Equity and Volatility Risk Premia: Sources, Risks, and Portfolio Approach

Summary

The article compares the equity risk premium (ERP), the expected compensation for holding risky equities, with the volatility risk premium (VRP), the tendency for implied volatility to exceed realised volatility. It frames the ERP as a long-term return source that is difficult to time, while the VRP resembles insurance selling: option writers collect premiums most of the time but can face sharp losses when volatility surges. Examples and historical charts illustrate equity drawdowns and the jump risk of short-volatility exposure.

The author’s approach is to hold diversified equity exposure with a volatility target and some bonds and gold, while keeping short-volatility positions small and adjusting exposure using signals from the VIX term structure. The account is personal rather than a controlled comparison, and the cited ETF illustrations omit trading and borrowing costs. Historical premium persistence is not a guarantee, and the discussion stresses that VRP requires more monitoring and risk control than passive ERP exposure.

Key ideas

• The ERP compensates investors for bearing broad equity risk, while the VRP is associated with bearing volatility-spike risk.
• Equity returns have historically rewarded long-term exposure, but substantial drawdowns and extended recovery periods are part of that exposure.
• Short-volatility positions may earn premium persistently but can suffer large losses during volatility shocks.
• The author favors diversified, steady equity exposure and attempts to time VRP exposure using VIX term-structure signals.
• Position sizing and ongoing monitoring matter more for short-volatility exposure than for the author’s ERP approach.

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