Testing the Volatility Term Structure Using Option Hedging Criteria
AbstractThe volatility term structure (VTS) reflects market expectations of asset volatility over different horizons. These expectations change over time, giving dynamic structure to the VTS. This paper evaluates volatility models on the basis of their performance in hedging option price changes due to shifts in the VTS. An innovative feature of the hedging approach is its increased sensitivity to several important forms of model misspecification relative to previous testing methods. Volatility hedge parameters are derived for several volatility models incorporating different predicted VTS dynamics and information variables. Hedging tests using S&P500 index options indicate that the GARCH components with leverage VTS estimate is most accurate. Evidence is obtained for mean-reversion in volatility and correlation between VTS shifts and S&P500 returns. While a convexity hedge dominates the volatility hedges for the observed sample, this result appears to be due to sample selection bias.
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Bibliographic InfoPaper provided by New York University, Leonard N. Stern School of Business- in its series New York University, Leonard N. Stern School Finance Department Working Paper Seires with number 96-24.
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- Robert F. Engle & Joshua Rosenberg, 1998. "Testing the Volatility Term Structure using Option Hedging Criteria," New York University, Leonard N. Stern School Finance Department Working Paper Seires 98-031, New York University, Leonard N. Stern School of Business-.
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