Journal of Risk

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The influence of tracking error on volatility risk premium estimation

James S. Doran

ABSTRACT

I investigate whether the volatility risk premium is negative in energy and equity markets by examining the statistical properties of delta–gamma hedged option portfolios (selling the option, hedging with the underlying contract, and correcting for tracking error with an additional option). By correcting for gamma, these hedged portfolios are not subject to the same discretization and model misspecification problems as traditional deltahedged portfolios. Within a stochastic volatility framework, I demonstrate that ignoring an option’s gamma can lead to incorrect inference on the magnitude of the volatility risk premium. Using a sample of S&P100 Index and natural gas contracts, empirical tests reveal that the delta–gamma hedged strategy outperforms zero and the degree of overperformance is proportional to the level of volatility.

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