Decomposing the Variance Risk Premium, Part 2

Key Takeaways

• Downside variance risk premium exceeds aggregate VRP
• Downside variance and skewness premiums forecast future equity returns
• Variance premium predictive power peaks at 3‑5 month horizon
• Skewness premium predicts returns over longer horizons
• Skewness term structure signals long‑run equity return expectations

Pulse Analysis

Volatility risk premium (VRP) has long been a cornerstone of options‑based research, representing the gap between implied and realized volatility. By decomposing VRP into upside and downside elements, the new study builds on the 2016 Feunou et al. framework and applies it to a fresh S&P 500 dataset spanning recent market cycles. This granular approach uncovers that investors demand a substantially higher premium for volatility tied to price declines, confirming that downside risk is priced more aggressively than overall market variance.

The empirical analysis shows that both downside variance risk premium and downside skewness risk premium possess predictive power for future equity returns. Specifically, the variance‑related signal is strongest at medium horizons of three to five months, aligning with prior literature that links short‑term volatility risk to near‑term return expectations. In contrast, the skewness premium retains significance over longer horizons, suggesting that market participants price tail‑risk concerns that materialize over extended periods. These findings reinforce the view that rare, large drawdowns are a distinct source of risk compensation.

For practitioners, the study’s most actionable insight lies in the term structure of the skewness risk premium. When longer‑maturity skewness premiums are more negative than their short‑term counterparts, subsequent long‑run equity returns tend to rise, indicating that investors’ expectations of future tail risk translate into higher required returns. Incorporating these asymmetric risk measures into asset‑allocation models can improve return forecasts and enhance risk‑adjusted performance, especially for strategies that hedge against downside volatility. The research thus bridges academic theory with practical portfolio construction, highlighting a nuanced avenue for alpha generation.