Information Content of Volatility Spreads

Abstract

This study reexamines the determinants of volatility spreads and suggests a new forecast of future volatilities. Contrary to earlier volatility forecasts, the newly introduced forecast is applicable when investors are not risk-neutral or when underlying returns do not follow a Gaussian probability distribution. This implies that the method is consistent with the presence of risk premia for other risks such as volatility risk. Using S&P 500 index options, we show that the new volatility forecast outperforms other volatility forecasts including risk-neutral implied volatility and historical volatility in two aspects. First, the new forecast is superior to other estimates in terms of forecasting errors for future realized volatilities. Second, it is an unbiased estimator of future realized volatilities. This is shown using an encompassing regression analysis.

Keywords: Volatility spreads, Realized volatility, Implied volatility, Historical volatility, Risk preference, Skewness, Kurtosis

JEL Classification: G11, G13