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Forecasting Volatility in the Presence of Limits to Arbitrage

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  • Lu Hong
  • Tom Nohel
  • Steven Todd

Abstract

In this article, we develop a novel model to forecast the volatility of S&P 500 futures returns by considering measures of limits to arbitrage. When arbitrageurs face constraints on their trading strategies, option prices can become disconnected from fundamentals, resulting in a distortion that reflects the limits to arbitrage. The corresponding market based implied volatility will therefore also contain these distortions. Our contributions are both conceptual and empirical. Conceptually, the limits to arbitrage framework can shed light on relative asset prices as exemplified by this particular study. Empirically, our volatility forecasting model explains 71% of the variation in realized volatility, a substantial improvement over a naive forecast based only on lagged realized volatility, which produces an R-super-2 of 53%. © 2014 Wiley Periodicals, Inc. Jrl Fut Mark 35:987–1002, 2015

Suggested Citation

  • Lu Hong & Tom Nohel & Steven Todd, 2015. "Forecasting Volatility in the Presence of Limits to Arbitrage," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 35(11), pages 987-1002, November.
    • Handle: RePEc:wly:jfutmk:v:35:y:2015:i:11:p:987-1002
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    Cited by:

    1. Manabu Asai & Michael McAleer, 2017. "Forecasting the volatility of Nikkei 225 futures," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 37(11), pages 1141-1152, November.
    2. Xu Gong & Boqiang Lin, 2018. "Structural breaks and volatility forecasting in the copper futures market," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 38(3), pages 290-339, March.

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