What is the VRP? The variance risk premium can be thought of as the average difference between the volatility you pay for and the volatility received in any kind of volatility derivative. In terms of trading options, this premium can be considered the average difference between the volatility level you bought and the actual volatility experience by the underlying contract during the life of the option. One might initially expect that over a large enough sample size, the difference between these two should net out to be approximately the same. Academic literature and real world experience suggest that this is typically not the case, and in fact the volatility realized over the life of a contract is often lower than the volatility implicit in the initial price of the contract. The magnitude of this difference—the variance risk premium—changes for different products, and is an important concept for any participant in volatility markets to understand. With the advent of the expanding world of volatility derivatives, this paper attempts to understand this premium in VIX options.
