Structural Relationships and Portfolio Efficiency

Abstract

Instead of relying on inherently frail statistical relationships, investors should base portfolio construction decisions on the enduring structural relationship between risk and return. Direct investments in implied volatility indexes, such as the VIX and related contracts, can provide a perfect hedge, because increases in risk feed back into the asset’s price: when an asset’s conditional volatility increases, its price falls. Empirical results align with theory, as increases in the front-month VIX futures contract have translated to downward stock price adjustments. Data demonstrate that the VIX is a reliable proxy for the market-wide price of risk and can generally anticipate flights to safety and explain stock returns and changes in credit spreads.