The Risk-Reversal Premium

Abstract

We study the risk-reversal premium, where out-of-the-money puts are over-priced relative to out-of-the-money calls. This effect is driven by investors’ utility preferences which lead them to over-pay for the risk reduction benefits of long puts instead of valuing options on the basis of expected returns. Investors can exploit this implied skewness premium by trading standard, exchange-traded index options. We also show that including risk-reversals in an equity portfolio creates a better portfolio (as measured by Sharpe ratio) compared to a pure index position.

Keywords: Volatility, Skewness, Options, Diversification, Alternative Beta, Portfolio Management

JEL Classification: G00, G1, G11, G13