Some thoughts about volatility and portfolio construction

When we think about volatility we mostly think about implied/realized (or what we predict vs current implied), but when we construct a volatility portfolio we should, imo, look at it from a different perspective
volatility, the way I see it, is a function of two parts : general market risk sentiment (say proxy to equity vol, rates vols), idiosyncratic/specific risk.

when we construct a volatility portfolio we generally want to eliminate market risk (i.e, beta to general risk sentiment)
and own specific risk the cheapest way we can... puzzled? let's take some rl example:

One of the most famous and talked about vol carry trade in financial markets is shorting US equity volatility (short ES option/short VIX futures/SPX varswaps..)
While these trade are systematically profitable trades, every now and then they tend to take a hit when risk sentiment turns sour (and these event, more often than not tend to escalate quickly as everyone and their mothers running to the exit)
So you probably say : "yes but on a long enough horizon we make money so why should we care??"

Just ask Parplus/Malachite/LJM what happens when your prime broker calls you asking for margin or else...

So what is the answer to that? having something to offset the left tail risk
which is easier said than done.... We want ideally to have a long vol component that performs well on 2< sigma that doesn't bleed our account dry when markets are sailing smooth....

This is where the beauty of a PB account that can cross margin and facilitate OTC comes into play
Obviously if we look for good hedge in the same market (i.e. buy ES puts) we basically buy the worst possible hedge (b/c every asset manager/pension fund buy the same insurance, which is why we make money shorting volatility to begin with...), so we need to look around for good
candidates for a hedge...

Being that I'm FX vol guy, I found that in FX (outside of the $ complex) one can find extremely good portfolio hedges..

If we think about FX crosses they are, in a way, a form of correlation trades, as they are quoted off liquid pairs x corr
So we can scan for currencies that have high beta to risk on one side, and plenty of specific risk to make the day to day vol when market is generally quiet...

The reason that there are couple of these around is b/c for the most part idiosyncratic risk is mostly underpriced
with implied correlation....

Currencies that have great risk on major downturn (NOK, NZD, AUD ,CAD) are priced at a very high correlation to their peers (intra High-beta) correlation, but when sht hits the fan they can go haywire with very little correlation to anything
obviously owning cheap volatility without a good reason is not a recipe for profitable book, but if we find these gems (and not just FX, we can also go in FI, credit, etc...) they can mitigate losses on these tail events...

Just my 2c

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5 Jun
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