Informational Content of S&P 100 Index Options Implied Volatility during 1990-2005

Abstract

Implied volatility has been regarded as an unbiased expectation of the realised volatility under the assumption that the market is informationally efficient and the option pricing model is specified correctly. The purpose of this thesis is to study how well implied volatility predicts future volatility and whether the volatility implied by index option prices offers a better forecast of the future realized volatility than the historical volatility forecast.

The historical volatility is calculated as annualized standard deviation of log returns of S&P 100 stock index portfolio over 30-day period preceding the date of the implied volatility. Implied volatilities can be solved for options from the observed prices using Cox-Ross-Rubinstein binominal model (1979) or Black-Scholes option pricing formula (1973). To mitigate forecasting errors that can arise using these option pricing methods the VIX, index of Chicago Board options Exchange (CBOE), is used as a measure of implied volatility. The predictive power of volatility forecasts is tested with regression based method.

Consistent with the existing literature, the results of this thesis show that implied volatility has significantly more predictive power than realized historical volatility, whether judged by the magnitude of the regression slope coefficients or by the R2 of regressions. In addition implied volatility contains information about future volatility and it appears to be almost unbiased forecast of future volatility.