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Does the Option Market Produce Superior Forecasts of Noise-Corrected Volatility Measures?

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  • Gael M. Martin

    ()

  • Andrew Reidy
  • Jill Wright

    ()

Abstract

This paper presents a comprehensive empirical evaluation of option-implied and returns-based forecasts of volatility, in which recent developments related to the impact on measured volatility of market microstructure noise are taken into account. The paper also assesses the robustness of the performance of the option-implied forecasts to the way in which those forecasts are extracted from the option market. Using a test for superior predictive ability, model-free implied volatility, which aggregates information across the volatility 'smile', and at-the-money implied volatility, which ignores such information, are both tested as benchmark forecasts. The forecasting assessment is conducted using intraday data for three Dow Jones Industrial Average (DJIA) stocks and the S&P500 index over the 1996-2006 period, with future volatility proxied by a range of alternative noise-corrected realized measures. The results provide compelling evidence against the model-free forecast, with its poor performance linked to both the bias and excess variability that it exhibits as a forecast of actual volatility. The positive bias, in particular, is consistent with the option market factoring in a substantial premium for volatility risk. In contrast, implied volatility constructed from liquid at-the-money options is given strong support as a forecast of volatility, at least for the DJIA stocks. Neither benchmark is supported for the S&P500 index. Importantly, the qualitative results are robust to the measure used to proxy future volatility, although there is some evidence to suggest that any option-implied forecast may perform less well in forecasting the measure that excludes jump information, namely bi-power variation.

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Bibliographic Info

Paper provided by Monash University, Department of Econometrics and Business Statistics in its series Monash Econometrics and Business Statistics Working Papers with number 5/07.

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Length: 41 pages
Date of creation: Jun 2007
Date of revision:
Handle: RePEc:msh:ebswps:2007-5

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Keywords: Volatility Forecasts; Quadratic Variation; Intraday Volatility Measures;

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Citations

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Cited by:
  1. Le-Yu Chen & Jerzy Szroeter, 2009. "Hypothesis testing of multiple inequalities: the method of constraint chaining," CeMMAP working papers CWP13/09, Centre for Microdata Methods and Practice, Institute for Fiscal Studies.
  2. Jozef Barunik & Michaela Barunikova, 2012. "Revisiting the fractional cointegrating dynamics of implied-realized volatility relation with wavelet band spectrum regression," Papers 1208.4831, arXiv.org, revised Feb 2013.
  3. Jason Ng & Catherine S. Forbes & Gael M. Martin & Brendan P.M. McCabe, 2011. "Non-Parametric Estimation of Forecast Distributions in Non-Gaussian, Non-linear State Space Models," Monash Econometrics and Business Statistics Working Papers 11/11, Monash University, Department of Econometrics and Business Statistics.
  4. Taylor, Stephen J. & Yadav, Pradeep K. & Zhang, Yuanyuan, 2010. "The information content of implied volatilities and model-free volatility expectations: Evidence from options written on individual stocks," Journal of Banking & Finance, Elsevier, vol. 34(4), pages 871-881, April.
  5. Worapree Maneesoonthorn & Gael M. Martin & Catherine S. Forbes & Simone Grose, 2010. "Probabilistic Forecasts of Volatility and its Risk Premia," Monash Econometrics and Business Statistics Working Papers 22/10, Monash University, Department of Econometrics and Business Statistics.

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