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Volatility says less about the future than accounting rules suggest

Schroeder, Gerhard (2015): Volatility says less about the future than accounting rules suggest.

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Abstract

In theory the market participants use the Black-Scholes-formula to asses the fair value of options as a benchmark. However, the formula requires the forward volatility that has to be assessed itself. On the other hand once the prices are known the socalled implied volatility matching the prices can be determined.

The volatility of the S&P 500 index, the VIX, is such an implied index published by the CBOE. Backtesting suggests that to a reasonable degree rather historical market data are used to determine future values.

Further analysis shows that neither the VIX nor historical volatility are sufficient predictors. In reality both values differ from future values significantly.

Testing the prediction quality by option strategies suggests that the observed level pricing of mispricing cannot be explained by wrong volatility prediction only. The results are compared with prominent options markets lectures.

Regression analysis shows a kind of circular reasoning when historical volatility is used for options trading and returned as implied volatility. The pricing formulas in use need to be revised. Yet, this questionable practice is covered by international accounting standards (IAS/IFRS) allowing "historical data and implied volatility" for "reasonable estimations".

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