A Fundamentally Different Interpretation of the Relation between Implied and Realized Volatility

47 Pages Posted: 2 Mar 2002

See all articles by Federico M. Bandi

Federico M. Bandi

Johns Hopkins University - Carey Business School

Benoit Perron

University of Montreal - Department of Economics; Center for Interuniversity Research and Analysis on Organization (CIRANO); University of Montreal - Center for Interuniversity Research in Econometrics

Date Written: February 15, 2002

Abstract

We argue that the persistence properties of financial market volatility need to be taken into account when carrying out inference about volatility measures, for example when assessing the relation between realized and implied volatility series. If these volatility measures display long memory, as often argued in recent work, then the conventional predictive regression between implied volatility (regressor) and realized volatility over the remaining life of the option (regressand) appears to be a (fractional) cointegrating relation. Since cointegration is associated with long-run comovements, this finding modifies the usual interpretation of such regression as a study towards assessing option market efficiency (based on a certain option pricing model) and/or short-term unbiasedness of implied volatility as a predictor of realized volatility. In this paper we use spectral methods and exploit the potential long memory in the data to design an econometric methodology which is robust to the various issues that the literature on the relation between implied and realized volatility has proposed as plausible explanations (measurement errors and presence of an unobservable time-varying risk premium, for instance) for an estimated slope coefficient less than one, implying biasedness, in the standard predictive regression. Our evidence in favor of long-run unbiasedness is rather strong. Little can be said about market efficiency and/or short-term unbiasedness which were the objects of the previous studies.

Keywords: Realized volatility, implied volatility, predictive regressions, long memory

JEL Classification: C22, G12, G13, G14

Suggested Citation

Bandi, Federico Maria and Perron, Benoit, A Fundamentally Different Interpretation of the Relation between Implied and Realized Volatility (February 15, 2002). Available at SSRN: https://ssrn.com/abstract=301832 or http://dx.doi.org/10.2139/ssrn.301832

Federico Maria Bandi (Contact Author)

Johns Hopkins University - Carey Business School ( email )

100 International Drive
Baltimore, MD 21202
United States

Benoit Perron

University of Montreal - Department of Economics ( email )

C.P. 6128, succursale Centre-Ville
Montreal, Quebec H3C 3J7
Canada
514-343-2126 (Phone)
514-343-5831 (Fax)

Center for Interuniversity Research and Analysis on Organization (CIRANO) ( email )

1130 Sherbrooke west, 14th floor
Montreal H3A 2M8, Quebec
Canada

University of Montreal - Center for Interuniversity Research in Econometrics ( email )

C.P. 6128, Succursale Centre-ville
Montreal, Quebec H3C 3J7
Canada

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