Friday, January 30, 2009

Implied Volitility Reflects Risk Premium

Implied volitility is typically greater than historical volitility. Why is that?

I suggest that reflects the value of a reduction of risk. 

What is worth more, a ticket for a 1 in 10 chance to earn $10, or a single dollar bill? It depends on how much money you have. If you have an un-ending money supply, you could buy an infinate number of tickets, and the value would be equal to the same number of dollar bills. 

But if you have a limited money supply, you might not want to take the risk. The value of risk reduction has evidence in insurance. If someone has an infinate money supply, insurance only makes sense if the insurance company has access to cheaper resources than you do; the reducion in risk is of no value. 

Similarly, stock option prices should incorporate the value of risk reduction whenever money supply is limited. In fact, the variance between historical and implied volititliy may be used to gauge the money supply.

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