The volatility risk premium (VRP) represents the compensation that investors earn for providing protection against unexpected market volatility. This paper first describes the VRP and the reasons why it may exist. We then explore its historical performance with a simple option-selling strategy and conclude by discussing approaches for including it in a portfolio.
The VRP is the compensation that investors earn for providing protection against market losses. In doing so, they are underwriting insurance — primarily option contracts — and as with all insurance, the underwriter seeks a risk premium. We show that the VRP has historically tended to deliver strong risk-adjusted returns and that it may provide useful diversification within an investor’s portfolio. Interested investors could consider adding the strategy alongside traditional long-only strategies or use it in conjunction with other non-traditional return sources.