Understanding the Volatility Risk Premium

Topics - Volatility Market Risk and Efficiency Derivatives Portfolio Risk and Performance

Read Time - 15 minutes

${ numberSection } ${ text }
Understanding the Volatility Risk Premium

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.


What's Inside?

  • The volatility risk premium (VRP) represents the reward for bearing an asset’s risk (e.g., equity downside risk). Such protection in financial instruments is best represented by option contracts. The insurance risk premium in options reflects investors’ risk aversion and their tendency to overestimate the probability of significant losses.
  • We believe an investor can systematically exploit these risk preferences and behavioral biases through an option-selling strategy and we show how it may benefit investor portfolios over the long run. 
  • Investors interested in adding the VRP to their portfolios can do so in a variety of ways. The strategy can be a stand-alone portfolio, one of multiple sleeves of a multi-alternative portfolio, part of a buy-write strategy, or part of a volatility-enhanced equity strategy.


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.

This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. This document is not to be reproduced or redistributed to any other person. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision. Past performance is not a guarantee of future performance. 

This material is not research and should not be treated as research. This paper does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR. The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein. 

The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the author guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. 

The information in this paper may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.