Is Implied Volatility an Informationally Efficient and Effective Predictor of Future Volatility?

Posted: 15 Oct 1998

See all articles by Louis H. Ederington

Louis H. Ederington

University of Oklahoma - Division of Finance

Wei Guan

University of South Florida St. Petersburg

Date Written: January 27, 1998

Abstract

This paper examines (1) whether implied volatility is an unbiased informationally efficient predictor of actual future volatility and (2) its predictive power. If markets are efficient and the option pricing model is correct, then the implied volatility calculated from option prices should be an unbiased and informationally efficient estimator of future volatility, that is, it should correctly impound all available information including the asset's price history. However, numerous studies have found that implied volatility is not informationally efficient and that historical volatilities have incremental predictive power -- often out-predicting implied volatilities. For the S&P 500 options on futures we find the following. One, at least part of the apparent inefficiency of implied volatility from past studies stems from measurement error which biases estimates of the importance of implied volatility downward and of the importance of historical volatility upward. Once we correct for this error, there is no significant inefficiency. Two, implied volatility has strong predictive power -- considerably stronger than found by previous equity index studies. Three, stock market volatility prediction results are quite sensitive to (1) the forecasting horizon and (2) whether the data period covers the October 1987 stock market crash.

JEL Classification: G13, G14

Suggested Citation

Ederington, Louis H. and Guan, Wei, Is Implied Volatility an Informationally Efficient and Effective Predictor of Future Volatility? (January 27, 1998). Available at SSRN: https://ssrn.com/abstract=136689

Louis H. Ederington (Contact Author)

University of Oklahoma - Division of Finance ( email )

Norman, OK 73019
United States
405-325-5591 (Phone)
405-325-7688 (Fax)

Wei Guan

University of South Florida St. Petersburg ( email )

College of Business
140 Seventh Avenue South
St. Petersburg, FL 33701-5016
United States
(727) 873-4945 (Phone)
(727) 873-4192 (Fax)

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