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# MP R A

## Implied Volatility using Variance Decomposition Method

Joocheol Kim, WooWhan Kim and KiHyung Kim Yonsei Univ.

November 2006

Online at http:// mpra.ub.uni-muenchen.de/ 936/ MPRA Paper No. 936, posted 27. November 2006 / 09:52

## Implied Volatility using Variance Decomposition Method

Joocheol Kim
Department of Economics, Yonsei University, Korea

WooWhan Kim
Department of Applied Statistics, Yonsei University, Seoul, Korea

KiHyung Kim1
Yonsei School of Business, Seoul, Korea

Abstract
Nov. 2006-11-27

This paper provides a new method-what is called variance decomposition method- to calculate market volatility index implied in option price and compares the prediction quality of realized volatility with VIX that is well known as volatility index. The volatility using variance decomposition has an advantage, since it reflects market participants expectation. Our method is based on the variance calculation decomposed into two components which are conditioned on other variable, strike price in this paper. We use highfrequency data (daily based) to calculate variance decomposition volatility as

## Corresponding Author: kim5246@yonsei.ac.kr

well as VIX and compare the prediction quality of these indexes for realized volatility. The empirical result shows that variance decomposition volatility index is similar to the dynamics of VIX and shows good prediction power of realized volatility. We also discuss our findings in long range dependence of realized volatility with respect to variance decomposition and VIX.

## Key words: Realized Volatility, Implied Volatility, Variance decomposition,

VIX

1. Introduction

This paper provides a new methodology of volatility implied in option price and shows predictive power of realized volatility based on this method. The proposed method, named variance decomposition volatility (VD hereafter), is derived using variance formula conditioned on other variable. Similar to VIX issued by Chicago Board Options Exchange (CBOE), VD is also contained future market expectation, since it is calculated using option price data. Recent studies show that the volatility implied in option price is more informative and has good prediction quality of realized volatility.

The classical methods to calculate volatility are divided into two main streams. One is oriented the stochastic behavior of underlying asset price, for example Exponentially Weighted Moving Average (EWMA), Generalized Autoregressive Conditional Heteroscedasticity (GARCH) and so on. The other is focused on extracting volatility from price of derivatives, lather than underlying asset itself. The latter has a great deal of advantage since it possibly shows market participants expectation on future price. Therefore, there are many attempts to describe market volatility using derivatives. One of well known method is VIX implemented by CBOE.

Our main purpose is to propose practical and factual measure of the market volatility. We provide new volatility measure with simple calculation using market option price, which is a good indicator of future expectation.

We believe that a good measure of market volatility would reflect the reality and peoples rational expectation. The VD measure gives a lot of information about both reality and market expectation, since we use option data and we take all recorded trades into account as possible, even though they are excluded in classical studies for some reasons.

We use daily based high-frequency data that are observed every minute and they are used to calculate VD and VIX, since high-frequency data is extremely useful to recognize volatility dynamics. High-frequency data contains more information about how price reacts to the market expectation. Recent studies show that intra day market data can capture the dynamics of volatility with consistent manners. The main features of intra day volatility are summarized as the almost normality of standardized return and log volatility. We use high-frequency data to describe the dynamics of volatility in consistent ways as remarked in previous studies.

This paper is structured in the following way: The second section briefly introduces existing volatility forecast model such as GARCH and Black-Scholes implied volatility, and we summarize the VIX calculation. The third section provides our proposed methodology based on variance decomposition. The forth section illustrates empirical analysis and compares proposed methodology with VIX of prediction quality on realized volatility. Section 5 concludes.

## 2. Classical Volatility Forecasting Models and VIX

Volatility is a key input in financial market, so accurate volatility measure is crucial. Broadly, there are two main streams to calculate and forecast stock volatility: one is statistical volatility and the other is option implied volatility. Statistical volatility depends on the choice of statistical model that employs historical asset return data. One of the most well known methods of statistical volatility is GARCH introduced by Bollerslev (1986). Under the GARCH, the stock volatility follows mean-reverting process. GARCH has developed many classes to reflect the phenomenon of stock volatility such as volatility clustering or persistence, however recent study shows that this method does not show good predictive quality in some sense.2

