Does the variance risk premium (VRP) from NIFTY options drive excess returns in a volatility-selling strategy?

Abstract

Although the variation Risk Premium (VRP), which is the difference between realized variation based on actual index returns and implied variance derived from option prices, has been well-documented in developed financial markets, it is still less understood in emerging economies like India.  Using daily data from the NIFTY 50 index and the India VIX over a five-year period, this study investigates the presence, longevity, and economic impact of VRP in the Indian equities market.  The analysis, which uses a methodology that computes implied variance from India VIX and realized variance from log returns, shows that implied variance regularly surpasses realized variance, producing a statistically significant and positive VRP. This demonstrates that Indian option markets have a premium for uncertainty, which reflects the need for protection against downside and the payment made to sellers for taking on volatility risk.

 There are opportunities for systematic trading methods because the actual data shows that this premium is both sustainable and economically significant.  This premium might be collected by techniques like shorting India VIX futures, creating synthetic short-variance swap positions, and selling at-the-money straddles with delta-hedging.  While these techniques can consistently produce excess returns, descriptive statistics and time-series dynamics show that they are nonetheless vulnerable to significant drawdowns during times of market stress when realized volatility exceeds implied expectations.  These results highlight the structural character of VRP as a type of compensation included into option pricing and are consistent with evidence from around the world.

Crucially, the paper emphasizes how VRP affects regulatory supervision, portfolio diversification, and risk management in the Indian setting.  If strong risk controls are put in place to reduce tail risks, the positive VRP provides investors with a route to systematic excess returns.  The endurance of VRP shows regulators how crucial it is to improve market depth and liquidity in volatility-linked securities in order to facilitate effective risk transfer.  Overall, the findings show that Indian financial markets display risk compensation patterns similar to those of developed nations, extending the worldwide VRP literature to an emerging market context.  In order to help scholars, investors, and policymakers navigate the changing terrain of volatility-based trading in India, the study offers both theoretical insights and practical applicability.