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Positive Alpha and Negative Beta (A Strategy for Counteracting Systematic Risk)

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  • Erik Sonne Noddeboe

    (ENCF Corp, Gaasevaenget 6, 2791 Dragoer, Copenhagen, Denmark)

  • Hans Christian Faergemann

    (ENCF Corp, Gaasevaenget 6, 2791 Dragoer, Copenhagen, Denmark)

Abstract

Undiversifiable (or systematic risk) has long been an enemy of investors. Many countercyclical strategies have been developed to counter this. However, like all insurance types, these strategies are generally costly to implement, and over time can significantly reduce portfolio returns in long and extended bull markets. In this paper, we discuss an alternative technique, founded on the premise of physiological bias and risk-aversion. We take a behavioral discussion in order to contextualize the insurance like characteristics of option pricing and discuss how this can lead to a mispricing of the asymmetric relationship between the VIX and the S&P 500. To test this, we perform studies in which we find statistical inefficiencies, thereby making it possible to implement a method of hedging index option premium in a way that has displayed no monthly drawdowns in bullish periods, while still providing large returns in major sell-offs. The three versions of the strategy discussed have negative betas to the S&P 500, while exhibiting similar risk-adjusted excess returns over both bull and bear markets. Further, the performance generated over the entire period, for all three strategies, is highly statistically significant. The results challenge the weak form of the Efficient Market Hypothesis and provide evidence that the methods of hedging could be a valuable addition to an equity rich portfolio for the purpose of counteracting systematic risk.

Suggested Citation

  • Erik Sonne Noddeboe & Hans Christian Faergemann, 2015. "Positive Alpha and Negative Beta (A Strategy for Counteracting Systematic Risk)," IJFS, MDPI, vol. 3(4), pages 1-20, September.
    • Handle: RePEc:gam:jijfss:v:3:y:2015:i:4:p:431-450:d:56484
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    References listed on IDEAS

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    1. Daniel Kahneman & Amos Tversky, 2013. "Prospect Theory: An Analysis of Decision Under Risk," World Scientific Book Chapters, in: Leonard C MacLean & William T Ziemba (ed.), HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part I, chapter 6, pages 99-127, World Scientific Publishing Co. Pte. Ltd..
    2. Jackwerth, Jens Carsten, 2000. "Recovering Risk Aversion from Option Prices and Realized Returns," The Review of Financial Studies, Society for Financial Studies, vol. 13(2), pages 433-451.
    3. Hibbert, Ann Marie & Daigler, Robert T. & Dupoyet, Brice, 2008. "A behavioral explanation for the negative asymmetric return-volatility relation," Journal of Banking & Finance, Elsevier, vol. 32(10), pages 2254-2266, October.
    4. Richard H. Thaler & Eric J. Johnson, 1990. "Gambling with the House Money and Trying to Break Even: The Effects of Prior Outcomes on Risky Choice," Management Science, INFORMS, vol. 36(6), pages 643-660, June.
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