Why a Security That Absorbs Asset Volatility May Have a Cost

Summary

The document asks whether investors can buy a derivative that offsets an asset’s uncertainty while retaining its expected value. It contrasts two hypothetical assets with similar average outcomes but different ranges, then suggests that an investor might pay a premium to transfer the volatility to a seller. The author compares this idea with familiar option combinations and observes that the combinations they considered appear to cost the seller rather than pay the holder.

The discussion poses questions about whether such a security exists, whether it could have positive value to its holder under a normally distributed random walk, and whether options could replicate it. It does not provide answers, a pricing model, or evidence that the proposed payoff is attainable. The examples are hypothetical and do not specify payoff details, market assumptions beyond the stated distribution, or how the risk transfer would be priced. The document is therefore useful as a framing of volatility transfer and derivative replication questions, rather than as a strategy or actionable construction.

Key ideas

• The author asks whether a derivative could transfer an asset’s uncertainty to a seller for a premium.
• The motivating comparison holds expected outcomes similar while varying the range of possible returns.
• The proposed security’s payoff and pricing rule are not specified.
• The document asks whether familiar options can replicate the proposed risk transfer but does not resolve the question.

Tags

# Hypothetic derivative that absorbs underlying volatility


# Hypothetic derivative that absorbs underlying volatility












Market participants are usually assumed to be risk-averse and striving to improve the Sharpe ratios of their portfolios. Thus, if we have an asset A, which is expected to return between \$900 and \$1100, and an asset B, which is expected to return something between \$500 - \$1500, then on the market should price A higher. For example, the A may cost \$995, while B \$975.

This reasoning predicts a potential existence of particular option-like securities that would absorb those assets' expected volatility. Such security, being sold, should probably cost around a difference between the average and assets market price, so the owner of asset A could buy it for \$5, while the other for, say, \$25. The security seller would receive the premium + all potential gains and losses from the underlying on a particular date.

What puzzles me is that I seemingly cannot construct something like this from securities accessible to a DIY investor like me, a combination of stocks, bonds, options, futures. Everything I could come up with causes the "seller" in the example above to pay the premium. For example, longing a call and shorting a put on the same strike price will be a net negative.

So, assuming a random walk with normal distribution, the questions are:

- Does anything like this exist in the finance world?

- Is it going to have at least a positive value for the holder? If no, why?

- Can you reproduce it with a set of options?

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.