The risk-reversal premium

Blair Hull and Euan Sinclair

Journal of Investment Strategies

Abstract: We study the risk-reversal premium, where out-of-the-money puts are overpriced relative to out-of-the-money calls. This effect is driven by investors’ utility preferences, which lead them to overpay for the risk reduction benefits of long puts instead of valuing options on the basis of expected returns. Investors can exploit this implied skewness premium by trading standard, exchange-traded index options. We show that including risk reversals in an equity portfolio creates a better portfolio (as measured by the Sharpe ratio) compared with a pure index position.

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