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Forecasting Volatility in the Presence of Limits to Arbitrage
Author(s) -
Hong Lu,
Nohel Tom,
Todd Steven
Publication year - 2015
Publication title -
journal of futures markets
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.88
H-Index - 55
eISSN - 1096-9934
pISSN - 0270-7314
DOI - 10.1002/fut.21696
Subject(s) - volatility (finance) , arbitrage , economics , volatility swap , volatility smile , implied volatility , futures contract , econometrics , financial economics , index arbitrage , forward volatility , risk arbitrage , capital asset pricing model , arbitrage pricing theory
In this article, we develop a novel model to forecast the volatility of S&P 500 futures returns by considering measures of limits to arbitrage. When arbitrageurs face constraints on their trading strategies, option prices can become disconnected from fundamentals, resulting in a distortion that reflects the limits to arbitrage. The corresponding market based implied volatility will therefore also contain these distortions. Our contributions are both conceptual and empirical. Conceptually, the limits to arbitrage framework can shed light on relative asset prices as exemplified by this particular study. Empirically, our volatility forecasting model explains 71% of the variation in realized volatility, a substantial improvement over a naive forecast based only on lagged realized volatility, which produces an R 2 of 53%. © 2014 Wiley Periodicals, Inc. Jrl Fut Mark 35:987–1002, 2015