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Long Memory and the Relation Between Implied and Realized Volatility

  • Federico M. Bandi
  • Benoit Perron

We argue that the predictive regression between implied volatility (regressor) and realized volatility over the remaining life of a European option (regressand) is likely to be a fractional cointegrating relation. Because cointegration is associated with long-run comovements, this classical regression cannot be used to test for option market efficiency and short-term unbiasedness of implied volatility as a predictor of realized volatility. Using narrow-band spectral methods, we provide consistent estimates of the long-run relation between implied and realized volatility even when implied volatility is measured with error and/or volatility is priced but the volatility risk premium is unobservable. Although little can be said about short-term unbiasedness, our results largely support a notion of long-run unbiasedness of implied volatility as a predictor of realized volatility. Copyright 2006, Oxford University Press.

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File URL: http://hdl.handle.net/10.1093/jjfinec/nbl003
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Article provided by Society for Financial Econometrics in its journal Journal of Financial Econometrics.

Volume (Year): 4 (2006)
Issue (Month): 4 ()
Pages: 636-670

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Handle: RePEc:oup:jfinec:v:4:y:2006:i:4:p:636-670
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  1. Comte, F. & Renault, E., 1996. "Long memory continuous time models," Journal of Econometrics, Elsevier, vol. 73(1), pages 101-149, July.
  2. Sassan Alizadeh & Michael W. Brandt & Francis X. Diebold, 2002. "Range-Based Estimation of Stochastic Volatility Models," Journal of Finance, American Finance Association, vol. 57(3), pages 1047-1091, 06.
  3. Donald W.K. Andrews & Patrik Guggenberger, 2000. "A Bias-Reduced Log-Periodogram Regression Estimator for the Long-Memory Parameter," Cowles Foundation Discussion Papers 1263, Cowles Foundation for Research in Economics, Yale University.
  4. Brunetti, Celso & Gilbert, Christopher L., 2000. "Bivariate FIGARCH and fractional cointegration," Journal of Empirical Finance, Elsevier, vol. 7(5), pages 509-530, December.
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  7. Baillie, Richard T. & Bollerslev, Tim & Mikkelsen, Hans Ole, 1996. "Fractionally integrated generalized autoregressive conditional heteroskedasticity," Journal of Econometrics, Elsevier, vol. 74(1), pages 3-30, September.
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  10. Bollerslev, Tim & Ole Mikkelsen, Hans, 1999. "Long-term equity anticipation securities and stock market volatility dynamics," Journal of Econometrics, Elsevier, vol. 92(1), pages 75-99, September.
  11. Dacorogna, Michael M. & Muller, Ulrich A. & Nagler, Robert J. & Olsen, Richard B. & Pictet, Olivier V., 1993. "A geographical model for the daily and weekly seasonal volatility in the foreign exchange market," Journal of International Money and Finance, Elsevier, vol. 12(4), pages 413-438, August.
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  14. Baillie, Richard T., 1996. "Long memory processes and fractional integration in econometrics," Journal of Econometrics, Elsevier, vol. 73(1), pages 5-59, July.
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