The Economic Value of Using Realized Volatility in Forecasting Future Implied Volatility
Wing H. Chan
Wilfrid Laurier University - School of Business & Economics; City University of Hong Kong (CityUHK) - Department of Economics & Finance
University of Waterloo - School of Accounting and Finance
Wilfrid Laurier University - School of Business & Economics
November 1, 2008
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. An analysis of delta-neutral straddles and naked and delta-hedged option positions shows that the statistical superiority of historical realized volatility demonstrated in the encompassing regressions and option pricing errors does not translate into economic gains, when trading and hedging in the options markets, after considering trading costs.
Number of Pages in PDF File: 42
Keywords: realized volatility, implied volatility, combination forecasts, volatility timing, option strategie
JEL Classification: G10, G14
Date posted: November 19, 2006 ; Last revised: December 26, 2008
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