Breaking Down the Volatility Risk Premium: Overnight vs. Intraday Returns

The decomposition of the volatility risk premium (VRP) into overnight and intraday components is an active area of research. Most studies indicate that the VRP serves as compensation for investors bearing overnight risks.

Reference [1] continues this line of research, with its main contribution being the decomposition of the variance risk premium into overnight and intraday components using a variance swap approach. The study also tests the predictive ability of these components and examines the seasonality (day-of-week effects) of the VRP.

The authors pointed out,

This paper uses the P&L of a hypothetical variance swap position and breaks down the variance risk premium into its overnight and intraday components to provide some further insights on the nature of the variance risk premium. In the empirical analysis we use implied variance stock indices in US, Europe and Asia and find that the variance risk premium switches sign between overnight and intraday periods. During the overnight period the variance risk premium is negative and during the intraday trading period the variance risk premium becomes positive. Our findings suggest that the negative variance risk premium reported in numerous previous studies is primarily driven by the overnight period variance risk premium component. We also evaluate the ability of the intraday and overnight variance risk premium to predict future equity returns. We find that that the intraday component captures short-term risk and displays predictive ability at 1–3-month horizons, while the overnight component reflects longer term risk and displays predictive ability at 6-12-month horizons.

In summary, the study reaffirms that the variance risk premium is significantly negative during the non-trading overnight period, while it becomes positive and often insignificant during the intraday trading period.

An interesting finding is the day-of-week seasonality. For instance, going long volatility at the open and closing the position at the close tends to be profitable on most days, except Fridays.

Let us know what you think in the comments below.

References

[1] Papagelis, Lucas and Dotsis, George, The Variance Risk Premium Over Trading and Non-Trading Periods (2024). https://ssrn.com/abstract=4954623