Analyzing Volatility Risk and Risk Premium in Option Contracts: A New Theory
56 Pages Posted: 3 Nov 2010 Last revised: 26 Jun 2017
Date Written: October 2, 2010
We develop a new option pricing framework that tightly integrates with how institutional investors manage options positions. The framework starts with the near-term dynamics of the implied volatility surface and derives no-arbitrage constraints on its current shape. Within this framework, we show that just like option implied volatilities, realized and expected volatilities can also be constructed specific to, and different across, option contracts. Applying the new theory to the S&P 500 index time series and options data, we extract volatility risk and risk premium from the volatility surfaces, and find that the extracted risk premium significantly predicts future stock returns.
Keywords: Implied volatility surface; Option realized volatility; Expected volatility surface; Volatility risk premium; Vega-gamma-vanna-volga; Proportional variance dynamics
JEL Classification: C13, C51, G12, G13
Suggested Citation: Suggested Citation