The Economic Value of Using Realized Volatility in Forecasting Future Implied Volatility

Posted: 15 Dec 2008

See all articles by Madhu Kalimipalli

Madhu Kalimipalli

Lazaridis School of Business and Economics, Wilfrid Laurier University

Wing H. Chan

Wilfrid Laurier University - School of Business & Economics; City University of Hong Kong (CityUHK) - Department of Economics & Finance

Ranjini Jha

University of Waterloo - School of Accounting and Finance

Date Written: December 14, 2008

Abstract

We examine the economic benefits of using realized volatility to forecast future implied volatility for pricing, trading, and hedging in the S&P 500 index options market. We propose an encompassing regression approach to forecast future implied volatility and hence future option prices by combining historical realized volatility and current implied volatility. An analysis of delta-neutral straddles and naked and delta-hedged option positions shows that the statistical superiority of historical realized volatility demonstrated in the encompassing regressions and option pricing errors does not translate into economic gains, when trading and hedging in the options markets, after considering trading costs.

Keywords: realized volatility, implied volatility, combination forecasts, volatility timing, option strategies

JEL Classification: G10, G14

Suggested Citation

Kalimipalli, Madhu and Chan, Wing H. and Jha, Ranjini, The Economic Value of Using Realized Volatility in Forecasting Future Implied Volatility (December 14, 2008). Journal of Financial Research, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1316125

Madhu Kalimipalli (Contact Author)

Lazaridis School of Business and Economics, Wilfrid Laurier University ( email )

Waterloo, Ontario N2L 3C5
Canada
519-884-0710 (Phone)

HOME PAGE: http://www.madhukalimipalli.com/

Wing H. Chan

Wilfrid Laurier University - School of Business & Economics ( email )

Waterloo, Ontario N2L 3C5
Canada
519-884-0710, ext. 2773 (Phone)
519-888-1015 (Fax)

City University of Hong Kong (CityUHK) - Department of Economics & Finance ( email )

83 Tat Chee Avenue
Kowloon
Hong Kong

Ranjini Jha

University of Waterloo - School of Accounting and Finance ( email )

200 University Avenue West
Waterloo, Ontario N2L 3G1 N2L 3G1
Canada

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