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Choosing a Horizon-Matched Measure of the Volatility Risk Premium

Article Quant Q&A · Author: Fadmad
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Summary

The document raises a measurement question for a volatility risk premium strategy using options on a futures contract. The underlying future expires annually, while options are available at quarterly expiries. The proposed measure is to compare the implied volatility of the nearest-quarter option with realized volatility annualized over the period until that option expires.

It asks whether this comparison is appropriate or whether a better measure is needed, but supplies no answer, formula, empirical evidence, or strategy results. The setup highlights the need to align option-implied and realized volatility horizons and to specify how realized volatility is estimated. It leaves open further choices, such as the exact variance-risk-premium definition, volatility surface or strike selection, and treatment of overlapping measurement windows.

Key ideas

  • The proposed measure compares front-quarter option implied volatility with realized volatility through that option's expiry.
  • The option and realized-volatility horizons should be aligned for a meaningful comparison.
  • The document poses the measurement problem but provides no recommended method or empirical validation.
  • Strike selection, realized-volatility estimation, and the precise definition of the premium remain unspecified.

Tags

FuturesOptionsVolatilityStatistics
Full text
# Best Way To Compute the Volatility Risk Premium


# Best Way To Compute the Volatility Risk Premium












I'm trying to come up with a measure for the volatility risk premium (VRP) for a strategy I want to implement, but I'm not entirely sure how to proceed. My situation is as follows.

- The underlying is a futures contract that expires yearly (December).

- There are four option contracts on this futures contract expiring quarterly (Mar, Jun, Sep, Dec).

I know that there are multiple ways to compute the VRP but I was hoping on getting some insight. One way I though of computing it is simply the difference between the front-quarter option Implied Volatility and the annualized future Realized Volatility until expiration of the appropriate front-option contract.

Could there be a better way or something that I'm missing?

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.