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Keywords:

  • implied volatility;
  • realised volatility;
  • fractional cointegration

ABSTRACT

This paper examines the long-run relationship between implied and realised volatility for a sample of 16 FTSE-100 stocks. We find strong evidence of long-memory, fractional integration in equity volatility and show that this long-memory characteristic is not an outcome of structural breaks experienced during the sample period. Fractional cointegration between the implied and realised volatility is shown using recently developed rank cointegration tests by Robinson and Yajima (2002). The predictive ability of individual equity options is also examined and composite implied volatility estimates are shown to contain information on future idiosyncratic or stock-specific risk that is not captured using popular statistical approaches. Implied volatilities on individual UK equities are thus closely related to realised volatility and are an effective forecasting method particularly over medium forecasting horizons. Copyright © 2011 John Wiley & Sons, Ltd.