Overview
The Volatility Risk Premium (VRP) is the persistent tendency for option-implied volatility to exceed subsequent realized volatility. Advanced quantitative funds decompose the VRP into its constituent, orthogonal components (moneyness, term structure, and correlation) to target structural inefficiencies driven by non-economic flows, moving beyond the simple selling of insurance.
Key Concepts
- VRP — The difference between the market's pricing of future variance under the risk-neutral measure (ℚ) and the expectation of variance under the physical measure (ℙ).
- Moneyness Decomposition — Isolating the pure variance premium (ATM) from skewness (Third Moment) and kurtosis/tail risk (Fourth Moment).
- Term Structure Decomposition — Isolating short-term mean-reverting tactical flows (Gamma) from long-term structural hedging flows (Vega).
- Correlation/Dispersion — Isolating the Correlation Risk Premium (CRP) by trading index volatility against its constituents.
- Vanna (∂Δ / ∂σ) — The sensitivity of an option's Delta to changes in volatility, driving mechanical dealer flows that can suppress volatility.
- Charm (∂Δ / ∂t) — The sensitivity of Delta to time decay, creating structural bids as options approach expiration.
Formulas
Key Takeaways
- The VRP is highly asymmetric. "Bad Variance" (downside) carries a persistent premium, while "Good Variance" (upside) can often be negligible due to overwriting supply.
- The ultimate goal of VRP decomposition is to construct a "Barbell" portfolio: harvesting the high-frequency core VRP (income), hedging the jump risk (protection), and using dispersion (alpha) to fund the protection leg.
- Pure ATM variance strategies are heavily influenced by Gamma flows, while downside skew is dominated by crash aversion from pension funds and insurers.