# No.

2002/04

**Forecasting Stock Market Volatility and the Informational Efficiency of the DAXindex Options Market
**

Holger Claessen / Stefan Mittnik

Center for Financial Studies an der Johann Wolfgang Goethe-Universität § Taunusanlage 6 § D-60329 Frankfurt am Main Tel: (+49)069/242941-0 § Fax: (+49)069/242941-77 § E-Mail: ifk@ifk-cfs.de § Internet: http://www.ifk-cfs.de

CFS Working Paper No. 2002/04

Forecasting Stock Market Volatility and the Informational Efficiency of the DAX-index Options Market *

Holger Claessen / Stefan Mittnik **

Abstract: Alternative strategies for predicting stock market volatility are examined. In out-of-sample forecasting experiments implied-volatility information, derived from contemporaneously observed option prices or history-based volatility predictors, such as GARCH models, are investigated, to determine if they are more appropriate for predicting future return volatility. Employing German DAX-index return data it is found that past returns do not contain useful information beyond the volatility expectations already reflected in option prices. This supports the efficient market hypothesis for the DAX-index options market.

JEL Classification: G14, C22, C53 Keywords: Market efficiency, implied volatility, GARCH, combined forecasting

*

Support by the Deutsche Forschungsgemeinschaft is gratefully acknowledged. We thank the Deutsche Börse AG for providing the data.

** Holger Claessen, Deutsche Bank AG, 31 West 52nd Street, New York, NY 10019-6160, U.S.A.

Prof. Stefan Mittnik, Ph.D., Institute of Statistics and Econometrics, University of Kiel, Olshausenstr. 40, D24118 Kiel; phone: +49 (431)-880-2166; fax: +49 (431)-880-7605; email: mittnik@stat-econ.uni-kiel.de and Center for Financial Studies, Taunusanlage 6, D-60329 Frankfurt

1

Introduction

The expected volatility of ﬁnancial markets is a key variable in ﬁnancial investment decisions. For example, it is common practice to reduce asset allocation decisions to a two–dimensional decision problem by focusing solely on the expected return and risk of an asset or portfolio, with risk being related to the volatility of the returns. The volatility of returns plays also a central role in the valuation of ﬁnancial derivatives such as options and futures, and can, in fact, have a greater inﬂuence on the value of derivative securities than price movements in the underlying assets. Options can be used either as part of a dynamic hedging strategy, to protect a portfolio against adverse price movements, or as a speculative asset which gains from expected price changes. To assess the fair value of an option or to hedge market risk, an investor needs to specify his or her expectations regarding future volatility. There are basically two approaches to generate volatility forecasts. One is to extract information about the variance of future returns from their history; the second is to elicit market expectations about the future volatility from observed option prices. Assuming that an option pricing model correctly represents investors’ behavior, the implied volatility can be derived from observed option prices and other observable variables by appropriately “inverting” the option pricing model. In informationally eﬃcient markets the implied volatility should reﬂect the information contained in past returns. Hence, forecasts based on past returns should not outperform forecasts based on implied volatilities. A number of empirical investigations support the idea of using implied volatility as a predictor for future volatility (see, for example, Latane and Rendleman, 1976; Chiras and Manaster, 1978; Gemmill, 1986; Shastri and Tandon, 1986; Scott and Tucker, 1989). However, the null hypothesis that historic returns add no information to that already contained in implied volatilities was empirically rejected by Day and Lewis (1992) in the case of the S&P100 index and by Lamoureux and Lastrapes (1993), who investigated several individual stocks. Xu and Taylor (1995) found support for this hypothesis using currency options traded on the Philadelphia stock exchange. These three studies follow the approach of Day and Lewis (1992) and consider implied volatility as an exogenous variable in the conditional variance equation of a GARCH(1,1) model. By doing so, one combines current market expectations, as reﬂected in option prices, with past return information captured by a 1

