Title: The smart vega factor-based investing: Disentangling risk premia from implied volatility smirk
Authors: Anmar Al Wakil - University Paris-Dauphine, PSL Research University (France) [presenting]
Abstract: The way is paved for new option-based volatility strategies genuinely built on factor-based investing. Since market option prices reflect uncertainty, the pricing discrepancy between the physical and the risk-neutral distributions, i.e. the fair price of moments, is exploited. From an economic perspective, the level, slope, and convexity associated to the implied volatility smirk quantify the departure of the returns probability distribution from the lognormal distribution. Subsequently, the so-called ``Smart Vega investing'' proposes option-based replication strategies mimicking the volatility, skewness, and kurtosis risk premia in the form of divergence swap contracts, tradeable at moderate transaction costs in incomplete option markets. Extending a quadratic approximation, an explicit representation of the implied volatility smirk function, conveniently expressed as a combination of tradeable time-varying risk premia that reward for bearing higher-order risks, is exploited. Furthermore, these theoretical underpinnings are tested on S\&P 500 and VIX options, under strongly skewed leptokurtic distributions.