The relation between implied and realised volatility in the Danish option and equity markets

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Abstract:

We show that the conclusions to be drawn concerning the informational efficiency of illiquid options markets depend critically on whether one carefully recognises and appropriately deals with the econometrics of the errors‐in‐variables problem. This paper examines the information content of options on the Danish KFX share index. We consider the relation between the volatility implied in an option’s price and the subsequently realised index return volatility. Since these options are traded infrequently and in low volumes, the errors‐in‐variables problem is potentially large. We address the problem directly using instrumental variables techniques. We find that when measurement errors are controlled for, call option prices even in this very illiquid market contain information about future realised volatility over and above the information contained in historical volatility.

Keywords: Illiquid markets; Implied volatility; Index options; Market efficiency; Volatility forecasting

Document Type: Original Article

DOI: http://dx.doi.org/10.1111/1467-629X.00059

Affiliations: School of Economics and Management, University of Aarhus, Building 350, DK‐8000 Aarhus C, Denmark

Publication date: November 1, 2001

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