We propose a direct and robust method for quantifying the variance risk premium on financial assets. We show that the risk-neutral expected value of return variance, also known as the variance swap rate, is well approximated by the value of a particular portfolio of options. We propose to use the difference between the realized variance and this synthetic variance swap rate to quantify the variance risk premium. Using a large options data set, we synthesize variance swap rates and investigate the historical behavior of variance risk premiums on five stock indexes and 35 individual stocks. (JEL G10, G12, G13) We thank Yacine Aït-Sahalia (the editor), an anonymous referee, and

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We document a surprising pattern in S&P 500 option prices. When implied volatilities are graphed against a standard measure of moneyness, the implied volatility smirk does not £atten out as maturity increases up to the observable horizon of two years. This behavior contrasts sharply with the implications of many pricing models and with the asymptotic behavior implied by the central limit theorem (CLT).We develop a parsimonious model which deliberately violates the CLT assumptions and thus captures the observed behavior of the volatility smirk over the maturity horizon. Calibration exercises demonstrate its superior performance against several widely used alternatives.

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