Financial market volatility plays a very important role in the theory and practice of asset pricing, risk management, portfolio selection and hedging. Because of its importance, both market participants and financial academics have long been interested in estimating and predicting future volatility.
Volatility models that fall into one of two categories, the ARCH family and the stochastic volatility family, have been commonly used in modeling volatility for estimation and forecasting. These models are based on historical data. Recently there has been a growing interest in extracting volatility from prices of options. This is because if markets are efficient and the option pricing model is correct, then the implied volatility calculated from option prices should be an unbiased and efficient estimator of future realized volatility, that is, it should correctly subsume information contained in all other variables including the asset’s price history.
The hypothesis that implied volatility (IV) is a rational forecast of subsequently realized volatility (RV) has been frequently tested in the literature. Empirical research across countries and markets so far has failed to provide a definitive answer. Early research on the predictive content of IV found that IV explains variation in future volatilities better than historical volatility (HV) (see, for example, Latane and Rendleman (1976), Chiras and Manaster (1978), Schmalensee and Trippi (1978) and Beckers (1981)).
In subsequent research, Kumar and Shastri (1990), Randolph et al. (1991), Day and Lewis (1992), Lamoureuax and Lastrapes (1993), and Canina and Figlewski (1993) found that IV is a poor forecast of the subsequently RV over the remaining life of the option. Specifically, Day and Lewis (1992) and Lamoureux and Lastrapes (1993) find that IV has some predictive power, but that GARCH and/or HV improve this predictive power and Canina and Figlewski (1993) show the absence of correlation between IV and future RV over the remaining life of the option.
But the findings in the papers above are subject to a few problems in their research designs, such as maturity mismatch and/or overlapping samples, among others. Overcoming these problems, more recent papers (e.g., Jorion (1995), Fleming (1998), Moraux et al. (1999), Bates (2000), Blair et al. (2001), Simon (2003), Corrado and Miller (2005)) confirm that IV still outperforms other volatility measures in forecasting future volatility, although there is some evidence that it is a biased forecast. Christensen and Prabhala (1998), using monthly non-overlapping data, find that IV in at-the-money one-month OEX call options is an unbiased and efficient forecast of ex-post RV after the 1987 stock market crash.
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The information content of implied volatility in the crude oil futures market