2
.1) model taking weekend and holiday eﬀects into account.e. out–of–sample results are presented in Section 4. . which is an unobservable variable.1) model combined with IV information. which has recently been introduced by the German options and futures exchange (DTB). We apply these approaches to daily returns on the DAX index.T +h 250 represents the annualized average volatility. ¯
is commonly used as the estimate of this period’s average volatility.1) model. an autoregressive model for squared past returns.T +h = 1 h−1
h i=1
(rT +i − rT +i )2 . i. we will use VT +1. the sample standard deviation over a time interval spanning the h trading days T + 1. the major German stock index.T +h as the true future average volatility over interval [T + 1. VT +1. ﬁnally. VT +1. implied volatility (IV) information. Two of them. . Section 2 brieﬂy summarizes the forecasting strategies considered. We investigate eight alternative approaches to forecasting stock market volatility. T + h. In this paper we investigate a range of alternative strategies for predicting volatility in ﬁnancial markets. We also consider a standard GARCH(1. T + h]. In–sample results are discussed in Section 3..standard GARCH model. Below. Here. use information about past returns in a rather naive manner. and analyze their in– and out–of–sample performance.
2
Volatility Forecasting Models
Before discussing speciﬁc volatility forecasting models the question of how to approximate volatility. and rt = ¯
1 h
h i=1 rt+i
Details on the construction of the VDAX will be given in the subsequent section. and. Section 5 concludes. Assuming 250 trading days per year. we
2
the asset return for trading day t. . Given daily return data. needs to be addressed. The VDAX is a publically reported volatility measure. rt denotes is the average return over √ this period. a modiﬁed GARCH(1. The importance of the information contained in these two diﬀerent sources is then judged by the statistical signiﬁcance of the corresponding parameter estimates. As a measure of implied volatility we will use the Volatility DAX (VDAX). the moving average and the random walk model. .2 The paper is organized as follows. a GARCH(1.

These models have been very successful in describing the behavior of ﬁnancial return data. the volatility forecast is given by the sample standard deviation ˆ VT +1.. i.1) Model
The autoregressive conditional heteroskedasticity (ARCH) models introduced by Engle (1982) and their generalization.
2.T . 1986) (see also Bollerslev et al.T +h = 1 N −1
N i=1
(rT −i − rT )2 ¯
.e.1) model combined with an AR(1) model for the mean to be appropriate.1
Historical Moving Average Model
A widely used estimator for future volatility is the square root of a moving average of past squared returns.. following the lines of Granger and Ramanathan (1984).
2.e.
Below we choose a window length of one calendar year. The estimation of a GARCH model involves the joint estimation of a mean and a conditional variance equation. Their appeal comes from the fact that they can capture both volatility clustering and unconditional return distributions with heavy tails—two stylized facts associated with ﬁnancial return data. ˆ VT +1.T +h = VT −h+1. N = 250 trading days. i. 1992. If we adjust for mean returns. 1994) have been the most commonly employed class of time series models in the recent ﬁnance literature.
2. i.
3
.. the so–called GARCH models (Bollerslev.e. rt = µ + φ rt−1 + t . The remainder of this section brieﬂy summarizes these eight approaches.2
Random Walk Model
If we assume a simple random walk model for the average volatility. For the forecast comparison we found a GARCH(1.consider combined forecasts..3
Standard GARCH(1. the forecast for the next h–day interval is given by the volatility of the past h days.

for many ﬁnancial time σ series the standardized residuals ˆt /ˆt still appear to be leptokurtic. 1989.
conditioned on the return information available
(1)
The returns were modeled by an AR(1) model. Lamoureux and Lastrapes. 4
. from which the normal distribution is a special case.
The daily s–step–ahead variance forecast from a GARCH(1.. 1). 1991. although the unconditional distribution of
t
normal errors has fatter tails than the normal distribution.
(2)
t+s−1 .h j=1
σT +j . Instead of assuming normally distributed innovations we use the generalized error distribution (GED) (Taylor. s > 1. Baillie and DeGennaro. assuming a leptokurtic unconditional distribution for derived by recursion σt+s = ˆ2
t
seems more appropriate. 1990. Engle et al. The GARCH(1. The reason for considering the GED is the fact that. West et al. 1994) for maximizing the likelihood function. 1990. For ν = 2 we have
t
∼ N (0. λ 21+1/ν Γ(1/ν) λ= 2−2/ν Γ(1/ν) Γ(3/ν)
1/2
. ν plays the role of a tail–thickness parameter and determines the shape of the distribution.
t.. Here.
so that the forecast for the average future volatility for the next h–day period is given by ˆ VT +1. while for ν < 2 the distribution has in a GARCH model with conditional
thicker tails than the normal.T +h = 1 NT
NT. The density function of the GED takes the form f ( t . Therefore.1) speciﬁcation (1) coincides with what has generally been regarded as an appropriate representation in the empirical literature (see.1) model can be
ω + α ˆ2 + β σt .h denoting the number of trading days in that h–day period. ˆ ˆ t ˆ 2 ω + (ˆ + β) σ 2 ˆ α ˆ ˆ
s = 1. 1990. ˆ2
(3)
with NT. Schwert and Seguin. Akgiray.with the conditional variance of up to time t − 1.
with ν > 0. 1993). It is estimated simultaneously with all other model parameters. since the coeﬃcient φ has been found signiﬁcant over several sub–samples of the data. ν) = ν exp(− 1 | t /λ|ν ) 2 . being given by
2 σt = ω + α 2 t−1 2 + β σt−1 . for example.

