What is VRP? Banner

What Is the Volatility Risk Premium?

Alex Zweber photo

Alex Zweber, CFA, CAIA

Managing Director, Investment Strategy

More about this author


Protective hedges against equity market volatility were more effective in 2020 than in 2022. We explain the role of the volatility risk premium.

The financial hurricane of Q1 2020 blindsided equity markets. The S&P 500® collapsed -33.9% in just 23 days, realized volatility neared triple digits, and many highly leveraged strategies were wiped out entirely. But tail-risk hedges, which offer insurance-like payouts against sharp equity market declines, produced significant positive cash flows to the lucky few. Fast-forward to 2022: The markets delivered the worst first half of a new year since 1970, when the S&P 500® dropped -20%. Investors who had allocated to these same tail-risk strategies didn’t realize the same benefit as in 2020.

Why such a different outcome in 2022? The answer lies in the pricing of these options-based insurance policies. In short, portfolio protection has been consistently expensive on a relative basis, and the presence of a robust volatility risk premium (VRP) drives that relative richness.

What is the VRP?

Just as we purchase insurance for homes and cars, investors can purchase insurance on their portfolios to hedge against unexpected market volatility. Like other insurance markets, options buyers don’t enter those transactions expecting a long-term profit. Profits instead accrue to options sellers—the party underwriting the risk that others seek to avoid—as insurance policies in a competitive marketplace are priced with an expected profit margin. For example, if 10 houses are estimated to burn down in an area each year, underwriters might price policies as if there would be claims on 20 homes, resulting in home insurance getting priced above its actuarial fair value. 

Similarly, options contracts are priced with an expected or implied level of volatility, and this implied volatility has historically been persistently higher than what the market ultimately delivers. This excess volatility is known as the VRP, the tailwind that can ultimately create an expected profit for options sellers.

Terminology Table 

We most commonly measure the VRP as the difference between the implied volatility (IV) and subsequent realized volatility (RV) of the underlying security. The difference represents a relative value measure for volatility, and a positive VRP implies a tailwind for option sellers. As shown in the chart below based on historical data for the S&P 500®, IV exceeds RV in approximately 85% of the observations dating back to 1990 across a range of market environments. The size and persistence of this insurance risk premium reflects behavioral factors, such as loss aversion; structural factors, such as an imbalance of natural longs and shorts; and economic factors, such as the added value of convex assets with negative correlations.

S&P 500® quarterly average implied vs. realized volatility

S&P 500® quarterly average implied vs. realized volatility graph

Sources: Bloomberg, Parametric, 6/30/2022. The years from 1990 to the present represent the longest period in which reliable data is available and easily accessible for the S&P 500® Volatility Index. S&P 500® Index options’ relative valuation is measured by taking daily observations of implied volatility (as measured by the VIX® Index) and subsequent realized volatility of the S&P 500® over the subsequent month (assuming 21 trading days). For illustrative purposes only. It is not possible to invest directly in an index.

We aim for persistent return without forecasts

Why should investors seek out the VRP now?

The most meaningful excess returns in traditional insurance markets have historically come on the back end of a significant event. Short-term losses for underwriters lead to rapid repricing of insurance and an expanded opportunity set in subsequent periods. This has also been the case historically with options-based VRP strategies: Persistently positive VRP has been most pronounced after a volatility event, improving opportunities for those willing to underwrite risk when risk aversion is at its highest. 

In our view, this characterizes the environment of the past two-plus years as the destructive financial storms of early 2020 significantly altered the supply–demand dynamics in the options market. The long-term VRP—as measured by VIX® minus subsequent realized S&P 500® volatility—has averaged about four volatility points since 1990. But it’s averaged over 6.5 points since Q1 2020, leading to some of the most profitable periods for options-selling strategies in the past decade.

We see support for these recent trends to continue. Based on both investor consensus and forward volatility curves, we expect volatility to remain elevated against a challenging backdrop for traditional equity and fixed income investments. While investors with long-term horizons are particularly well-suited to benefit from the historical tailwinds of the VRP, we believe the current environment—one of heightened investor concern, muted return expectations, and rising short-term rates—is especially compelling for prudent VRP strategies to shine.

How should investors harness the VRP?

We believe the best method of implementing a VRP strategy includes a focus on diversification, efficiency, accessibility, and transparency. This can be accomplished using listed options contracts on broad-based equity indexes. Rather than make active bets or forecasts on the direction of markets or volatility, investors should consider using a research-driven approach that aims to get in the path of a persistent risk premium effectively and consistently. Risk management is also a key element of a rules-based portfolio construction process: The sale of fully collateralized put and call options can help VRP investors avoid leverage.

Consider as well how home and auto insurance underwriters seek to diversify across property types and geographic areas. In a similar fashion, well-constructed VRP strategies can diversify across option tenors, strike prices, start and end dates (laddering of expirations), and underlying indexes. The end result is a low-cost, consistent approach that aims to deliver a diversifying risk premium to the end investor.

The bottom line

Many investors use VRP strategies to enhance returns while reducing overall portfolio risk. These VRP allocations may supplement existing equity portfolios, replace traditional low-volatility equity and hedged-equity strategies, or serve as a highly liquid component within an alternative asset allocation. The persistence of the VRP means these strategies don’t have to rely on market timing or active market bets to offer compelling diversification or potentially enhanced returns. That can be a useful tool in navigating portfolios through today’s challenging markets.

More to explore

Blog post Read more
Tag icon
Liability-driven investing, Volatility, Overlay, Fixed income, Commodity, Options, Institutional investor, +4
Blog post Read more
Tag icon
Commodity, Volatility, Institutional investor, Wealth manager, +1
Blog post

Bonds Are Back: What Are You Waiting For?

Bernie Scozzafava}
Kevin  Lynyak}

With interest rates rising to attractive levels, we believe it’s time to take advantage of a potentially overlooked opportunity. Find out why.

Read more
Tag icon
Fixed income, Market activity, Volatility, Wealth manager, Institutional investor, +2
Blog post Read more
Tag icon
Market activity, Options, Volatility, Institutional investor, +1

The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss. Prospective investors should consult with a tax or legal advisor before making any investment decision. Please refer to the Disclosure page on our website for important information about investments and risks.