Thursday, December 11, 2008

The Predictive Power of Implied Volatility: Evidence from the Over-the-Counter Stock Index Options Market in Hong Kong and Japan by Wayne Yu, Evans Lui

In preparing for this weekend's derivatives lecture, I found this new paper by Yu and Lui that is consistent with the previous view that Implied Volatility is a better forecaster than either historical (naive) forecasts or GARCH forecasts.

One look at their paper from SSRN-The Predictive Power of Implied Volatility: Evidence from the Over-the-Counter Stock Index Options Market in Hong Kong and Japan by Wayne Yu, Evans Lui:

"Our findings suggest that implied volatility is superior to historical volatility or a GARCH-type volatility forecast in predicting future volatility in both the OTC and exchange markets. Our results also hold when we use the overlapping sampling procedure. We also compare the predictive power of implied volatility in the OTC market to that in the exchange market and we find that both markets are of similar efficiency.

"Using a proprietary database on the index options trading, we examine the predictive power of the implied volatility of both OTC and exchange-traded index options in Hong Kong and Japan. For the OTC market, our analysis reveals that the implied volatility of index options is informative of future realized volatility, that it outperforms the historical volatility and the GARCH(1,1) volatility forecast, and that it subsumes both of the historically-based volatility measures. Those findings are the same when we use the overlapping daily data. Our findings therefore support a popular theoretical proposition that implied volatility should be efficient since it is determined by market participants who are more informed and/or trained for predicting future volatility. After all, implied volatility is a forward-looking forecast, unlike any of the historically-based volatility including the more sophisticated GARCH forecast. Consistent with prior studies such as Christensen & Prabhala (1998) and Hansen (2001), in spite of its outperformance over the historically-based volatility measures, implied volatility is not an unbiased estimator for future volatility."

Now since this is looking at Hong Kong and Japanese markets, it might be useful to look back at some of the previous work on US option markets. For instance, consider this dated examination from Jonathan Godbey and myself.

Forecasting Power of Implied Volatility:Evidence from Individual Equities

"We find that [Implied Volatility (IV), Historical Volatility (HV) and GARCH based forecasts (GAR)] all provide useful information in forecasting realized volatility. However, the information content of the variables is not the same. Both alone and in more inclusive models, IV has more predictive ability than HV or GAR. Moreover, when all variables are examined simultaneously,
only IV is significant for all quintiles. These findings are consistent with the hypothesized view that IV has higher information content than HV or GAR. Equally interestingly, we show that while implied volatility is a significant predictor of realized volatility, its predictive ability increases with option market volume. This last finding may have important implications for options that trade infrequently.

Our work is unique in that we look at implied volatility from calls and puts separately while previous research relied solely on calls or an index of both. Because individual equity options are American options, the implied volatility based on puts and calls may be different. By keeping the data separate, we are able to show that the implied volatility estimate from each type of option has the similar amount of information and this information content is positively related to
the liquidity of the options"


*-RUDY-* said...

In my experience,
Realized Volatility >> Implied Volatility >> GARCH >> Historical Volatility defined as the standard deviation of a series of returns.

Will you mention your students what is Realized Volatility too?


FinanceProfessor said...

Yes, we will be discussing realized volatility.