Volatility Risk Premium

Volatility Trading uses Investment strategies generating High and Stable profits analogous to the long-term success of insurance companies. Volatility Investments aim to receive the Volatility Risk Premium. Volatility Investment Strategies are executed by using variance swaps or volatility swaps.

Volatility Risk Premium is the return investor A gets as compensation for insuring investor B for risk of losses during sudden increases in market volatility and extreme market events like financial crisis. Technically, volatility premium is the profit gained from the difference between implied and realized volatility.

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Volatility Risk Premium versus Insurance Premium (term)

Volatility Risk Premium is similar to the insurance premium insurance companies receive for insuring clients against extreme events like flood.

The insurance premium exists because the implied risk (what clients pay to get insured) is higher than the actual risk (what insurance companies pay out in case of flood) for these catastrophes occurring.

In finance markets, most participants in options are options buyers willing to hedge their portfolios. Selling options is regarded dangerous and hence is avoided. Hence the price paid by buyers to get insured against extreme events is high since demand is much larger than supply for insurance.

The imbalance between demand and supply is very high after a market crisis when investor protection demand spikes whereas investors willing to offer protection decreases. As a result, volatility trading is the one of the best investments after major market crisis.

Extreme Event Insurance example (term)
Insurance company A insures clients for flood. Typically this is a profitable business with occasional payouts more than covered by premiums received. Suddenly, a 200 year storm occurs. Insurers suffer losses and raise their insurance premiums. Citizens became afraid of potential future floods and hence demand more insurance protection for future floods.

High demand and low supply for insurance produces very high flood insurance rates but the probability of future floods occurring has not changed. A 200 year storm has remained a 200 year storm. As a result, the best time to issue insurance policies is immediately after a crisis when risk premium is highest.