Option Prices and Implied Volatilities: An Empirical Analysis

This paper investigates the efficiency of Australian options markets using a version of the Black-Scholes model. Under the joint null hypothesis that the pricing model is valid, and that forecasts are efficient, the implied volatilities calculated from observed option prices should be efficient predictors of squared changes in the prices of the underlying instruments. This hypothesis is tested using weekly data on prices of Australian financial futures options, and over-the-counter currency options. The results indicate significant forecasting biases for each of the contracts studied. In each case, implied volatilities appear to overpredict changes in the true volatility of underlying prices. Although these conclusions are conditional on the validity of the pricing model used to calculate implied volatilities, our evidence suggests that biases in the Black-Scholes formula are unlikely to explain fully the apparent forecast biases.