Construction and Interpretation of Model-Free Implied Volatility

37 Pages Posted: 23 Jun 2008 Last revised: 12 Oct 2011

See all articles by Torben G. Andersen

Torben G. Andersen

Northwestern University - Kellogg School of Management; National Bureau of Economic Research (NBER); Aarhus University - CREATES

Oleg Bondarenko

University of Illinois at Chicago - Department of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: September 17, 2007

Abstract

The notion of model-free implied volatility (MFIV), constituting the basis for the highly publicized VIX volatility index, can be hard to measure with accuracy due to the lack of precise prices for options with strikes in the tails of the return distribution. This is reflected in practice as the VIX index is computed through a tail-truncation which renders it more compatible with the related concept of corridor implied volatility (CIV). We provide a comprehensive derivation of the CIV measure and relate it to MFIV under general assumptions. In addition, we price the various volatility contracts, and hence estimate the corresponding volatility measures, under the standard Black-Scholes model. Finally, we undertake the first empirical exploration of the CIV measures in the literature. Our results indicate that the measure can help us refine and systematize the information embedded in the derivatives markets. As such, the CIV measure may serve as a tool to facilitate empirical analysis of both volatility forecasting and volatility risk pricing across distinct future states of the world for diverse asset categories and time horizons.

Keywords: Model-Free Implied Volatility, Corridor Implied Volatility, Realized Volatility, VIX, Volatility Forecasting, Risk-Neutral Density

JEL Classification: C53, G12, G13

Suggested Citation

Andersen, Torben G. and Bondarenko, Oleg, Construction and Interpretation of Model-Free Implied Volatility (September 17, 2007). Available at SSRN: https://ssrn.com/abstract=1150136 or http://dx.doi.org/10.2139/ssrn.1150136

Torben G. Andersen (Contact Author)

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Oleg Bondarenko

University of Illinois at Chicago - Department of Finance ( email )

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