Variance Risk Premiums
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What they found
Carr and Wu used the fact that a variance swap can be synthesized from a portfolio of options to compute the variance risk premium (the difference between implied and realized variance) for the S&P 500, Dow, Nasdaq, and 35 individual stocks from 1996 to 2003. The index premiums were strongly negative: realized variance came in well below what options implied, so sellers of variance earned large average returns. For individual stocks the premium was smaller and often insignificant. The premiums could not be explained by standard stock factors, indicating that variance is a separately priced risk.
What you can use
- Index variance is systematically overpriced relative to what materializes; that gap is the variance risk premium sellers collect.
- The premium is much smaller in single-stock options, so the 'sell volatility' edge is largely an index phenomenon.
- The variance risk premium is a distinct risk factor, and being short it means being short crash insurance.
Caveats
1996 to 2003 sample; synthesizing variance swaps requires a full strike range and clean data. The average premium hides enormous losses in crashes.
Tags: options, variance-risk-premium, variance-swaps, implied-volatility
Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.