Forecasting the term structure of option implied volatility: The power of an adaptive method
Ying Chen, Qian Han, Linlin Niu
Journal of Empirical Finance (2018) 49: 157-177.(
#002377 20181201 (published) Views:4094
We model the term structure of implied volatility (TSIV) with an adaptive approach to improve predictability, which treats dynamic time series models of globally time-varying but locally constant parameters and uses a data-driven procedure to find the local optimal interval. We choose two specifications of the adaptive models: a simple local AR (LAR) model for a univariate implied volatility series and an adaptive dynamic Nelson-Siegel (ADNS) model of three factors, each based on an LAR, to model the cross-section of the TSIV simultaneously with parsimony. Both LAR and ADNS models uniformly outperform more than a dozen alternative models with significance across maturities for 1-20 day forecast horizons. Measured by RMSE and MAE, the forecast errors of the random walk model can be reduced by between 20% and 60% for the 5 to 20 days ahead forecast. In terms of prediction accuracy of future directional changes, the adaptive models achieve an accuracy range of 60%–90%, which strictly dominates the range of 30%–59% of the alternative models.
JEL-Codes: C32; C53
Keywords: Term structure of implied volatility; Local parametric models; Forecasting