Implied volatility is originated from the celebrated work of Black and Scholes. In Black-Scholes model, it is assumed that the underlying asset in a frictionless market follows Geometric Brownian motion. Given the price of a call or put option, the Black-Scholes implied volatility is the unique volatility parameter for which the Black-Scholes formula recovers the option price. Implied volatility is calculated using Black-Scholes option pricing formula and market option data with a numerical optimization technique such as Newton-Raphson method. We suggest seeing the review of S. Poon and C. W. J. Granger (2003) to outline this classical research.
Details are in Ralf Becker, Adam E. Clements, Scott I. White, On the informational efficiency of S&P500 implied volatility, North American Journal of Economics and Finance, 17 (2006) 139153
2

Since the forward looking nature of option price, recent interest has been focused on extracting information about market expectation from it. In this viewpoint, option implied volatility is widely studied in academic field as well as practical interest. About this matter, a brilliant approach is proposed by Goldman Sachs. In 1999, K. Demeterfi, E. Derman, Michael Kamal and J. Zou derived the portfolio of options whose variance sensitivity is independent on price of underlying asset. In ideal case, variance exposure of the portfolio only depends on the time to expiration3, so it is apt to use for variance swap. It is implemented as a market volatility measure by CBOE. Even though original VIX (VXO) was issued in 1993, CBOE improved computation methodology in 2003. In this improvement, its core is stemmed from the variance swap portfolio idea. CBOE rewrite variance swap portfolio formula with respect to the variance, and modify it for application to the real market.

## The modified formula is:

K 2 1F = 2i e RT Q( K i ) 1 T i Ki T K0
2

(1)

, where

T
3

## = VIX/100 = Time to expiration.

More details are in K. Demeterfi, E. Derman, M. Kamal and J. Zou, More Than Ever Wanted to Know about Volatility Swaps Goldman Sachs Quantitative Strategies Research Notes, March 1999.

= Forward index level derived from index option prices. = strike price of ith out-of the money option; a call if K i > F and a

Ki
put if

Ki < F K i
on either side of K i = Interval between strike prices half the distance between the strike

K i =

K i +1 K i 1 2
= First strike below the forward index level, F = Risk-free interest rate to expiration

K0
R

Q( K i ) = The midpoint of the bid-ask spread for each option with strike K i

As mentioned above and expressed in the formula, this variance is depend on the time to maturity of options which compose the portfolio. Avoiding this defect, CBOE fix the time to expiration as 30 days by
2 interpolating near term options and next near term options. Let 12 and 2

are the variance calculated from near term options and next near term options, respectively. Then interpolating formula is:

= T1 12

N T2 N 30 N 30 N T1 N 365 2 + T2 2 N T2 N T1 N T2 N T1 N 30

(2)

, where

N T1

## = number of minutes to expiration of the near term options

N T2

= number of minutes to expiration of the next term options = number of minutes in 30 days = number of minutes in a 365-day year

N 30 N 365

The index is based on the CBOE index options on the S&P 500. The VIX is often referred to as the investor fear gauge that means it reflect market expectation on the future stock price movements4.

## 3. Implied Volatility using Variance Decomposition Method

We propose new methodology to calculate stock volatility implied by option price based on variance decomposition formula that uses conditional expectation and conditional variance. As mentioned above, good measure for market volatility should reflect market participants rational expectation. In this viewpoint, our approach is a good candidate for volatility prediction.

The variance of random variable X can be computed conditioned on other random variable Y. The general formula of variance decomposition is as follow.

(3)

## Our motivation is to calculate the stock variance based on above

4

To see more details, please refer to VIX -CBOE Volatility Index- CBOE white paper (2003)

## Var ( Rt ) = E { Var ( Rt | K )} + Var {E ( Rt | K )}

(4)

, where Rt denotes the returns of underlying assets at time t and K denotes the strike prices of the options.

Our innovative idea is presented in the right hand side of above equation intensively. The meaning of the decomposition components will be explained after. Before the explanation, let us consider asset return first. Since Rt + t = ln S t + t ln S t and E (S t + t ) = S t e rt , equation (4) is amended to

## Var ( Rt ) = E { Var ( Rt | K )} + Var {ri }

(5)

We regard the interest rate as a random variable. Traditionally BS implied volatility was computed under the assumption of constant risk free interest rate, so it was not a random variable. Consequently, it was meaningless to calculate variance and expectation of constant. It is possible, however, to obtain a random variable, namely implied risk free rate, by applying the well-known put-call parity for each strike prices.

