Forecasting Volatility in the S&P500 Index

Several people have asked me for copies of this reserach article, which develops a new theoretical framework, the ARFIMA-GARCH model as a basis for forecasting volatility in the S&P 500 Index.  I am in the process of updating the research, but in the meantime a copy of the original paper is available here

Forecast vs Actual Realized Volatility

In this analysis we are concerned with the issue of whether market forecasts of volatility, as expressed in the Black-Scholes implied volatilities of at-the-money European options on the S&P500 Index, are superior to those produced by a new forecasting model in the GARCH framework which incorporates long-memory effects.  The ARFIMA-GARCH model, which uses high frequency data comprising 5-minute returns, makes volatility the subject process of interest, to which innovations are introduced via a volatility-of-volatility (kurtosis) process.  Despite performing robustly in- and out-of-sample, an encompassing regression indicates that the model is unable to add to the information already contained in market forecasts.  However, unlike model forecasts, implied volatility forecasts show evidence of a consistent and substantial bias.  Furthermore, the model is able to correctly predict the direction of volatility approximately 62% of the time whereas market forecasts have very poor direction prediction ability.  This suggests that either option markets may be inefficient, or that the option pricing model is mis-specified.  To examine this hypothesis, an empirical test is carried out in which at-the-money straddles are bought or sold (and delta-hedged) depending on whether the model forecasts exceed or fall below implied volatility forecasts.  This simple strategy generates an annual compound return of 18.64% over a four year out-of-sample period, during which the annual return on the S&P index itself was -7.24%.  Our findings suggest that, over the period of analysis, investors required an additional risk premium of 88 basis points of incremental return for each unit of volatility risk.

Yield Curve Construction Models – Tools & Techniques

Yield Curve

Yield curve models are used to price a wide variety of interest rate-contingent claims.  The existence of several different competing methods of curve construction available and there is no single standard method for constructing yield curves and alternate procedures are adopted in different business areas to suit local requirements and market conditions.  This fragmentation has often led to confusion amongst some users of the models as to their precise functionality and uncertainty as to which is the most appropriate modeling technique. In addition, recent market conditions, which inter-alia have seen elevated levels of LIBOR basis volatility, have served to heighten concerns amongst some risk managers and other model users about the output of the models and the validity of the underlying modeling methods.

The purpose of this review, which was carried out in conjunction with research analyst Xu Bai, now at Morgan Stanley, was to gain a thorough understanding of current methodologies, to validate their theoretical frameworks and implementation, identify any weaknesses in the current modeling methodologies, and to suggest improvements or alternative approaches that may enhance the accuracy, generality and robustness of modeling procedures.

Download paper here.

The Lognormal Mixture Variance Model

LNVM Voatility Surface

The LNVM model is a mixture of lognormal models and the model density is a linear combination of the underlying densities, for instance, log-normal densities. The resulting density of this mixture is no longer log-normal and the model can thereby better fit skew and smile observed in the market.  The model is becoming increasingly widely used for interest rate/commodity hybrids.

In this review of the model, I examine the mathematical framework of the model in order to gain an understanding of its key features and characteristics. 

Download article here.