Implied volatility structure and forecasting efficiency: evidence from Indian option market

Abstract

Volatility forecasting is an important task in financial market. The Black-Scholes formula provided investors a relationship between volatility and option value. Investors thereby could derive volatility implied from options traded in the market; this is what is known as implied volatility. Implied volatility is derived from contracts that are traded based on the market participants? expectations about the future volatility that cannot be captured by statistical models. For this reason, research on volatility has attracted a lot of attention within finance, both academics and practitioners. First, the volatility structure implied by SandP CNX Nifty and selected stock options are examined during the period from January 2002 to June 2010. The volatility structure with respect to moneyness and time to maturity are investigated for both call and put option price series. It is found that the ?U? pattern is more pronounced for the call and put options implied volatilities. The results indicate that the Black-Scholes-Merton model applied in this study tends to misprice in-the-money and out-of-the-money options. At-the-money options are often most actively traded and hence they are less likely to be mispriced. This result is consistent with the well-documented evidence of volatility smile on other market. Second, the relation between implied volatility and realized volatility is investigated by using non-overlapping at-the-money option contract. It is found that implied volatility subsumes all the information to predict the future realized volatility except SBI. The implied volatilities of SandP CNX Nifty option are slightly biased and informationally efficient forecast of future realized volatility. Reliance call and put volatility, Infosys call volatility and ITC put volatility seem to be unbiased and informationally efficient forecast of future realized volatility. Remaining stock options are found to be biased. This implies that EIV problem for the measurement of implied volatility is more likely to exist.