What is the Price of Risk Aversion?

Those of you familiar with First Degree’s investment process will know that we focus on risk aversion as the major determinant of asset prices. Risk aversion, in our opinion, dominates cash flow variation as the driver of returns – easily by a factor of ten times or more. If risk aversion is so important, is there a way to calculate the market price of risk aversion?

My friends at JPMorgan seem to have discovered a method for trying to understand this question by looking at the VIX futures market. VIX futures allow investors to buy or sell volatility as measured by the S&P Index of Implied Volatility. JPM has constructed an index which measures the degree of backwardation in the VIX futures – where backwardation refers to the difference in the VIX price of near maturities versus longer dated maturities in futures…

…to give an example, currently the one month VIX futures trades at around 20 while the seven month future trades at around 27. This is incredibly steep – it means that investors are prepared to pay 34% more to buy protection from volatility in seven months’ time than they are prepared to pay for a one month hedge. To put this in perspective, a similar comparison in the gold futures market shows that investors are only prepared to pay 0.47% for to buy seven month gold versus the one month price. Put another way, investors are prepared to pay 70 times more to hedge their volatility exposure forward seven months than they are prepared to pay to hedge gold risk!!!

I was literally astounded when I saw this data, which made me think exactly what the ‘equilibrium’ degree of backwardation should be for implied volatility. Without going into technicalities, one argument suggests the time-structure should be flat – that is, the long term average spread of one month v seven month VIX futures should be zero. An alternative view is that the market price of volatility risk should be displayed in the futures backwardation. If the latter view is true then this is strong evidence in favour of our belief that risk aversion dominates cash flow variability as a determinant of asset prices…

How important is the price of risk aversion? Put simply, judging by JPM’s index, risk aversion provides a rate of return that is about three times greater than equities for similar risk, and is about even with High Yield bonds in terms or return per unit risk. There are also diversification benefits. Investors should consider adding this into their portfolios.