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Implied Volatility with Time-Varying Regime Probabilities

  • Lanne, Markku
  • Ahoniemi, Katja

This paper presents a mixture multiplicative error model with a time-varying probability between regimes. We model the implied volatility derived from call and put options on the USD/EUR exchange rate. The daily first difference of the USD/EUR exchange rate is used as a regime indicator, with large daily changes signaling a more volatile regime. Forecasts indicate that it is beneficial to jointly model the two implied volatility series: both mean squared errors and directional accuracy improve when employing a bivariate rather than a univariate model. In a two-year out-of-sample period, the direction of change in implied volatility is correctly forecast on two thirds of the trading days.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 23721.

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Date of creation: Dec 2008
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Handle: RePEc:pra:mprapa:23721
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