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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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  • 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 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.

Suggested Citation

  • Gael M. Martin & Andrew Reidy & Jill Wright, 2006. "Assessing the Impact of Market Microstructure Noise and Random Jumps on the Relative Forecasting Performance of Option-Implied and Returns-Based Volatility," Monash Econometrics and Business Statistics Working Papers 10/06, Monash University, Department of Econometrics and Business Statistics.
  • Handle: RePEc:msh:ebswps:2006-10
    as

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    File URL: http://www.buseco.monash.edu.au/ebs/pubs/wpapers/2006/wp10-06.pdf
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    References listed on IDEAS

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    More about this item

    Keywords

    Volatility Forecasts; Quadratic Variation; Intraday Volatility Measures; Model-free Implied Volatility.;

    JEL classification:

    • C10 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - General
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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