(1994).2. (1993) modify the conditional variance equation of the GARCH(1.3 For successive trading days during the week we have dt = 1. for Mondays we have dt = 3. (1993) interpret parameter δ as average speed of the variance rate since the previous
close. For δ = 1.1) model so that:
2 σt = dδ [ω + d−δ (α t t−1 2 t−1 2 + β σt−1 )]
(4)
Dividing α
2 t−1
2 + β σt−1 . such as weekends and holidays.e. dt . σt+s = ˆ2 dδ (ˆ + d−δ α ˆ ˆ2 t+s−1 (ˆ + β) σt+s−1 ]).5
Autoregressive Model
t
Bollerslev (1986) showed that a GARCH process for an ARMA model for
3
can be expressed in terms of
2 t.
5
. s > 1. The multiplication by dδ t inﬂates the one–day volatility according to the length of the non–trading period between days t and t − 1 and the average variance rate during this period.1) Model with Weekend and Holiday Eﬀects
The standard GARCH speciﬁcation (1) ignores the fact that days where there is no trading. as exponent of dt . may have an eﬀect on volatility. for trading days with dt > 1 (216 observations) the return variance exceeded that for trading days with dt = 1 (767 observations) by 75.
δ −δ d ω α 2 ˆ 2 t+1 [ˆ + dt (ˆ ˆt + β σt )]. They incorporate a variable. the variance rate would not decrease on non–trading days.4
GARCH(1. In our sample. determining the degree with which non–trading days aﬀect volatility. The resulting GARCH(1. in general. t+s ω while relationship (3) still applies. in (4). (1993) and Noh et al. and a parameter. dt > 1.. which reﬂects the number of calendar days elapsed since the most recent trading day.
2. A GARCH model allowing for such eﬀects has been proposed in Engle et al. we expect δ to be less than 1.7%. To illustrate the empirical relevance of this phenomenon we computed the return variance for trading days for which dt = 1 and for trading days following weekends or holidays. by dδ scales past volatility information so that t−1
it corresponds to that of a one–day non–trading period. δ ≥ 0.1) forecasting recursion is of the form s = 1.
Using a long autoregression for the squared residuals in (1)
Engle et al. Therefore. i. To include this weekend and holiday eﬀect Engle et al.

focusing on at–the–money or near–at–the–money options not only helps to minimize the bias induced by thinly traded options.4 The Frankfurt Stock Exchange has published daily an implied volatility index. An autoregression of order p or. T
2. 1994. an AR(p) model for implies predictions ˆ2 +s = α0 + α1 ˆ2 +s−1 + . ˆ ˆ T ˆ T T for future
2 t ’s.T +h = 1 Nt
Nt j=1
ˆ2 +j . even when markets are eﬃcient. in short. The VDAX combines volatilities implied by call and put DAX–index
4
However.
6
. under the assumption of rationality. yield an eﬃcient predictor. if volatility is stochastic and uncorrelated with aggregate consumption (see Hull and White. past information should not help to predict future volatility. + αp ˆ2 +s−p . 1987. 1989). the forecast for the average
volatility over the next h days is ˆ VT +1. since May 12. A potential problem associated with IVs is that one assumes an underlying option pricing model. Then. it is well known that the IV derived from the Black–Scholes model for an at–the–money option yields an approximately unbiased estimator of the average volatility over the remaining life of the option. any speciﬁcation error arising from the inappropriateness of the Black–Scholes model
makes it less likely that IVs are the best predictors. but should also minimize the speciﬁcation error due to assuming the validity of the Black–Scholes model. Therefore. Ideally. Feinstein.6
Implied Volatilities (IVs)
If ﬁnancial markets use information eﬃciently. . the results for the IV predictor in the following forecast comparison can be interpreted as conservative estimates of the information contained in IVs. This is due to the fact that for at–the–money options the Black–Scholes model is almost linear in average volatility. the widely used Black–Scholes model requires constant volatility. However. For example.
with ˆ2 +j = T
2 T +j
for j ≤ 0.as an approximation for the ARMA representation of
2 t. the volatility implied by observed option prices reﬂects the volatility expectation of the market participants and should. 1992. . Therefore. it has been reconstructed backward until January 1. called VDAX.
one may expect that an
2 t
OLS estimation of such an autoregression performs more or less like an estimated GARCH model.

