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Title Information content of implied volatility

Author(s) Sihvonen, Markus
Date 2010-06-21
URL http://hdl.handle.net/10138/17137

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 Helsingin yliopisto - Helsingfors universitet - University of Helsinki
Tiedekunta-Fakultet-Faculty Laitos-Institution-Department
Faculty of Social Sciences Department of Economic and Political Studies
Tekijä-Författare-Author
Sihvonen, Markus
Työn nimi-Arbetets titel-Title
Information Content of Implied Volatility
Oppiaine-Läroämne-Subject
Economics: Econometrics
Työn laji-Arbetets art-Level Aika-Datum-Month and year Sivumäärä-Sidantal- Number of pages
Master's thesis 2010-05-11 63
Tiivistelmä-Referat-Abstract

In this thesis we study the information content of the market's volatility expectations derived from options or implied
volatility. The key idea of the thesis is that if markets are efficient and the pricing model used is correct, implied volatility
should be an unbiased forecast of future volatility and contain the information in alternative volatility forecasts. Similarly
deviations from unbiasedness or informational efficiency give possible indications on market efficiency and the correctness of
the pricing framework used.

The thesis consists of a theoretical and empirical part. The theoretical part introduces options pricing theory and explains how
implied volatility can be calculated from the prices of traded options as well as reviews related empirical findings. We focus
on the classic Black-Scholes model, which assumes a strict parametric structure for the stock price, as well as on the VIX
index which is a practical implementation of the more flexible model-free implied volatility concept. Both Black-Scholes
implied volatilities calculated from call and put options with different strikes and the VIX index are then used in the empirical
part.

The empirical part focuses on the actual information content of implied volatility calculated from Standard & Poor's 500 index
options. First we study the explanatory power and possible biasness of implied volatility using a common in-sample
regression specification. Then we move on to consider the actual forecasting power of implied volatility and whether this can
be improved with forecasts created with a GARCH model. During the empirical part we focus especially on the differences in
results when using implied volatilities calculated differently.

We find that Black-Scholes implied volatilities calculated from out-of-the-money calls are unbiased forecasts of future
volatility and also have a higher information content than especially at-the-money implied volatilities that have been preferred
in the previous literature. Moreover the information content of the VIX index is also high, though not clearly higher than that
of the best Black-Scholes implied volatilities. Finally, using GARCH forecasts with implied volatility seems to reduce
forecast errors in all cases, though the reduction is not significant with the best implied volatility series including the VIX
index.

Avainsanat-Nyckelord-Keywords
implied volatility
Black-Scholes model
VIX index
information content
GARCH model

Muita tietoja-Övriga uppgifter-Additional information