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FRM Part I · FRM Exam Part I · Measuring Return, Volatility, and Correlation

An analyst finds that a stock's 30-day implied volatility is persistently above subsequently realized volatility, with the average gap of about 3 percentage points. Which is the most reasonable explanation?

The persistent gap is best explained by a variance risk premium: investors pay more for options as protection against volatility spikes, so risk-neutral implied volatility tends to exceed subsequently realized volatility on average.

  1. AImplied volatility includes a variance risk premium because option sellers demand compensation for bearing volatility riskCorrect
  2. BBlack-Scholes-Merton always overstates option prices when volatility is constant
  3. CRealized volatility is always measured with look-ahead bias
  4. DImplied volatility is computed from past returns and lags the market

Explanation

Implied volatility reflects risk-neutral expectations, which typically exceed physical expectations due to a negative variance risk premium: investors pay to hedge against volatility spikes. Implied vol is forward-looking, not lagged, so the lag explanation is wrong.

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