Equity Portfolio Hedging Using Volatility ETN-Options

Traditionally the standard deviation, also called volatility, of asset returns is used as an estimate for the riskiness of the asset in question. Volatility as a measure of risk is generally accepted and it is a very significant concept, both theoretically and in practice. Volatility can also be seen as an asset class on its own. VIX-index is known as a measure of the near term riskiness of the stock market. The VIX index is calculated from derivatives prices. However, volatility of market returns is not stable over time. During severe market drawdowns, volatility usually increases substantially. By taking advantage of this effect, investors can limit their risks and increase the diversification of their portfolios. This thesis discusses the possibilities of using volatility derivatives as a safe haven for protecting an equity portfolio during risky periods. Previous work on the subject has been promising and this thesis provides a simple approach through which the benefits of volatility assets could be extracted. The Efficient Market Hypothesis is discussed alongside with a more recent approach called Adaptive Market Hypothesis. Adaptive Market Hypothesis provides a synthesis of the critique and explains empirical observations both for and against the Efficient Market Hypothesis. This thesis shows that using call options on a VIX related exchange traded product improves the long term returns relative to risk when combined with an equity position, while allowing for a larger amount of leverage. The limits for the application of leverage is discussed using a multi period framework of geometric returns and the concept of ergodicity. The results of this thesis provide evidence against weak form of market efficiency