Inventory Risk and Its Impact on the Volatility Risk Premium

The volatility risk premium (VRP) is the difference between the implied volatility of options and the realized volatility of the underlying asset, representing the compensation investors earn for taking on volatility risk.

Recent research suggests that the VRP is specifically a reward for bearing overnight risk. Reference [1] goes further by attempting to answer why this is the case. It provides an explanation in terms of market makers' inventory risks. The authors pointed out,

This paper suggests that S&P 500 option risk premia largely result from the combination of options demand and overnight equity illiquidity, which expose risk-averse intermediaries to unhedgeable inventory risk. I show that S&P 500 option risk premia are on average insignificant intraday, but significantly negative overnight, outside of regular exchange trading hours. Dealers’ inventory exposure to overnight equity price gaps can explain this finding. Dealers have a net-short position in put options, which exposes them to overnight equity “gap risk”, the risk that equity prices change overnight, since overnight equity liquidity is too low for continuous delta-hedging. In contrast, intraday equity liquidity presents few such obstacles. Supporting this channel, the emergence of overnight equity trading around 2006 leads to a relative reduction in option risk premia over parts of the week that include more overnight trading sessions, suggesting a causal effect of equity liquidity on option risk premia, likely through dealers’ inventory risk.

In summary, the article concluded that,

• Put option risk premia are significantly negative overnight when equity exchanges are closed and continuous delta-hedging is not feasible. Intraday, when markets are liquid and delta-hedging is possible, put option risk premia align with the risk-free rate. Call options show no significant risk premia during the sample period.
• Dealers' short positions in puts expose them to overnight equity price "gap" risks, while their call option positions are more balanced between long and short, resulting in minimal exposure to gap risk.
• Increased overnight liquidity reduces option risk premia. Regulatory changes and the acquisition of major electronic communication networks in 2006 boosted overnight equity trade volumes from Monday to Friday, reducing the magnitude of weekday option risk premia compared to weekend risk premia.

An interesting implication of this research is that the introduction of around-the-clock trading could potentially reduce the VRP, as increased liquidity and continuous trading would mitigate overnight risk exposure for market participants.

Let us know what you think in the comments below or in the discussion forum.

References

[1] J Terstegge, Intermediary Option Pricing, 2024, Copenhagen Business School

Originally Published Here: Inventory Risk and Its Impact on the Volatility Risk Premium

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