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Long Memory and the Relation Between Implied and Realized Volatility

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  • Federico M. Bandi
  • Benoit Perron

Abstract

We argue that the predictive regression between implied volatility (regressor) and realized volatility over the remaining life of a European option (regressand) is likely to be a fractional cointegrating relation. Because cointegration is associated with long-run comovements, this classical regression cannot be used to test for option market efficiency and short-term unbiasedness of implied volatility as a predictor of realized volatility. Using narrow-band spectral methods, we provide consistent estimates of the long-run relation between implied and realized volatility even when implied volatility is measured with error and/or volatility is priced but the volatility risk premium is unobservable. Although little can be said about short-term unbiasedness, our results largely support a notion of long-run unbiasedness of implied volatility as a predictor of realized volatility. Copyright 2006, Oxford University Press.

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  • Federico M. Bandi & Benoit Perron, 2006. "Long Memory and the Relation Between Implied and Realized Volatility," Journal of Financial Econometrics, Oxford University Press, vol. 4(4), pages 636-670.
    • Handle: RePEc:oup:jfinec:v:4:y:2006:i:4:p:636-670
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    File URL: http://hdl.handle.net/10.1093/jjfinec/nbl003
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    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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