Long Memory and the Relation between Implied and Realized Volatility
Posted: 2 Apr 2008
Date Written: 2006
We argue that the predictive regression between implied volatility (regressor) and realized volatility over the remaining life of a European option (regressand) is likely to be a fractional cointegrating relation. Because cointegration is associated with long-run comovements, this classical regression cannot be used to test for option market efficiency and short-term unbiasedness of implied volatility as a predictor of realized volatility. Using narrow-band spectral methods, we provide consistent estimates of the long-run relation between implied and realized volatility even when implied volatility is measured with error and/or volatility is priced but the volatility risk premium is unobservable. Although little can be said about short-term unbiasedness, our results largely support a notion of long-run unbiasedness of implied volatility as a predictor of realized volatility.
Keywords: fractional cointegration' implied volatility' long memory' predictive regression' realized volatility
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