The Volatility Risk Premium

The VS strike represents the market’s fair price for exposure to realised variance over a specified period of time.

However, VS levels tend to trade consistently above comparable realised volatility: 

- payoff convexity

- volatility risk premium

 

Back-testing: 

- long vol positions are biased to make a loss

- short vol positions are on average profitable 

 

Bias = volatility risk premium

- In the real world, investors are not risk-neutral.

- Investors are prepared to pay slightly higher than fair value for exposure to long vol. 

- long vol = buying insurance --> small premium for potential large payout, but expect to forfeit some/all of the premium on most occasions.  

 

To sum up:

- Returns from long variance positions have long upside tails. 

- Returns from long variance positions are not normally distributed. 

- Long positions tend to lose a little and often, but can occasionally make large profits. 

- Short positions usually make modest gains, but can be exposed to very large losses if vol spikes up. 

 

Volatility risk premium = IV - RV: 

- carry of the short vol position. 

- good source for generating alpha --> strategies continuously selling variance through VS. 

 

Quantifying the volatility risk premium is complicated by:

- lack of real variance swap data

- part of the risk premium is attributable to the convexity of the VS payout. 

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