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Testing the Volatility Term Structure Using Option Hedging Criteria

28 Pages Posted: 7 Nov 2008  

Robert F. Engle

New York University - Leonard N. Stern School of Business - Department of Economics; New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER)

Joshua V. Rosenberg

Federal Reserve Bank of New York

Multiple version iconThere are 2 versions of this paper

Date Written: March 1998

Abstract

The volatility term structure (VTS) reflects market expectations of asset volatility over different horizons. These expectations change over time, giving dynamic structure to the VTS. This paper evaluates volatilitymodels on the basis of their performance in hedging option price changes due to shifts in the VTS. An innovative feature of the hedging approach is its increased sensitivity to several important forms of model misspecification relative to previous testing methods. Volatility hedge parameters are derived for several volatility models incorporating different predicted VTS dynamics and information variables. Hedging tests using S&P500 index options indicate that the GARCH components with leverage VTS estimate is most accurate. Evidence is obtained for meanreversion in volatility and correlation between VTS shifts and S&P500 returns. While a convexity hedge dominates the volatility hedges for the observed sample, this result appears to be due to sample selection bias.

Suggested Citation

Engle, Robert F. and Rosenberg, Joshua V., Testing the Volatility Term Structure Using Option Hedging Criteria (March 1998). NYU Working Paper No. FIN-98-031. Available at SSRN: https://ssrn.com/abstract=1297078

Robert F. Engle (Contact Author)

New York University - Leonard N. Stern School of Business - Department of Economics ( email )

269 Mercer Street
New York, NY 10003
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New York University (NYU) - Department of Finance

Stern School of Business
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New York, NY 10012-1126
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National Bureau of Economic Research (NBER)

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Joshua V. Rosenberg

Federal Reserve Bank of New York ( email )

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New York, NY 10045
United States
212-720-6317 (Phone)
212-720-1582 (Fax)

HOME PAGE: http://www.ny.frb.org/research/economists/rosenberg/index.html

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