Vol Premium [Partial] Justification

I’m about halfway through Colin Bennet’s terrific book Trading Volatility, Correlation, Term Structure and Skew (pdf).

Bennet is (or was) the Head of Quantitative Derivatives Strategy at Santandar. The book sits in a very sweet spot. It has lots of practical insights into managing vol portfolios and the mechanics of both vanilla and exotic options, var, and vol swaps. I’ll likely do a full post summarizing the takeaways I appreciated most, but in the meantime I thought to share this blurb about the oft-referred VRP (vol risk premium).

Just because implied vols trade over realized does not mean they are mispriced:

[To be fair the author asserts they still are. More importantly, you should read ch. 3 of the book to see how he decomposes the premium to systematic risk and pure vol demand premia.]

I wrote something similar a few weeks back:

Index options should be “overpriced”.

The question is how much premium do they deserve. If stocks warrant a risk premium over the RFR it’s because their systematic risk cannot be hedged. Index options must conceptually inherit this premium otherwise there would an arb in portfolio allocation.

An index option, held delta neutral, gets paid as correlations in the marketplace increase. It literally makes money when systematic risk embodies.

A standard for deciding if puts are expensive: Its price should have enough premium in it that by buying a put, if delta hedged, that you would actually have basis risk. In other words, it’s premium should make it uncertain that you would actually make money in a sell-off. If your argument is that it’s expensive in a vacuum (perhaps as a comparison to realized vol) then what if it was only 1% premium to realized? That sounds like a bargain for something that hedges the risk that, like, the whole world has. This isn’t news to most investors or anyone who understands portfolio construction and the beauty of neg correlations. It’s just another instance of my sun/rain example.

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