What is the volatility risk premium and why does it exist?

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AcadiFi · Accepted Answer

The volatility risk premium (VRP) is the persistent gap between option-implied volatility and subsequently realized volatility on the underlying. Empirically, 30-day S&P 500 implied vol averages roughly 3-4 vol points above realized.

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From a pricing perspective, the risk-neutral measure used to price options overweights bad states of the world relative to their physical probability. When variance itself is correlated with the marginal utility of consumption (high vol = bad times), risk-averse agents accept a negative expected return on long variance positions. That flips into a positive return for sellers.

A concrete example: imagine Meadowlark Capital systematically sells 1-month S&P variance swaps. Over a decade the fund collects an average carry of roughly 2.5 vol points per month. But the distribution is extremely left-skewed — August 2015, February 2018, and March 2020 delivered 4-6 standard deviation losses that wiped out years of premium. That asymmetry is exactly the compensation structure: you get paid small amounts frequently to accept catastrophic jump risk infrequently. FRM exam questions typically ask you to distinguish VRP (implied vs realized) from the variance risk premium (variance swap rate vs realized variance) and to identify the skewness of the payoff.

What is the volatility risk premium and why does it exist?

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