An empirical investigation of the premium for volatility risk in currency options for the British pound

This article estimates the premium for volatility risk using option prices for the British pound from 1993 to 1995. The risk premium is estimated as the difference between a hedge portfolio return and risk-free return. The annualized premium for volatility risk is statistically non-zero. Further, the risk premium is both variant to the option's moneyness and positively related to the level of volatility. The relation of the risk premium to volatility is not proportional, however. The finding of a nonzero risk premium contradicts the assumption of a zero price of volatility risk in many existing stochastic-volatility option pricing models and the option pricing formulas in those models.