The premium that corresponds to volatility risk; it is the compensation for bearing the price volatility risk of a financial product/ instrument/ contract (and asset classes). It reflects the difference between risk-neutral (options-implied) and real expectations of returns variation (variability).
The volatility risk premium (VRP) constitutes the compensation (premium) market participants earn or pay for insurance against market losses (excess volatility). Due to incomplete market settings, this premium represents the average implied volatility above realized volatility. This phenomenon can be consistently modeled using, for example, jump-diffusion or stochastic volatility models.
In a market (particularly, the equity market) where risk-averse investors are overall long the underlying products/ contracts, the “average” volatility risk premium is positive, reflecting a long-term discrepancy between options-implied volatility and realized returns variance. The premium varies over time, increasing at times of higher volatility risk aversion and decreasing at times when risk aversion is lower.
A high positive premium would implicate viability of short volatility positions, while a negative premium would justify long volatility positions. An investor taking a short volatility position is considered betting on a decreasing volatility, and a long volatility position represents a bet on an increasing volatility.
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