The Volatility Premium

Abstract

Implied option volatility averages about 19% per year, while the unconditional return volatility is only about 16%. The difference, coined the volatility premium, is substantial and translates into large returns for sellers of index options. This paper studies a general equilibrium model based on long-run risk in an effort to explain the premium. In estimating the model on past data of stock returns and volatility (VIX), the model is successful in capturing the premium, as well as the large negative correlation between shocks to volatility and stock prices. Numerical simulations verify that writers of index options earn high rates of return in equilibrium. JEL classification: G12, G13, C15. ∗Wisconsin School of Business, University of Wisconsin. I thank Ivan Shaliastovich for valuable research assistance, Ravi Bansal, Tim Bollerslev, Mike Gallmeyer, Mark Ready, George Tauchen and seminar participants at Duke University, Texas A&M University, University of Wisconsin and the Triangle Econometrics Conference, Caesarea Annual Finance Conference, and Multinational Finance Society Conference for valuable comments