Friday, July 13, 2007

Predicting equity volatility using Implied Volatilty

Predicting actual volatility using Implied Volatility
"In this paper the authors examine460 of the S&P 500 firms to demonstrate that: (1) implied volatility is a better forecaster of realized volatility than historic volatility or GARCH models and (2) the information content of implied volatility significantly decreases with liquidity."
Both points are important. The first says that markets are good at predicting future volatility, but the second shows the limits of markets where there is little volume (an important consideration given the large number options that rarely trade.

Be sure to check this one out! I know the authors ;)

1 comment:

Glyn Holton said...

These are interesting results, and they generally conform to what market participants would expect. Implied vols are not so much predictions of vol as they are option prices expressed as vols. In the FX markets, for example, options are quoted as vols, not prices. Where there is liquidity, market forces drive vols towards a market consensus prediction of what vol will actually be (the paper's first conclusion). Where there is less liquidity, a few dealers can quote prices (vols) that will be more profitable for them (the paper's second conclusion). Note that liquidity can dry up in any market. The worst time to rely on implied vols for anticipating market vol is in a crisis or looming crisis.