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Can someone provide an intuitive understanding of the variance risk premium? I am very confused by this definition and cannot interpret my time series analysis.

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  • $\begingroup$ The variance risk premium is the expected payoff of a variance swap. This swap can be used to hedge changes in average voltility over a predefined period of time. The buy side buys a fixed average voltility and the sell side recieves the time-varying realized voltility. In addition the buy side pays the variance risk premium (vrp) for extra compensation. Now, the higher the vrp the higher the extra buy-costs and if the buy side is willing to pay this premium they fear high future vola/market crashes. $\endgroup$ – Phun Oct 4 '15 at 6:42
  • $\begingroup$ Which definition are you referring to? Could you please give your source? $\endgroup$ – vonjd Oct 4 '15 at 11:25
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    $\begingroup$ public.econ.duke.edu/~boller/Published_Papers/rfs_09.pdf read chapter 2. $\endgroup$ – Phun Oct 4 '15 at 12:34
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Intuitively: empirical research has shown that options on the S&P are priced at a slightly higher implied vol than the actual historical vol of the S&P (on average). Why? Likely this is because holding these options provides insurance against bad states of the economy (volatility increases when the economy is in trouble); this is valuable and raises their price. In any case, the difference between the squared implied vol and the squared historical vol is called the VRP or Variance Risk Premium. The key paper is Bollerslev's in RFS 2009 (cited above by Phun).

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