How Accurate Is Intraday Implied Volatility in Forecasting Realized Volatility

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Implied volatility is a theoretical value that measures the expected volatility of a financial instrument over a specific period of time. It is derived from the price of a financial instrument and can be used to gauge market expectations.

Implied volatility is often used by traders to make decisions about their trading strategies. A high level of implied volatility indicates that the market is expecting large price movements. A low level of implied volatility indicates that the market is expecting small price movements.

Implied volatility is often calculated using end-of-day data.  However, it can also be calculated using intraday data. Reference [1] examined the properties of intraday implied volatilities in the foreign exchange market. It pointed out,

This study examines the performance of intraday implied volatility (IV) in estimating currency options prices. Options quotations at a different trading time, such as the opening period, midday period and closing period of a trading day with one-month, two months’ and three months’ maturity, are employed to compute intra-day IV for pricing currency options. We use the Mincer–Zarnowitz regression test to analyse the volatility forecast power of IV for three different forecast horizons (within a week, one week and one month). Intraday IV’s capability in estimating currency options price is measured by the mean squared error, mean absolute error and mean absolute percentage error measure. The empirical findings show that intraday IV is the key to accurately forecasting volatility and estimating currency options prices precisely. Moreover, IV at the closing period of the beginning of the week contains crucial information for options price estimation. Furthermore, the shorter maturity intraday IV is suitable for pricing options for a shorter horizon. In comparison, the intraday IV based on the longer maturity options subsumes appropriate information to price options with higher accuracy for the longer horizon. Our paper proposes a new approach to accurately pricing currency options using high-frequency data.

Briefly, the article concluded that,

  • The intraday IV based on one- and two-month maturity options contains the required information to forecast the underlying FX volatility for the forecast horizon of one week and one month, respectively. However, the three-month maturity IV was found to contain no required information to price options accurately;
  • The intraday IV based on the shorter maturity options is suitable for pricing options for a shorter horizon. In comparison, the intraday IV based on the longer maturity options contains the required information for the longer horizon options price;
  • The IV’s information is irrelevant for the price of less than a week horizon options.

References

[1] Thi Le, and Ariful Hoque, Pricing European Currency Options with High-Frequency Data, 2022, Risks 10(11):208

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