Article by: Stephen Figlewski
Published by: New York University Stern School of Business
Date: 24 Apr 2004
“This monograph puts together results from several lines of research that I have pursued
over a period of years, on the general topic of volatility forecasting for option pricing
applications. It is not meant to be a complete survey of the extensive literature on the subject,
nor is it a definitive set of prescriptions on how to get the best volatility forecast. While at the
outset, I had hoped to find the Best Method to obtain a volatility input for use in pricing options,
as the reader will quickly determine, it seems that I have been more successful in uncovering the
flaws and difficulties in the methods that are widely used than I have been in determining a
single optimal strategy myself.
“Since I am not revealing the optimal approach to volatility forecasting, the major value of
this work, if any, is more to share with the reader a variety of observations and thoughts about
volatility prediction, that I have arrived at after investigating the problem from a number of
different angles. Two major themes emerge, both having to do with the connection, or perhaps
more correctly, the possibility of a disconnection between theory and practice in dealing with
volatility prediction and its role in option valuation. Two general classes of theories are
involved.
“First, there is the statistical theory involved in modeling price behavior in financial markets. In
Chapter I we bring out the distinction between a physical process and an economic process in
terms of the stability of their internal structure and the prospects for making accurate predictions
about them. We argue that simply applying the theoretical estimation methodology appropriate
for physical processes to the economic process of price behavior in a financial market can lead
one to build models that are too complex and hold inappropriately high expectations about the
potential accuracy of volatility forecasts from those models.
“The second area where conflict between theory and practice arises is in the use of implied
volatility from option market prices. The conflict comes from the disparity between the trading
strategies arbitrage-based derivatives valuation models assume investors follow and what actual
market participants do. In theory, the implied volatility is the market=s well-informed prediction
of future volatility. In practice, however, the arbitrage trading that is supposed to force option
prices into conformance with the market=s volatility expectations may be very hard to execute. It
will also be less profitable and entail more risk than simple market making that maximizes order
flow and earns profits from the bid-ask spread. The latter, however, does little to enforce
theoretical pricing in the face of the forces of supply and demand in the market.
In both cases, I try to point out important implications for estimating volatility that tend to be
overlooked by those following the more traditional lines of thought. I hope the reader will find
some of these insights to be of value.”
Full article (Large PDF): Link