THE ECONOMIC VALUE OF USING REALIZED VOLATILITY IN FORECASTING FUTURE IMPLIED VOLATILITY

Authors


  • The authors thank the editor, Gerald Gay, and the referee, George Jiang, for their valuable comments that greatly improved the quality of this article. The authors also thank seminar participants at the Bank of Canada, McMaster University, University of Houston, University of Toronto, York University, Northern Finance Association Meetings 2004, Financial Management Association Meetings 2004, Annual Summer Conference at the Indian School of Business (ISB) 2005, the Eastern Finance Association Meetings 2005, and the Financial Management Association European Conference 2007 for their suggestions. This article received the Best Paper Award (Derivatives Category) at the Northern Finance Association Meetings 2004. The authors gratefully acknowledge Phelim Boyle, Melanie Cao, Peter Christoffersen, Kris Jacobs, Ravi Jagannathan, Mark Kamstra, Raymond Kan, Michael King, Praveen Kumar, Thomas McCurdy, Raul Susmel, and Yisong Tian for helpful comments that have significantly improved the article. This research is supported by the Social Sciences and Humanities Research Council of Canada.

Abstract

We examine the economic benefits of using realized volatility to forecast future implied volatility for pricing, trading, and hedging in the S&P 500 index options market. We propose an encompassing regression approach to forecast future implied volatility, and hence future option prices, by combining historical realized volatility and current implied volatility. Although the use of realized volatility results in superior performance in the encompassing regressions and out-of-sample option pricing tests, we do not find any significant economic gains in option trading and hedging strategies in the presence of transaction costs.

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