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Matthias Knab, Opalesque: Virtus Investment Partners published on Harvest Exchange:
What is the volatility risk premium?
Over the past several decades, traders and investors have observed that the expected future volatility level embedded in option prices(the "implied volatility") typically exceeds the volatility that is experienced by the underlying asset during the life of the option (the "realized volatility").
To make sense of this terminology, we need a bit of background on how option prices are determined. Conveniently, option prices can be reasonably estimated using well-known, closed-form equations, such as the Black-Scholes formula1. To determine an option’s theoretical price(aside from supply/demand forces), a handful of inputs to the formula are needed: the underlying price, the option strike price, the maturity date (or time to maturity), the risk-free interest rate2, the underlying dividend yield, and the expected underlying volatility over the life of the option. The problem immediately becomes clear: all of these are well-defined, observable values, except for the volatility input.
What this means is that an assumption needs to be made about what the future volatility will be. Typically, the recent volatility of the underlying as...................... To view our full article Click here
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