Forecasting Volatility in the Presence of Limits to Arbitrage

Forthcoming in the Journal of Futures Markets

30 Pages Posted: 20 Sep 2014

See all articles by Lu Hong

Lu Hong

Loyola University of Chicago

Tom Nohel

Loyola University of Chicago

Steven K. Todd

Loyola University of Chicago

Date Written: August 12, 2014

Abstract

In this paper, we develop a novel model to forecast the volatility of S&P 500 futures returns by considering measures of limits to arbitrage. When arbitrageurs face constraints on their trading strategies, option prices can become disconnected from fundamentals, resulting in a distortion that reflects the limits to arbitrage. The corresponding market based implied volatility will therefore also contain these distortions. Our contributions are both conceptual and empirical. Conceptually, the limits to arbitrage framework can shed light on relative asset prices as exemplified by this particular study. Empirically, our volatility forecasting model explains 71% of the variation in realized volatility, a substantial improvement over a naive forecast based only on lagged realized volatility, which produces an R2 of 53%.

Keywords: Volatility Forecasting, Implied Volatility, Limits to Arbitrage

JEL Classification: G1, G12,G13

Suggested Citation

Hong, Lu and Nohel, Tom and Todd, Steven K., Forecasting Volatility in the Presence of Limits to Arbitrage (August 12, 2014). Forthcoming in the Journal of Futures Markets, Available at SSRN: https://ssrn.com/abstract=2498025 or http://dx.doi.org/10.2139/ssrn.2498025

Lu Hong

Loyola University of Chicago ( email )

25 East Pearson Street
Chicago, IL 60611
United States

Tom Nohel (Contact Author)

Loyola University of Chicago ( email )

820 North Michigan Avenue
Chicago, IL 60611
United States
312-915-7065 (Phone)
312-915-8508 (Fax)

Steven K. Todd

Loyola University of Chicago ( email )

820 North Michigan Avenue
Chicago, IL 60611
United States
(312) 915-7218 (Phone)
(312) 915-8508 (Fax)

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