We investigate whether funding liquidity and market spillover variables can improve predictions of implied volatility surfaces. Following Goncalves and Guidolin (2006), we adopt a two-stage deterministic approach to model the volatility surfaces. First, we model the daily surfaces as a deterministic polynomial function of moneyness and time-to-maturity. Second, we fit a variety of VARX specifications to capture the dynamics of estimated first-stage coefficients. Through empirical tests on S&P500 and STOXX50 options, we show that incorporating recent dynamics of funding liquidity variables increases the predictability of implied volatilities, while spillover variables can only marginally improve performance when interacted with liquidity ones, especially for STOXX50 options. Economic value is assessed by simulating in real time three different trading strategies based on one-day-ahead forecasts. Although the funding liquidity and spillover-augmented models yield high absolute and risk-adjusted mean returns, profits disappear when we impute plausible transaction costs in the form of bid-ask spreads.

Can Funding Liquidity and Market Spillovers Help Forecast the Dynamics of Implied Volatility Surfaces? Evidence from Equity Index Options

GUIDOLIN, MASSIMO;SAITA, FRANCESCO
2013-01-01

Abstract

We investigate whether funding liquidity and market spillover variables can improve predictions of implied volatility surfaces. Following Goncalves and Guidolin (2006), we adopt a two-stage deterministic approach to model the volatility surfaces. First, we model the daily surfaces as a deterministic polynomial function of moneyness and time-to-maturity. Second, we fit a variety of VARX specifications to capture the dynamics of estimated first-stage coefficients. Through empirical tests on S&P500 and STOXX50 options, we show that incorporating recent dynamics of funding liquidity variables increases the predictability of implied volatilities, while spillover variables can only marginally improve performance when interacted with liquidity ones, especially for STOXX50 options. Economic value is assessed by simulating in real time three different trading strategies based on one-day-ahead forecasts. Although the funding liquidity and spillover-augmented models yield high absolute and risk-adjusted mean returns, profits disappear when we impute plausible transaction costs in the form of bid-ask spreads.
Guidolin, Massimo; Longo, Lorenzo; Saita, Francesco
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Utilizza questo identificativo per citare o creare un link a questo documento: https://hdl.handle.net/11565/3986570
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