Implied Volatility with Time-Varying Regime Probabilities

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

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.

• Item Type: MPRA Paper
• Language: English
• Keywords: Implied volatility; option markets; multiplicative error models; forecasting
• Subjects: C - Mathematical and Quantitative Methods > C3 - Multiple or Simultaneous Equation Models ; Multiple Variables > C32 - Time-Series Models ; Dynamic Quantile Regressions ; Dynamic Treatment Effect Models ; Diffusion Processes ; State Space Models; C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C53 - Forecasting and Prediction Methods ; Simulation Methods; G - Financial Economics > G1 - General Financial Markets > G13 - Contingent Pricing ; Futures Pricing

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