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- The Volatility Risk Premium
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.