Risk Premium investing – A tale of two tails
In this note we introduce Risk Premia as generically encompassing a set of strategies where investors are compensated for assuming risk.
This compensation comes in the form of a regularly received premium and results in a strategy with a positive expected return.
This positive performance continues until the moment the hidden risk, which is being assumed, is realised, resulting in a sharp negative move.
The argument generally invoked is that this premium is proportional to the risk or volatility of the investment or instrument being held, a measure which uses both sides of the return distribution.
In this paper we expand on the idea of a risk premium, with the help of a few example strategies, and show that the premium is in fact compensation for downside deviation or negative skewness risk, an idea which is justified with empirical evidence and also appeals to common sense.