Abstract
The expected returns of short maturity options are large and negative, implying a negative variance risk premium. We find that the magnitude of this negative risk premium is monotonically decreasing with option maturity. The risk premium becomes insignificant for maturities beyond 6 months and the cost to insure the variance risk using long maturity options is 6 bps per month. In the context of a classical asset pricing model, this pattern suggests that variance betas should also be declining with maturity because the risk premium is proportional to the factor loading. However, variance betas are increasing with option maturity, challenging a one-factor model of the variance risk. A one-factor model of the short-term variance risk (level) fails to explain the cross-section of option returns and is forcefully rejected by asset pricing tests. We identify a slope factor in the term structure of risk neutral variances and find it crucial in explaining the cross section of option returns. The slope and level factors combined explain over 90% of the option return variations.
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