Expected VIX Option Returns

50 Pages Posted: 22 Oct 2012

See all articles by Zhaogang Song

Zhaogang Song

Johns Hopkins University - Carey Business School

Date Written: October 22, 2012


We dissect the fine structure of volatility risks, as an important component of time-varying investment opportunities, by studying returns on VIX option portfolios. In particular, we provide model-free evidence regarding the two leading channels in modeling volatility risks: stochastic volatility-of-volatility and volatility jumps. We find that zero-delta straddles and delta-hedged portfolios of VIX options, which are neutral to changes in VIX but sensitive to volatility-of-volatility, underperform zero. In contrast, tail portfolios, which we construct by out-of-the-money and at-the-money VIX options and are only sensitive to tails risks of volatility, outperform zero. Therefore, risks in volatility-of-volatility and jump-induced volatility tails are priced, providing empirical support for both of the two leading channels. We further construct measures for volatility-of-volatility and volatility tail risks, by the whole set of out-of-the-money VIX options, to understand how they are priced relative to variance and equity risk premiums. We find that both measures predict short-horizon market returns, with the predictability from volatility-of-volatility risks subsumed by the variance premium but the volatility tail risk standing as a separate channel. Different from existing tail risk measures of merely market returns, our volatility tail index provides important information regarding how investors gauge the extreme volatility risks.

Keywords: return predictability, stochastic volatility-of-volatility, variance risk premium, VIX options, volatility tail risks

Suggested Citation

Song, Zhaogang, Expected VIX Option Returns (October 22, 2012). Available at SSRN: https://ssrn.com/abstract=2165584 or http://dx.doi.org/10.2139/ssrn.2165584

Zhaogang Song (Contact Author)

Johns Hopkins University - Carey Business School ( email )

100 International Drive
Baltimore, MD 21202
United States

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