Munich Personal RePEc Archive

Implied Volatility with Time-Varying Regime Probabilities

Lanne, Markku and Ahoniemi, Katja (2008): Implied Volatility with Time-Varying Regime Probabilities.

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Abstract

This paper presents a mixture multiplicative error model with a time-varying probability between regimes. We model the implied volatility derived from call and put options on the USD/EUR exchange rate. The daily first difference of the USD/EUR exchange rate is used as a regime indicator, with large daily changes signaling a more volatile regime. Forecasts indicate that it is beneficial to jointly model the two implied volatility series: both mean squared errors and directional accuracy improve when employing a bivariate rather than a univariate model. In a two-year out-of-sample period, the direction of change in implied volatility is correctly forecast on two thirds of the trading days.

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