Volatility premium The volatility risk premium is related to the more widely accepted idea of the equity risk premium. While the equity risk premium refers to the return an investor expects to gain on average in exchange for the possibility that they may incur a loss, the volatility risk premium refers to the return an investor expects to gain on average in exchange for the risk that volatility may turn out to be higher than expected. The potential for this strategy to generate investment returns is shown in Chart 2.

The top panel shows the historical one month implied volatility and subsequent one month realised volatility for the S&P 500 Index from 1986 to 2008. The gap between implied and realised volatility is shown in the second panel. On average, realised volatility has been lower than implied volatility, confirming the existence of a volatility risk premium. Currency cary premium For many decades there has been a well documented tendency for higher yielding currencies to depreciate less than would be expected against lower yielding currencies over long periods of time.

This tendency is punctuated, like equities, by periods of extreme moves but is nevertheless real, demonstrable and positive. In other words, countries with higher yielding currencies are paying a premium for borrowing money from low yielding currency countries over and above the interest rate differentials. Back to the basics – ris k premia an d alternative beta Over the past year investors have developed an aversion to risk, which itself has resulted in increased investor interest in understanding more precisely what risk is in their portfolios; the return (premium) for the risk; and the existence of non traditional risk premia.

If there is a basic lesson to be learnt from the present investment market chaos it is that effective investing should always focus on risk premia as the basic building block rather than asset classes. A priority for managers putting together diversified portfolios will be finding more cost and risk-effective ways of accessing both traditional and alternative premia in a more targeted fashion.