Confronting the Volatility Risk Premium on the S&P500 Index: An Empirical Study

Abstract

This thesis examines the effectiveness of different short vega option combinations’ ability to capture the volatility risk premium on the S&P500 index. We find evidence that delta neutrality of the option combinations is required to gain factor exposure linked to the volatility risk premium. The short delta-hedged strangle proves to be the most profitable strategy to capture the volatility risk premium. However, neither of the initially tested strategies yields statistically significant returns. Using market timing indicators based on moving averages of the VIX- and CDX index, the returns of the option combinations considered are consistently improved and yield statistically significant returns. When considering transaction costs and margin requirements faced when trying to capture the volatility risk premium, the investment doesn’t seem as attractive, but is perusable when using market timing indicators.