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On the role of risk premia in volatility forecasting

Chernov, Mikhail (2007) On the role of risk premia in volatility forecasting. Journal of Business and Economic Statistics, 25 (4). pp. 411-426. ISSN 0735-0015

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Abstract

I explain why at-the-money implied volatility is a biased and inefficient forecast of future realized volatility using the insights from the empirical option-pricing literature. First, I explain how the risk premia, which manifest themselves through disparity between objective and risk-neutral probability measures, lead to the disparity between realized and implied volatilities. Second, I show that this disparity is a function of the latent spot volatility, which I estimate using the historical volatility and high–low range. An empirical exercise that is based on at-the-money implied volatility series of foreign currencies and stock market indexes, is supportive of my risk premia-based explanation of the bias.

Item Type: Article
Official URL: http://www.amstat.org/publications/jbes.cfm
Additional Information: © 2007 American Statistical Association
Library of Congress subject classification: H Social Sciences > HB Economic Theory
H Social Sciences > HG Finance
Journal of Economic Literature Classification System: E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E47 - Forecasting and Simulation
F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F47 - Forecasting and Simulation
Sets: Departments > Finance
Collections > Economists Online
Rights: http://www.lse.ac.uk/library/usingTheLibrary/academicSupport/OA/depositYourResearch.aspx
Date Deposited: 10 Nov 2011 10:08
URL: http://eprints.lse.ac.uk/39393/

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