C + Ke rT = P + St

(6)

In the above equation, the only unobservable variable is r. So we can rewrite it about r

P + St C r = ln K

(7)

The first step to measure market volatility is to compute implied riskfree rate for each strike price. Sometimes it yields negative risk-free rate. In classical research, these cases should be filtered out for causing the arbitrage. However, we often find this phenomenon in reality and there are numerous reasons to explain it. For example, we can consider dividend, inflation rate and so on. If the reality exists, we have a tool to describe it, even though it is impossible to elucidate it in conventional method.

The second step is to calculate the value and understand the meaning of two components of equation (5), Var {ri } and E { Var ( Rt | K )} , using the implied risk free rate for each strike prices. Var {ri } is simple variance of the implied risk free rates. As mentioned above, traditional BS risk-free rate was constant; therefore this term was meaningless under the assumption. We substituted implied risk-free rates for traditional risk-free rates; hence this is not equal to 0. It captures the difference of risk-free rates which market participants expect. On the other hand, Var ( Rt | K ) means variance of underlying asset conditional to each strike price. The expectation of

## Var ( Rt | K )} , might be implied volatility. Since we substituted Var ( Rt | K ) , E {

implied risk-free rate for BS risk-free rate, implied volatility is also random variable for each strike price. So E { Var ( Rt | K )} is the expected value of random implied volatility.

The remained problem is the probability measure of the expectation and variance. At first, we just calculate naive expectation and variance which is assumed equally weighted probability. The variance decomposition index which is based on the nave quantities is unstable, because of certain deep out-of-the money or deep in-the-money options which are rarely traded. But, whenever it is traded, its effect of the variance decomposition index is huge. It is not reasonable that extremely expectation of a few people affects too much on whole market expectation.

Consequently, We take trading volume into calculation. Let i = 1,2, L , N k , and N k means the number of strike prices. Let define ri = ln

Pi + St Ci Ki

## and i is implied volatility corresponding to ri . K i denotes i-th strike price.

Pi and Ci represent put option price and call option price corresponding to
the i-th strike price. Let Qi means the proportion of trading volume of i-th strike price. Then we can rewrite the equation (5) as:

## Var ( Rt ) = E Q { Var ( Rt | K )} + Var Q {ri }

, where

(8)

EQ{ Var ( Rt | K )} = Qi i2
i 2

(9)

## Var {rt } = Qi (ri )

Q i

Qi ri i

(10)

4. Empirical Analysis

In this section, we provide a practical calculation of VIX and VD method. We generally follow the previous section to calculate both volatility indexes. However, we need some technical adjustment for practical calculation and comparison analysis. We explain adjustment briefly in this section and provide result of empirical analysis.

4.1. Data

We analyze KOSPI 200 stock index and KOSPI 200 option, which is reported by minute for the period of July, 1, 2004 through June, 30, 2005. The sample contains 93,985 observations. The KOSPI 200 index is the representative stock market index of republic of Korea and KOSPI 200 option is a simple European option whose underlying is KOSPI 200. The data are obtained from Korea Exchange.

The reasons for using the high frequency data are followings. As many research indicated, it gives advantage to grasp dynamic pattern of volatility. Secondly, Korean stock market settle daily close price through the

simultaneous bids and offers system. The price determined by this system can not be sure to reflect the rational expectation of market participants. So we analyze volatility dynamics from intraday data. Finally, VIX is calculated by minute, it is more convenient to use high-frequency data for comparison analysis.

