Forecasting Volatility Using Long Memory and Comovements: An Application to Option Valuation Under SFAS 123r

31 Pages Posted: 14 Mar 2006 Last revised: 20 Feb 2013

See all articles by George J. Jiang

George J. Jiang

Washington State University

Yisong S. Tian

York University - Schulich School of Business

Date Written: May 28, 2009

Abstract

Horizon-matched historical volatility is commonly used to forecast future volatility for option valuation under the Statement of Financial Accounting Standards 123R. In this paper, we empirically investigate the performance of using historical volatility to forecast long-term stock return volatility in comparison with a number of alternative forecasting methods. Analyzing forecasting errors and their impact on reported income due to option expensing, we find that historical volatility is a poor forecast for long-term volatility and shrinkage adjustment towards comparable-firm volatility only slightly improves its performance. Forecasting performance can be improved substantially by incorporating both long memory and comovements with common market factors. We also experiment with a simple mixed-horizon realized volatility model and find its long-term forecasting performance to be more accurate than historical forecasts but less accurate than long-memory forecasts.

Keywords: Volatility forecasting, Option expensing, Historical volatility, Shrinkage forecast, Long memory, Fractional integration, Comovements

JEL Classification: G13, G18, G38, M52, E37

Suggested Citation

Jiang, George and Tian, Yisong Sam, Forecasting Volatility Using Long Memory and Comovements: An Application to Option Valuation Under SFAS 123r (May 28, 2009). Journal of Financial and Quantitative Analysis (JFQA), Vol. 45, No. 2, 2010. Available at SSRN: https://ssrn.com/abstract=890702

George Jiang

Washington State University ( email )

Department of Finance and Management Science
Carson College of Business
Pullman, WA 99-4746164
United States
509-3354474 (Phone)

HOME PAGE: http://directory.business.wsu.edu/bio.html?username=george.jiang

Yisong Sam Tian (Contact Author)

York University - Schulich School of Business ( email )

4700 Keele Street
Toronto, Ontario M3J 1P3
Canada
416-736-2100, ext 77943 (Phone)
416-736-5687 (Fax)

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