The Influence of Tracking Error on Volatility Premium Estimation

38 Pages Posted: 22 Feb 2005

See all articles by James Doran

James Doran

University of New South Wales

Date Written: May 26, 2006

Abstract

I investigate whether the volatility risk premium is negative in energy and equity markets by examining the statistical properties of delta-gamma hedged option portfolios (selling the option, hedging with the underlying contract, and correcting for tracking error with an additional option). By correcting for gamma, these hedged portfolios are not subject to the same discretization and model misspecification problems as traditional delta-hedged portfolios. Within a stochastic volatility framework, I demonstrate that ignoring an option's gamma can lead to incorrect inference on the magnitude of the volatility risk premium. Using a sample of S&P 100 and natural gas contracts, empirical tests reveal that the delta-gamma hedged strategy outperforms zero and the degree of over-performance is proportional to the level of volatility.

Keywords: Volatility, risk premium, option pricing, nonparametric estimation, energy markets

JEL Classification: G12, G13, C14, C15, Q4

Suggested Citation

Doran, James, The Influence of Tracking Error on Volatility Premium Estimation (May 26, 2006). Available at SSRN: https://ssrn.com/abstract=670223 or http://dx.doi.org/10.2139/ssrn.670223

James Doran (Contact Author)

University of New South Wales ( email )

College Rd
Sydney, NSW 2052
Australia

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