Value for Equity Index Options: Expected—Not Realized—Volatility and the Distribution of Forecasts

Abstract

Models of option returns neglect the distribution of expected asset volatility, unfortunately for not only derivatives traders but also investors who monitor options as <i>fear gauges</i>. Six common GARCH (generalized autoregressive conditional heteroskedasticity) models afford estimates of the physical, rather than the risk-neutral, distribution of anticipated—instead of historical—volatility, as well as of volatility disagreement. This value specification covering nine global equity indexes and five expiries from 1 to 12 months fits implied volatilities closely, with sizeable and robust error-correction speeds out of sample, all else equal. Exploratory backtests of delta-neutral trading rules produce high Sharpe ratios and alphas, with modest drawdowns and skew.