Academic theory predicts that the volatility implied by the VIX index will be greater than the realized volatility. That difference can be thought of as an insurance premium investors are willing to pay because volatility tends to spike when stocks crash, as in the last bear market. New research confirms that investors can profit from this and that such a strategy is uncorrelated with other traditional sources of return.

The volatility of asset returns is regime dependent, changing over time as the economy goes through periods of tranquility and periods of turbulence. Changes in the volatility of asset returns are priced into options markets. Theory suggests that the price of volatility risk should be negative because increases in volatility are viewed by investors as a deterioration in the investment environment. Thus, assets that purchase volatility insurance (such as variance swaps and options) that pay off positively when the markets unexpectedly become more turbulent should have negative expected returns. Conversely, selling volatility insurance should have positive expected returns.

The variance risk premium (VRP) refers to the fact that, just as theory suggests, over time the option-implied volatility has tended to exceed the realized volatility of the same underlying asset. This has created a profit opportunity for volatility sellers – those willing to write the volatility insurance options, collect the premiums and bear the risk that volatility will increase by more than the implied volatility. Investors are willing to pay a premium because risky assets, such as stocks, tend to perform poorly when volatility increases. Thus, the VRP isn’t an anomaly that should be expected to be arbitraged away. And since the risks of the VRP tend to show up in bad times (when risky assets are performing poorly), we should expect a significant premium. Thus, the VRP should be considered a unique risk premium that investors with long horizons and stable finances (allowing them to take on cyclical risks that show up in bad times) can harvest.