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THE ECONOMIC VALUE OF USING REALIZED VOLATILITY IN FORECASTING FUTURE IMPLIED VOLATILITY
Author(s) -
Chan Wing Hong,
Jha Ranjini,
Kalimipalli Madhu
Publication year - 2009
Publication title -
journal of financial research
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.319
H-Index - 49
eISSN - 1475-6803
pISSN - 0270-2592
DOI - 10.1111/j.1475-6803.2009.01249.x
Subject(s) - implied volatility , volatility smile , volatility (finance) , volatility swap , economics , forward volatility , volatility risk premium , econometrics , variance swap , realized variance , financial economics , stochastic volatility , valuation of options , transaction cost , finance
We examine the economic benefits of using realized volatility to forecast future implied volatility for pricing, trading, and hedging in the S&P 500 index options market. We propose an encompassing regression approach to forecast future implied volatility, and hence future option prices, by combining historical realized volatility and current implied volatility. Although the use of realized volatility results in superior performance in the encompassing regressions and out‐of‐sample option pricing tests, we do not find any significant economic gains in option trading and hedging strategies in the presence of transaction costs.