The Information Content of Model-Free Implied Volatility

Authors

  • Xin Cheng,

    1. Xin Cheng is a Research Analyst at McKinsey & Company Shanghai, China
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  • Joseph K.W. Fung

    Corresponding author
    • Joseph K.W. Fung is a Professor of Finance, Department of Finance and Decision Sciences, Hong Kong Baptist University, Kowloon, Hong Kong, China and also a Member of the Council of Advisors, Hong Kong Institute for Monetary Research, Central, Hong Kong, China
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  • We would like to acknowledge with thanks help received from the Hong Kong Exchanges and Clearing Ltd. in providing the data. The authors thank Paul Draper and Bob Webb (the editor) for many helpful comments and suggestions. This study is based, in part, on Cheng's PhD thesis at Hong Kong Baptist University. The views expressed in this study are those of the authors, and do not necessarily reflect those of the Hong Kong Institute for Monetary Research, its Council of Advisors, or the Board of Directors.

Correspondence author, Department of Finance and Decision Sciences, Hong Kong Baptist University, Kowloon, Hong Kong, China. Tel: 852-6332-7992, Fax: 852-3411-5585.

Abstract

This study examines the information content of model-free implied volatility (MFIV) estimates with respect to the options and futures markets in Hong Kong. In this study, the volatility forecasting performance of MFIV is compared, using different prediction horizons, to IV estimates based on Black's futures option pricing model (BIV) and time-series forecasts based on historical volatility (TS-HV). The results show that the BIV prediction is unbiased for different horizon forecasts. MFIV outperforms TS-HV forecasts and, most importantly, BIV subsumes the information content of both MFIV and TS-HV forecasts. The results are largely maintained for next-day forecasts but the forecasting quality of the two IV measures declines as expiration day approaches. The information contents of MFIV and TS-HV forecasts are complementary. © 2012 Wiley Periodicals, Inc. Jrl Fut Mark 32:792-806, 2012

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