Volatility Derivatives and Downside Risk

The challenge in long volatility strategies is to minimize the cost of carrying such insurance due to negative roll yields and negative volatility risk premia. This study proposes a hedging strategy for volatility as an asset class that provides substantial protection against market crashes, while still participating upside preservation. The results show (i) timely hedging strategy removes the extreme negative tail risk and reduces the negative skewness in exchange for slightly fewer instances of large positive returns; (ii) dynamic allocation effectively mitigates the negative cost-of-carry problem; (iii) using volatility contracts as extreme downside hedges can be a viable alternative to buying out-of-the-money SP and (iv) the significant volatility-hedged return is a form of compensation for investable higher-moment equity risk factors.