The information content of corridor implied variances and their economic difference in the DJX options market

Shan Lu

Research output: Working paperDiscussion paper

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Abstract

This paper investigates the ability of corridor implied variances (CIV) with different corridors to forecast conditional volatility of DJIA index returns, and compares their performance with a CBOE volatility index, VXD, by employing several GARCH models in a model-based out-of-sample context. Besides, it explores the reasons behind the differences in the forecasting ability of CIVs and VXD through a decomposition of the model-free implied volatility. In addition, it addresses the economic difference among aforementioned implied volatility measures in a simulated options market. We find that narrow-corridor CIVs outperform wide-corridor CIVs and VXD in terms of the forecasting ability, as wide-corridor CIVs and VXD impound information from deep out-of-the-money options whose prices contain large volatility risk premiums and may not reflect a fair market expectation of volatility. In the economic sense, wide-corridor CIVs and VXD outperform narrow-corridor CIVs in turbulent periods, while narrow-corridor CIVs outperform wide-corridor CIVs and VXD in medium- and low-volatility periods. The profitability pattern is consistent both in-sample and out-of-sample, before and after transaction costs are considered, and is also robust to option strategy choices.
Original languageEnglish
PublisherUniversity of Aberdeen Business School
Number of pages51
Publication statusPublished - Mar 2017

Publication series

NameDiscussion Paper in Economics
PublisherUniversity of Aberdeen
No.3
Volume17
ISSN (Electronic)0143-4543

Keywords

  • Corridor implied variance
  • model-free implied volatility
  • information content
  • volatility forecasting
  • GARCH models
  • option trading strategy

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