Volatility Forecasts, Trading Volume and the ARCH vs Option-Implied Volatility Tradeoff

SFU Economics Discussion Paper No. 01-1

Sauder School of Business Working Paper

25 Pages Posted: 21 Feb 2001  

R. Glen Donaldson

University of British Columbia (UBC) - Sauder School of Business

Mark J. Kamstra

York University - Schulich School of Business; Rady School of Management

Date Written: February 2001

Abstract

Market expectations of future return volatility play a crucial role in finance; so too does our understanding of the process by which information is incorporated in security prices through the trading process. This paper seeks to learn something about both of these issues by investigating empirically the role of trading volume (a) in predicting the relative informativeness of volatility forecasts produced by ARCH models versus the volatility forecasts derived from option prices, and (b) in improving volatility forecasts produced by ARCH and option models and combinations of models. We find that if trading volume was low during period t-1 then ARCH is much more important than options for forecasting future stock market volatility. Conversely, if volume was high during period t-1, then option-implied volatility is much more important than ARCH for forecasting future volatility. Our findings reveal an important regime-switching role for trading volume and suggest that option markets may be more efficient in high volume states. Results from various tests also uncover possible sources of volume-related nonlinearity in the relationship between past and future return innovations as captured by asymmetric ARCH models.

Keywords: return volatility, ARCH models, options-implied volatility, trading volume, combining models

JEL Classification: G12, C32, C52, C53

Suggested Citation

Donaldson, R. Glen and Kamstra, Mark J., Volatility Forecasts, Trading Volume and the ARCH vs Option-Implied Volatility Tradeoff (February 2001). SFU Economics Discussion Paper No. 01-1; Sauder School of Business Working Paper. Available at SSRN: https://ssrn.com/abstract=261003 or http://dx.doi.org/10.2139/ssrn.261003

R. Glen Donaldson

University of British Columbia (UBC) - Sauder School of Business ( email )

2053 Main Mall
Department of Finance
Vancouver BC V6T 1Z2
Canada
604-822-8344 (Phone)
604-822-8521 (Fax)

Mark J. Kamstra (Contact Author)

York University - Schulich School of Business ( email )

4700 Keele Street
Toronto, Ontario M3J 1P3
Canada

Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States

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