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Assessing the Impact of Market Microstructure Noise and Random Jumps on the Relative Forecasting Performance of Option-Implied and Returns-Based Volatility

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Author Info
Gael M. Martin ()
Andrew Reidy
Jill Wright ()

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Abstract

This paper presents a comprehensive empirical evaluation of option-implied and returns-based forecasts of volatility, in which new developments related to the impact on measured volatility of market microstructure noise and random jumps are explicitly taken into account. The option-based component of the analysis also accommodates the concept of model-free implied volatility, such that the forecasting performance of the options market is separated from the issue of misspecification of the option pricing model. The forecasting assessment is conducted using an extensive set of observations on equity and option trades for News Corporation for the 1992 to 2001 period, yielding certain clear results. According to several different criteria, the model-free implied volatility is the best performing forecast, overall, of future volatility, with this result being robust to the way in which alternative measures of future volatility accommodate microstructure noise and jumps. Of the volatility measures considered, the one which is, in turn, best forecast by the option-implied volatility is that measure which adjusts for microstructure noise, but which retains some information about random jumps.

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Paper provided by Monash University, Department of Econometrics and Business Statistics in its series Monash Econometrics and Business Statistics Working Papers with number 10/06.

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Length: 48 pages
Date of creation: 2006
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Handle: RePEc:msh:ebswps:2006-10

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Related research
Keywords: Volatility Forecasts; Quadratic Variation; Intraday Volatility Measures; Model-free Implied Volatility.;

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Find related papers by JEL classification:
C10 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: General - - - General
C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Other Model Applications
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing

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  16. Ole E. Barndorff-Nielsen & Shephard, 2002. "Econometric analysis of realized volatility and its use in estimating stochastic volatility models," Journal Of The Royal Statistical Society Series B, Royal Statistical Society, vol. 64(2), pages 253-280. [Downloadable!] (restricted)
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  17. Anderson, Heather M. & Vahid, Farshid, 2007. "Forecasting the Volatility of Australian Stock Returns: Do Common Factors Help?," Journal of Business & Economic Statistics, American Statistical Association, vol. 25, pages 76-90, January. [Downloadable!] (restricted)
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  20. Ole E. Barndorff-Nielsen, 2004. "Power and Bipower Variation with Stochastic Volatility and Jumps," Journal of Financial Econometrics, Oxford University Press, vol. 2(1), pages 1-37. [Downloadable!] (restricted)
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  24. Jim Griffin & Roel Oomen, 2008. "Sampling Returns for Realized Variance Calculations: Tick Time or Transaction Time?," Econometric Reviews, Taylor and Francis Journals, vol. 27(1-3), pages 230-253. [Downloadable!] (restricted)
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  27. Heston, Steven L, 1993. "A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 6(2), pages 327-43. [Downloadable!] (restricted)
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