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The Hazards of Volatility Diversification

ICMA Centre Discussion Paper in Finance No. DP2011-04

24 Pages Posted: 1 Feb 2011 Last revised: 8 Feb 2011

Carol Alexander

University of Sussex - School of Business, Management and Economics

Dimitris Korovilas

University of Reading - ICMA Centre

Date Written: February 4, 2011

Abstract

Recent research advocates volatility diversification for long equity investors. It can even be justified when short-term expected returns are highly negative, but only when its equilibrium return is ignored. Its advantages during stock market crises are clear but we show that the high transactions costs and negative carry and roll yield on volatility futures during normal periods would outweigh any benefits gained unless volatility trades are carefully timed. Our analysis highlights the difficulty of predicting when volatility diversification is optimal. Hence insitutional investors should be sceptical of studies that extol its benefits. Volatility is better left to experienced traders such as speculators, vega hedgers and hedge funds.

Keywords: Black-Litterman Model, Institutional Investors, Mean-Variance Criterion, Optimal Asset Allocation, SPY ETF, VIX Futures

JEL Classification: G11, G15, G23

Suggested Citation

Alexander, Carol and Korovilas, Dimitris, The Hazards of Volatility Diversification (February 4, 2011). ICMA Centre Discussion Paper in Finance No. DP2011-04. Available at SSRN: https://ssrn.com/abstract=1752389 or http://dx.doi.org/10.2139/ssrn.1752389

Carol Alexander

University of Sussex - School of Business, Management and Economics ( email )

Falmer, Brighton BN1 9SL
United Kingdom

HOME PAGE: http://www.sussex.ac.uk/bam

Dimitris Korovilas (Contact Author)

University of Reading - ICMA Centre ( email )

Whiteknights Park
P.O. Box 242
Reading RG6 6BA
United Kingdom
+44 (0)118 378 8239 (Phone)
+44 (0)118 931 4741 (Fax)

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