## 4.2. VIX Calculation

We generally follow VIX calculation based on the white paper published by CBOE , however there is a little difference to calculate VIX in our analysis. The data we used for empirical analysis is not reported bid-ask spread. So we just use reported option price instead of the mid-point of bidask spread ( Q( K i ) in formula (1) for VIX calculation. Additionally, we adjust the formula based on calendar day to business day, since there is a problem of non-existence of realized volatility on the date of reference trading day. To avoid this problem, we use business day and then interpolate the volatility. This adjust make reference date consistent, and it does not cause any change of property of VIX except on reference date. To do this, we change as follows; NT1, NT2 is based on business day, not calendar day and then calculate the remaining times to expiration. We use N22 instead of N30, since there is 22 trading days on average. Additionally, we change N365 to N252 because of 252 trading gays in a year. Consequently, the equation [2] is changed as following:

= T1 12

, where

(11)

N T1

## = number of minutes to expiration of the near term options,

based on businessday

N T2

## = number of minutes to expiration of the next term options,

based on businessday

N 22 N 252

## = number of minutes in 22 days = number of minutes in a 252 day year

As it is well-known, VIX is called investor fear gauge. It is confirmed in the Korean stock market. Following graph compares the VIX and Kospi200 index.

4.3. VD Calculation

The VD calculation is basically followed in the third section. We derive implied interest rate through Put-Call parity, we only use strike price that is reported both call and put price to calculate variance. This variance also calculated using the nearest two expirations and then interpolated. We technically adjusted VD as same as VIX for easy comparison.

## 4.4. Realized Volatility and descriptive statistics

We use simple realized volatility as reference volatility which is realized on the same period of VIX and VD calculation. For example, we calculate VIX and VD using traded option on AM 10:00 October, 3, 2005, we calculate realized volatility using realized KOSPI 200 stock index on AM 10:00 November, 3, 2005.

## The realized volatility is calculated as follow

, where s =

1 n (ui u ) 2 n 1 i =1

, u i = ln

## Si and represents length of time interval in years. S i 1

We set =1/(252*6*60), since there is 6 trading hours per day. This adjust is to reflect the reality based on the assumption of 252 trading days. We can calculate only from Jul 2004 to May 2005, because of the restriction of data.

As we seen from above graphs, there are some outliers. So we screen some data for analysis. We exclude the data from 9:00 a.m. to 10:00 a.m. because of insufficient trading volume. Additionally, we exclude the data after 14:50 because of concurrent bid-ask rule. Finally, we exclude unexpected outliers: from 13:08 to 13:09 Aug 16, 2004, from 13:02 to 13:06 March 11, 2005, forenoon data of March 31, 2005, and 10:33~10:49 May 27 2005.

The descriptive statistics are in Table 4.1 and 4.2, and representative graphs are illustrated in this chapter, detail graphs are in appendix. \ Mean of Kospi 200 Whole 114.41 Stdev of Kospi 200 10.63 Mean of Realized Volatility 16.23 Stdev of Realized Volatility 5.68 67244 Number of observations

Period Jul-04 Aug-04 Sep-04 Oct-04 Nov-04 Dec-04 Jan-05 Feb-05 Mar-05 Apr-05 May-05 Jun-05 96.36 99.08 107.63 109.54 111.71 112.10 117.09 125.09 127.42 123.46 121.18 127.55 1.52 3.15 2.16 3.31 1.90 1.83 2.76 2.95 2.46 3.51 1.98 1.56 21.95 16.40 19.33 20.63 18.91 16.91 16.15 16.99 17.91 16.51 13.11 N/A 2.41 0.60 1.25 0.79 0.71 0.20 0.20 0.31 0.64 1.30 3.19 N/A 6402 6139 5098 6100 5994 4486 6108 4701 5245 5713 5349 5909

Descriptive statistics of Kospi 200 index and Realized volatility are given the following table.

of Mean VD 18.89

of Stdev VD 3.61

## of Number observations 67244

of

1.63 2.81

24.77 22.14

1.22 2.70

6402 6139

Sep-04 Oct-04 Nov-04 Dec-04 Jan-05 Feb-05 Mar-05 Apr-05 May-05 Jun-05

22.51 25.71 25.12 22.75 19.59 17.39 20.37 20.61 19.25 16.53

1.13 1.58 1.17 1.26 1.20 0.81 1.39 1.59 1.82 0.53

18.78 21.95 21.88 19.15 16.21 14.82 17.40 17.16 16.54 13.94

1.25 1.22 1.37 0.71 1.83 1.39 1.53 1.31 1.82 0.56

5098 6100 5994 4486 6108 4701 5245 5713 5349 5909

## 4.5. Forward looking of daily volatility

A popular evaluation criterion for volatility model is to use R2 which is originated the work of Mincer-Zarnowitz. Many researches adapted this approach for evaluation of volatility models. However, this approach is arguable for evaluating the forecasting power of volatility. An alternative is based on loss function approach. Popular evaluation measures for comparing forecasting performance are Mean Square Error (MSE), Root Mean Square Error (RMSE), Mean Absolute Error (MAE), Mean Absolute Percent Error (MAPE), and Mean Logarithm of Absolute Error (MLAE).

