The Risk-Reversal Premium
15 Pages Posted: 23 Nov 2021
Date Written: November 21, 2021
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
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