Volatility Managed Short Duration Premium

Abstract

This thesis investigates if the short duration premium of the equity duration strategy can be improved by managing its volatility. Based on estimates by Gonçalves (2021), we replicate equity duration sorted portfolios of U.S. stocks from 1973 to 2019, and identify a 9.3% premium for a strategy buying short duration firms, and selling long duration firms. These findings support literature suggesting the existence of a downward-sloping equity term structure. Managing the volatility of the equity duration strategy results in a reduction of 4.2% annualized risk-adjusted return, suggesting that volatility management does not lead to an improvement of the short duration premium. In contrast to strategies for which volatility management increases premiums, we note that the original equity duration strategy has a high positive skewness of 0.64, which is completely diminished. We argue that volatility management is not suitable for the equity duration strategy as strategy returns are generally high in periods of high volatility, and returns are generally low in periods of low volatility. We finalize our exploration of the short duration premium by testing its merits in a multi-factor environment. We show that combining the equity duration strategy with traditional asset pricing models in Markowitz’s (1952) portfolio optimization model increases Sharpe ratios significantly. Our findings underscore the viability of the equity duration investment strategy but warn investors of scaling investments to its volatility.