Number of Observation

Mean

Standard Deviation

75 Percentile

Median

25 Percentile

vixmse 04-Jul 04-Aug 04-Sep 04-Oct 04-Nov 04-Dec 05-Jan 05-Feb 05-Mar 05-Apr 05-May 6402 6139 5098 6100 5994 4486 6108 4701 5245 5713 5349 0.0063 0.0102 0.0012 0.0030 0.0040 0.0036 0.0013 0.0001 0.0007 0.0023 0.0046

vdmse 0.0013 0.0040 0.0002 0.0005 0.0011 0.0006 0.0003 0.0007 0.0002 0.0006 0.0020

vixmse 0.0026 0.0054 0.0009 0.0021 0.0016 0.0018 0.0008 0.0001 0.0006 0.0022 0.0058

vdmse 0.0016 0.0030 0.0002 0.0006 0.0011 0.0004 0.0003 0.0005 0.0003 0.0005 0.0044

vixmse 0.0085 0.0144 0.0016 0.0043 0.0050 0.0036 0.0020 0.0002 0.0011 0.0040 0.0044

vdmse 0.0024 0.0068 0.0004 0.0007 0.0017 0.0007 0.0004 0.0011 0.0003 0.0006 0.0019

vixmse 0.0054 0.0117 0.0009 0.0027 0.0036 0.0030 0.0012 0.0001 0.0005 0.0023 0.0029

vdmse 0.0004 0.0040 0.0001 0.0002 0.0007 0.0005 0.0002 0.0007 0.0001 0.0004 0.0007

vixmse 0.0044 0.0048 0.0006 0.0012 0.0027 0.0026 0.0006 0.0000 0.0003 0.0002 0.0021

vdmse 0.0001 0.0010 0.0001 0.0000 0.0003 0.0003 0.0001 0.0002 0.0000 0.0002 0.0003

Number of Observation

Mean

Standard Deviation

75 Percentile

Median

25 Percentile

vixrmse 04-Jul 04-Aug 04-Sep 04-Oct 04-Nov 04-Dec 05-Jan 05-Feb 05-Mar 05-Apr 05-May 6402 6139 5098 6100 5994 4486 6108 4701 5245 5713 5349 0.0777 0.0968 0.0318 0.0508 0.0621 0.0584 0.0344 0.0092 0.0245 0.0410 0.0614

vdrmse 0.0288 0.0574 0.0130 0.0173 0.0297 0.0224 0.0150 0.0238 0.0113 0.0214 0.0343

vixrmse 0.0160 0.0283 0.0120 0.0212 0.0122 0.0133 0.0114 0.0060 0.0106 0.0255 0.0286

vdrmse 0.0214 0.0262 0.0070 0.0136 0.0149 0.0077 0.0092 0.0103 0.0077 0.0105 0.0287

vixrmse 0.0920 0.1199 0.0402 0.0656 0.0708 0.0600 0.0448 0.0135 0.0334 0.0630 0.0663

vdrmse 0.0486 0.0827 0.0188 0.0266 0.0417 0.0272 0.0195 0.0332 0.0168 0.0252 0.0431

vixrmse 0.0734 0.1084 0.0306 0.0519 0.0603 0.0551 0.0342 0.0087 0.0217 0.0478 0.0540

vdrmse 0.0197 0.0630 0.0122 0.0145 0.0265 0.0227 0.0123 0.0271 0.0095 0.0200 0.0274

vixrmse 0.0662 0.0694 0.0241 0.0347 0.0522 0.0507 0.0246 0.0045 0.0162 0.0140 0.0456

vdrmse 0.0122 0.0320 0.0074 0.0057 0.0184 0.0168 0.0083 0.0135 0.0057 0.0152 0.0170

