The Role of Implied Volatility in Forecasting Future Realized Volatility and Jumps in Foreign Exchange, Stock, and Bond Markets

41 Pages Posted: 23 Jun 2008

See all articles by Thomas Busch

Thomas Busch

Danske Markets; CREATES

Bent Jesper Christensen

Aarhus University; Aarhus University; Aarhus University

Morten Ørregaard Nielsen

Queen's University - Department of Economics

Date Written: June 6, 2007

Abstract

We study the forecasting of future realized volatility in the stock, bond, and foreign exchange markets, as well as the continuous sample path and jump components of this, from variables in the information set, including implied volatility backed out from option prices. Recent nonparametric statistical techniques of Barndor-Nielsen & Shephard (2004, 2006) are used to separate realized volatility into its continuous and jump components, which enhances forecasting performance, as shown by Andersen, Bollerslev & Diebold (2005). We generalize the heterogeneous autoregressive (HAR) model of Corsi (2004) to include implied volatility as an additional regressor, and to the separate forecasting of the realized components. We also introduce a new vector HAR (VecHAR) model for the resulting simultaneous system, controlling for possible endogeneity issues in the forecasting equations. We show that implied volatility contains incremental information about future volatility relative to both continuous and jump components of past realized volatility. Indeed, in the foreign exchange market, implied volatility completely subsumes the information content of daily, weekly, and monthly realized volatility measures, when forecasting future realized volatility or its continuous component. In addition, implied volatility is an unbiased forecast of future realized volatility in the foreign exchange and stock markets. Perhaps surprisingly, the jump component of realized return volatility is, to some extent, predictable, and options appear to be calibrated to incorporate information about future jumps in all three markets.

Keywords: Bipower variation, HAR, Heterogeneous Autoregressive Model, implied volatility, jumps, options, realized volatility, VecHAR, volatility forecasting

JEL Classification: C22, C32, F31, G1

Suggested Citation

Busch, Thomas and Christensen, Bent Jesper and Nielsen, Morten Orregaard, The Role of Implied Volatility in Forecasting Future Realized Volatility and Jumps in Foreign Exchange, Stock, and Bond Markets (June 6, 2007). Available at SSRN: https://ssrn.com/abstract=1148738 or http://dx.doi.org/10.2139/ssrn.1148738

Thomas Busch

Danske Markets ( email )

Holmens Kanal 2-12
DK-1092 Copenhagen K
Denmark

CREATES ( email )

Univeristy of Aarhus
Building 350
DK-8000 Aarhus C
Denmark

HOME PAGE: http://person.au.dk/da/tbusch@econ

Bent Jesper Christensen (Contact Author)

Aarhus University ( email )

Fuglesangs Alle 4
DK-8210 Aarhus V, 8210
Denmark

Aarhus University ( email )

Fuglesangs Alle 4
DK-8210 Aarhus V, 8210
Denmark

Aarhus University ( email )

Fuglesangs Alle 4
DK-8210 Aarhus V, 8210
Denmark

Morten Orregaard Nielsen

Queen's University - Department of Economics ( email )

94 University Avenue
Kingston K7L 3N6, Ontario
Canada

HOME PAGE: http://www.econ.queensu.ca/faculty/nielsen/

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