The Limits to Volatility Predictability: Quantifying Forecast Accuracy Across Horizons

Abstract

Volatility forecasting is crucial for portfolio management, risk management, and pricing of derivative securities. Still, little is known about how far ahead one can forecast volatility. First, in this paper we introduce the notions of the spot and forward predicted volatilities and propose to describe the term structure of volatility predictability by the spot and forward forecast accuracy curves. Then, by employing a few popular time-series volatility models, we perform a comprehensive empirical study on the horizon of volatility predictability. Our results suggest that, whereas the spot volatility can be predicted over horizons that extend to 35 weeks, the horizon of the forward volatility predictability is rather short and limited to approximately 7.5 weeks. Finally, we suggest a plausible explanation for why standard models fail to provide sensible longer-horizon volatility forecasts.

Keywords: spot volatility, forward volatility, volatility forecasting, forecast accuracy, term structure, out-of-sample forecasting, model comparison, meta-analysis

JEL Classification: C22, C53, C58, G17