Number of Observation

Mean

Standard Deviation

75 Percentile

Median

25 Percentile

vixmae 04-Jul 04-Aug 04-Sep 04-Oct 04-Nov 04-Dec 05-Jan 05-Feb 05-Mar 05-Apr 05-May 6402 6139 5098 6100 5994 4486 6108 4701 5245 5713 5349 0.0777 0.0968 0.0318 0.0508 0.0621 0.0584 0.0344 0.0092 0.0245 0.0410 0.0614

vdmae 0.0288 0.0574 0.0130 0.0173 0.0297 0.0224 0.0150 0.0238 0.0113 0.0214 0.0343

vixmae 0.0160 0.0283 0.0120 0.0212 0.0122 0.0133 0.0114 0.0060 0.0106 0.0255 0.0286

vdmae 0.0214 0.0262 0.0070 0.0136 0.0149 0.0077 0.0092 0.0103 0.0077 0.0105 0.0287

vixmae 0.0920 0.1199 0.0402 0.0656 0.0708 0.0600 0.0448 0.0135 0.0334 0.0630 0.0663

vdmae 0.0486 0.0827 0.0188 0.0266 0.0417 0.0272 0.0195 0.0332 0.0168 0.0252 0.0431

vixmae 0.0734 0.1084 0.0306 0.0519 0.0603 0.0551 0.0342 0.0087 0.0217 0.0478 0.0540

vdmae 0.0197 0.0630 0.0122 0.0145 0.0265 0.0227 0.0123 0.0271 0.0095 0.0200 0.0274

vixmae 0.0662 0.0694 0.0241 0.0347 0.0522 0.0507 0.0246 0.0045 0.0162 0.0140 0.0456

vdmae 0.0122 0.0320 0.0074 0.0057 0.0184 0.0168 0.0083 0.0135 0.0057 0.0152 0.0170

Number of Observation

Mean

Standard Deviation

75 Percentile

Median

25 Percentile

vixmlae 04-Jul 04-Aug 04-Sep 04-Oct 04-Nov 04-Dec 05-Jan 05-Feb 05-Mar 05-Apr 05-May 6402 6139 5098 6100 5994 4486 6108 4701 5245 5713 5349 1.5566 1.8411 1.6769 1.6116 1.6986 1.8083 1.8532 1.8013 1.7504 1.8347 2.0064

vdmlae 1.5548 1.8394 1.6751 1.6100 1.6972 1.8066 1.8512 1.7997 1.7488 1.8329 2.0049

vixmlae 0.1112 0.0360 0.0640 0.0393 0.0374 0.0122 0.0123 0.0186 0.0352 0.0808 0.0395

vdmlae 0.1115 0.0359 0.0640 0.0393 0.0375 0.0122 0.0121 0.0183 0.0352 0.0808 0.0394

vixmlae 1.6763 1.8654 1.7324 1.6162 1.7272 1.8216 1.8631 1.8086 1.7783 1.9269 2.0535

vdmlae 1.6747 1.8638 1.7309 1.6143 1.7258 1.8193 1.8611 1.8075 1.7767 1.9250 2.0518

vixmlae 1.5186 1.8548 1.6813 1.5978 1.6982 1.8026 1.8524 1.8008 1.7487 1.8043 2.0186

vdmlae 1.5169 1.8531 1.6791 1.5963 1.6970 1.8011 1.8502 1.7994 1.7474 1.8024 2.0173

vixmlae 1.4680 1.8355 1.6269 1.5893 1.6600 1.7977 1.8461 1.7879 1.7178 1.7663 1.9741

vdmlae 1.4661 1.8335 1.6250 1.5876 1.6587 1.7962 1.8435 1.7862 1.7164 1.7645 1.9726

5. Conclusion

We propose new methodology to calculate stock volatility implied by option price based on variance decomposition formula that uses conditional expectation and conditional variance. Our motivation is to calculate the stock variance based on variance formula. Variance is organized into two parts; variance of the implied risk free rates and the expected value of random implied volatility.

We analyze KOSPI 200 stock index and KOSPI 200 option, which is reported by minute for the period of July, 1, 2004 through June, 30, 2005. We would like to give proof the empirical result which shows that variance decomposition volatility index is similar to the dynamics of VIX and shows good prediction power for realized volatility.

However, we need to discover better way to calculate realized volatility and to verify the prediction power for realized volatility than the way we employed. And also we remain studies for statistical property of VD behind.

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Appendix