility skew is a complex and fascinating aspect of the financial markets that has significant implications for portfolio construction and risk management. By understanding the causes of volatility skew and developing effective strategies to manage it, investors can create more resilient and profitable portfolios.