The Economic Value of Using Realized Volatility in the Index Options Market
49 Pages Posted: 22 Jun 2006
Date Written: May 31, 2006
We examine the economic benefits of using high frequency volatility measures for pricing, trading and hedging in the S&P 500 index options market. Using the encompassing regression framework, we generate volatility forecasts combining information from long memory high-frequency volatility specifications and option-based implied volatilities. We conduct out-of-sample tests of the volatility forecasts by examining option pricing performance, trading performance based on volatility timing strategies, and the performance of covered options positions for index option writers. Our results support combining forecasts of implied volatility and realized volatility and illustrate that the realized volatility approach has economic value in the context of option pricing and risk management.
Keywords: realized volatility, ARFIMA models, implied volatility, encompassing regressions, combination forecasts, volatility timing, option trading strategies
JEL Classification: G10, G14
Suggested Citation: Suggested Citation