Structured Perspectives part 2: How Autocalls harness the Volatility Risk Premium
- JJ Baker
- Nov 18
- 5 min read
This is a marketing communication for professional investors only. Capital at risk.
In part 1 of our Structured Perspective series, we looked at two popular types of Defined Outcomes Investments: the Buffer ETF and the Defensive Autocall. We touched on the structural Volatility Risk Premium that exists in options markets and looked at how both investments can take advantage of this, but to differing extents. In this note, we will explore the Volatility Risk Premium further by examining what impact this has on the returns of Defined Outcome Investments.
Recap: Volatility Risk Premium
Volatility is a key concept in finance, usually measured as the annualised standard deviation of daily returns over a specified period. This familiar concept is known as realised volatility, but in derivatives, we use a slightly different concept known as implied volatility. This measures the market’s expectations of volatility over a specific time period. As implied volatility cannot be measured, it is instead backed out (implied – hence the name) from option prices equations.
What is the Volatility Risk Premium?
The Volatility Risk Premium measures the difference between implied volatility and realised volatility.
The graph below shows how the size of the volatility risk premium varies across indices when comparing actual realised volatility to at-the-money implied volatility over time.
Volatility Risk Premium
Source: Atlantic House, Solactive. UK Large Cap: Solactive United Kingdom Large Cap ex Investment Trust Index, US Large Cap Index, European Large Cap: Solactive Euro 50 Index, 15/10/2014 to 25/06/2025
As mentioned in part 1, a similar dynamic is also found in traditional insurance markets. Why do insurers make money? Because providers (such as car or home insurers) typically collect more in premiums than they pay out in claims over time. Likewise, in capital markets, sellers of downside options receive compensation in the form of premiums that often exceed the actual cost of realised losses over time.
Volatility Skew
In addition to this “at-the-money volatility risk premium”, there is also a well-established phenomenon found in equity markets known as volatility skew, particularly in relation to broad indices.
What is Volatility Skew?
Skew refers to the difference in implied volatility across option strike prices for the same underlying asset. Most of the time, implied volatility measures are skewed such that higher levels are observed the lower the strike of the option for a particular underlying.
Volatility Skew occurs as a result of a combination of structural supply and demand imbalances and behavioural market dynamics:
1. Asymmetric nature of equity markets:
This is one of the primary drivers of Volatility Skew, often described as "stairs up, elevator down". While market rallies tend to be gradual, drawdowns are typically sharp and abrupt. This asymmetry, especially over shorter time horizons, creates persistent demand for downside protection. That demand increases the price, and therefore the implied volatility, of lower strike options.
2. The influence of systematic hedging programmes:
Institutional investors such as pension funds, insurers, and asset managers are often subject to regulatory stress testing and internal risk controls that require them to hedge material equity drawdowns. These participants commonly use out-of-the-money put options to meet these requirements, not because they expect them to finish in the money, but because they deliver mark-to-market gains during market stress. These gains support valuations, improve capital ratios, and help meet regulatory thresholds. Importantly, these investors tend to be less price sensitive because their focus is on the protection's regulatory and accounting benefits, not its terminal payoff. Out-of-the-money options are especially capital efficient in this context, offering large notional protection for relatively low upfront cost.
This creates persistent structural demand for downside options, inflating their implied volatility relative to at-the-money options.
Harnessing the Volatility Risk Premium
To understand the impact the volatility risk premium can have on the price of Defined Return Investments, we can look at a popular investment, the Defensive Autocall, more closely. The equity downside of a Defensive Autocall is structured by selling knock-in puts, typically struck at-the-money but with deep out-of-the-money barriers. This means that these strategies are sensitive to both the embedded Volatility Skew Premium as well as the at-the-money Volatility Risk Premium.
In other words, Defensive Autocall buyers become equity downside volatility sellers and are compensated for taking on that downside risk by harvesting the higher premiums that have been systematically overpriced by the market due to Volatility and Skew Risk Premium being present.
Supporting data:
This claim can be demonstrated using real data. Looking at weekly data since 2015, the average 6-year 100-65 skew (defined as the implied volatility difference between 100% and 65% strikes measured weekly) has been approximately 4% higher on the 65% strike options than their at-the-money counterparts. This highlights the persistent and exploitable opportunity of this structural dislocation in index options markets that investments such as the Defensive Autocall can benefit from.
The graph below shows this data across different markets.
Source: Atlantic House, Solactive. UK Large Cap: Solactive United Kingdom Large Cap ex Investment Trust Index, US Large Cap: Solactive US Large Cap Index, European Large Cap: Solactive Euro 50 Index, 15/10/2014 to 25/06/2025.
The impact of the Volatility Risk Premium in Buffer ETFS and Defensive Autocalls
Whilst both Buffer ETFs and Defined Return Investments harness the volatility risk premium in some form, there is a marked difference in how and to what extent this is done. As we saw in part 1, Defensive Autocalls take advantage of the prevailing Volatility Risk Premium to a greater extent, with the initial Vega (sensitivity to moves in implied volatility) being circa five times greater than that of a Buffer ETF. Additionally, by targeting a longer term and further “out-of-the-money” options, Defensive Autocalls have richer volatility and skew risk premia than Buffer ETFs.
What does this mean for Defensive Autocall returns potential?
To quantify the impact of this premium in terms of return potential, we priced a representative Defensive Autocall note structure typical of our Defined Returns Fund across different index combinations. The UK/Europe combination priced at 8.60% and the UK/US combination slightly lower at 8.40%.
Common terms:
Annual Autocall Barrier Levels: 100% / 95% / 90% / 85% / 80% / 69%
Conditional Capital Protection Barrier: 64% (i.e. capital protected up to a 36% fall)
UK/Europe | UK/US | |
|---|---|---|
Return Yield (with Volatility and Skew Risk Premium) | 8.60% | 8.40% |
Return Yield (without Volatility Risk Premium) | 8.10% | 7.60% |
Return Yield (without Volatility Skew) | 6.90% | 6.10% |
Source: Atlantic House, 25/06/2025
Having calculated the average Volatility Risk Premium since 2015 to be 1.03% for the UK, 1.58% for the US and 0.75% for the EU, we shifted the volatility surface down by those amounts to understand the pricing impact of the Volatility Risk Premium. We found the pricing was 0.50% lower at 8.10% on the UK/EU Autocall and nearly 1% lower on the UK/US Defensive Autocall at 7.60%.
We then repriced the Autocall with a flat volatility surface with no skew, i.e. assuming the implied volatility of all options are equal for one tenor, and the respective returns dropped to 6.90% and 6.10% respectively. These results illustrate the tangible return enhancement from the persistent structural premium in equity volatility, offering around 2% per annum pickup in pricing.
Conclusion
Whilst both Buffer ETFs and Defensive Autocall strategies take advantage of the Volatility Risk Premium, Defensive Autocalls not only take greater advantage by being 5 times shorter volatility but, as a result of their longer term and further out-the-money option selling, they also take advantage of more persistent and richer longer-dated volatility and skew risk premia. This materially impacts for the better the returns that can be offered. In part three, we will look at another main driver of Defensive Autocall returns, the Equity Risk Premium.
