The Information Content of Implied Volatilities and Model-Free Volatility Expectations: Evidence from Options Written on Individual Stocks

64 Pages Posted: 6 Mar 2008

See all articles by Stephen J. Taylor

Stephen J. Taylor

Lancaster University - Department of Accounting and Finance

Pradeep K. Yadav

University of Oklahoma Price College of Business

Yuanyuan Zhang

Sun Yat-Sen University (SYSU) - Lingnan (University) College; Lancaster University - Department of Accounting and Finance

Multiple version iconThere are 2 versions of this paper

Date Written: 2007

Abstract

The volatility information content of stock options for individual firms is measured using option prices for 149 U.S. firms during the period from January 1996 to December 1999. Volatility forecasts defined by historical stock returns, at-the-money (ATM) implied volatilities and model-free (MF) volatility expectations are compared for each firm. The recently developed model-free volatility expectation incorporates information across all strike prices, and it does not require the specification of an option pricing model.

Our analysis of ARCH models shows that, for one-day-ahead estimation, historical estimates of conditional variances outperform both the ATM and the MF volatility estimates extracted from option prices for more than one-third of the firms. This result contrasts with the consensus about the informational efficiency of options written on stock indices; several recent studies find that option prices are more informative than daily stock returns when estimating and predicting index volatility. However, for the firms with the most actively traded options, we do find that the option forecasts are nearly always more informative than historical stock returns.

When the prediction horizon extends until the expiry date of the options, our regression results show that the option forecasts are more informative than forecasts defined by historical returns for a substantial majority (86%) of the firms. Although the model-free (MF) volatility expectation is theoretically more appealing than alternative volatility estimates and has been demonstrated to be the most accurate predictor of realized volatility by Jiang and Tian (2005) for the S&P 500 index, the results for our firms show that the MF expectation only outperforms both the ATM implied volatility and the historical volatility for about one-third of the firms. The firms for which the MF expectation is best are not associated with a relatively high level of trading in away-from-the-money options.

Keywords: Stock options, Information conten, Implied volatility, Model-free volatility expectations, ARCH models

JEL Classification: C22, C25, G13, G14

Suggested Citation

Taylor, Stephen J. and Yadav, Pradeep K. and Zhang, Yuanyuan, The Information Content of Implied Volatilities and Model-Free Volatility Expectations: Evidence from Options Written on Individual Stocks (2007). Available at SSRN: https://ssrn.com/abstract=1102269 or http://dx.doi.org/10.2139/ssrn.1102269

Stephen J. Taylor

Lancaster University - Department of Accounting and Finance ( email )

The Management School
Lancaster LA1 4YX
United Kingdom
+ 44 15 24 59 36 24 (Phone)
+ 44 15 24 84 73 21 (Fax)

HOME PAGE: http://www.lancs.ac.uk/staff/afasjt

Pradeep K. Yadav

University of Oklahoma Price College of Business ( email )

307 W.Brooks, Room 205A Division of Finance
Norman, OK 73019
United States
4053256640 (Phone)
4053255491 (Fax)

HOME PAGE: http://www.ou.edu/price/finance/faculty/pradeep_yadav.html

Yuanyuan Zhang (Contact Author)

Sun Yat-Sen University (SYSU) - Lingnan (University) College ( email )

Hong Kong

Lancaster University - Department of Accounting and Finance ( email )

Lancaster, Lancashire LA1 4YX
United Kingdom

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