Volatility Risk Premium Index Construction
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Solution Overview
Problem
Existing financial instruments fail to effectively capture the volatility risk premium, which is the difference between near-term implied volatility and realized volatility of underlying assets, limiting their ability to provide a market-neutral return driven by volatility differences.
Innovation Solution
A Volatility Risk Premium Total Return Index is created by implementing a method that involves receiving and processing data to calculate and manage a monthly-rolling short position in a strip of front-month exchange-listed options, with equal numbers of call and put options, to capture the volatility risk premium, using a processing system with processors to credit and debit accounts accordingly.
Engineering Contradictions & Design Principles
Engineering Contradiction Analysis
1Reliability
If existing financial instruments are used, then simplicity is maintained, but the ability to capture volatility risk premium is insufficient
Solution Approach 1:
The option strip is segmented into multiple individual options (typically 4-6 options) with different strike prices and maturities. Each option is separately selected, priced, and managed to capture different aspects of the volatility surface, allowing the instrument to precisely capture the volatility risk premium while maintaining manageable complexity through modular construction
Solution Approach 2:
The option strip structure serves multiple functions simultaneously: it captures the volatility risk premium, provides market neutrality through delta-hedging, manages gamma risk through diversification across strikes and maturities, and offers flexibility for dynamic rebalancing. This multi-functionality allows a single instrument structure to address multiple trading objectives
2Stability of the object's composition
If a market-neutral option strip position is established, then directional risk is reduced, but the complexity of maintaining market neutrality increases
Solution Approach 1:
The option strip position requires dynamic rebalancing as market conditions change. The delta-hedging ratios are continuously adjusted based on changes in implied volatility, option Greeks, and underlying asset price movements. This dynamic management maintains market neutrality while adapting to evolving market conditions, transforming a static position into an actively managed portfolio
Solution Approach 2:
The system incorporates continuous feedback mechanisms where the market-neutral status is monitored through delta calculations and hedging ratios. When the position deviates from market neutrality due to price movements or volatility changes, feedback signals trigger rebalancing actions to restore the neutral status, creating a self-correcting system that maintains stability
3Reliability
If monthly-rolling short option positions are used, then volatility risk premium capture is improved, but the frequency of trading and transaction costs increase
Solution Approach 1:
The option strip position is established and held for fixed monthly periods, with systematic rebalancing occurring at predetermined intervals rather than continuously. This periodic action captures the volatility risk premium over each monthly cycle while limiting transaction frequency, thereby reducing transaction costs compared to continuous trading strategies
Solution Approach 2:
The option strip is constructed and positioned in advance for each monthly period with predetermined strike prices and maturities. By establishing the position beforehand and holding it through the monthly cycle, the strategy captures the full volatility risk premium for the period while minimizing intermediate trading and associated transaction costs
Data Source
AI summary
An exemplary aspect comprises receiving data related to an underlying asset; calculating values corresponding to near-term implied volatility and realized volatility for the underlying asset; and transmitting data sufficient to describe an index based on a difference between the values corresponding to the near-term implied volatility and the realized volatility for the underlying asset. Another exemplary aspect comprises receiving electronic data related to an underlying asset; calculating data sufficient to describe a plurality of call options and a plurality of put options related to the underlying asset and written on a first settlement date; crediting an account with proceeds from selling the call and put options; and debiting the account to settle one or more of the options that are in-the-money on a second settlement date. Other aspects are apparent from the description and claims.