t
5
The computation of each subindex is based on IVs of options with strike prices lying in a ±100
index point interval around the actual DAX level. IVs derived from longer maturity options can also serve as indicators for future volatility. Independently of the particular IV variant used. we adopt the speciﬁcation rt = µ + φ rt−1 + t . Here.T +h = IVT . this corresponds to an exclusion of all options which were more than 4% – 7% in– or out–of–the–money.
7
. the resulting volatility forecast is given by VT +1. but with γ IV2 /250 added to forecasting recursion (2). 1995). σt ). Only those options that were less than 10% in– or out–of–the–money as well as options with a remaining lifetime of more than 10 trading days are used. the maturities of the remaining options are varying between 11 and 32 calendar days. and Xu and Taylor. Lamoureux and Lastrapes. 1992. 6 Clearly.5 The two times to maturity are chosen such that they encompass a duration of 45 days. Thus. But since the longest forecast horizon considered in our forecast comparison is one month.
2 + β σt−1 + γ IV2 /250.
2. t−1
(5)
The resulting variance forecast equations correspond to those of the pure GARCH case.options for eight diﬀerent strike prices and two diﬀerent times to maturity. short–term options are expected to be more appropriate for our purposes.1)–IV model combines the information contained in both past returns and option prices by adding an IV variable as an exogenous variable to the GARCH model (see Day and Lewis.7
GARCH(1. 1993. For our sample period.1)–IV Model
The GARCH(1. Instead of employing the VDAX as a predictor for future volatility.6 We computed daily IVs from transaction options data recorded at the German options exchange DTB. First.
2 σt = ω + α 2 t−1 t 2 ∼ GED(0. for each individual time to maturity a subindex of implied volatilities for the diﬀerent strike prices is determined by a nonlinear least squares procedure. Linear interpolation between the two time indices gives an implied volatility of a synthetic DAX index option with a remaining life of exactly 45 days. one could use IVs derived from the shortest maturity index option of each day as an estimate of the next period’s average volatility.

but now with term IV2 /250 being included. the IV variable represents market expectations of the average daily volatility over the option’s remaining lifetime. Here. A problem with this approach is the maturity mismatch of the GARCH and the IV forecasts.9
Combined Forecasts
An alternative way of combining forecasts is simply to compute linear combinations of forecasts generated by alternative models. Whereas the GARCH model predicts the conditional variance for the next period (here. To do so. t
2. so that the conditional variance equation takes the form
2 σt = dδ [ω + d−δ (α t t−1 2 t−1 2 + β σt−1 + γ IV2 /250)]. Xu and Taylor (1994) proposed a Kalman ﬁltering approach for modeling volatility expectation as an unobservable factor. If the options market is indeed informationally eﬃcient. the conditional variance equation contains no explicit GARCH terms. indicating to what extent an individual forecast enters the combined forecast. An intuitive way of combining forecasts is to average the individual forecasts.
2.1)–IV Model with Weekend and Holiday Effects
* The GARCH–IV model with weekend and holiday eﬀects simply combines models (4) and (5). the constraints α = β = 0 implied by (6) should not be rejected. In the context of testing the eﬃcient market hypothesis the special case of (5) given by
2 σt = ω + γ IV2 /250 t−1
(6)
is of interest. In their forecasting comparison for currency options data Xu and Taylor (1995) found no evidence suggesting that the choice of the IV predictor (short maturity or next period’s volatility estimate) aﬀects the predictive power of the mixed GARCH–IV model. the next day). This requires forecasts of volatility realizations 8
. a vector of weights.8
GARCH(1. needs to be speciﬁed. t−1
(7)
The forecast recursions for the conditional variances are obtained as for model (4). A more elaborate technique is the regression–based approach proposed by Granger and Ramanathan (1984).Model (1) can be interpreted as the special case of model (5) where γ = 0.

Though the null of no ARCH eﬀects cannot be rejected at a signiﬁcance level of 10% for a lag–length p = 8. Granger and Ramanathan (1984) showed that under a mean–squared–error criterion an unrestricted regression including a constant term should be preferred. even more so. the DAX index return series seems best described by an unconditional leptokurtic distribution and possesses signiﬁcant conditional heteroskedasticity.
3
In–sample Results
Table 1 displays some sample statistics for the 982 daily DAX index returns from February 3. the estimated regression coeﬃcients can be used as weights for a linear combination. The squared returns and. shared by many other asset return series. be rejected at any reasonable level for p = 16.of each of the individual model. The inclusion of a constant term should lead to an unbiased combined forecast. Assuming 250 trading days per year the standard deviation for the daily returns amounts to an annualized standard deviation of 14. This is also supported by the Jarque–Bera test. 1992 through December 29.7 The GARCH models (1) and (4) indicate a high persistence
7
In the following we report only estimates of the conditional variance equation and not the
mean equation. In summary. the absolute returns display highly signiﬁcant autocorrelations. When the series of past realized volatility is then regressed on these ex–post forecasts. Table 2 compares the in–sample performance of the GARCH models described in the previous section. even if individual forecasts are biased. it can. is the conditional heteroskedasticity of the returns as is reﬂected by both the Ljung–Box statistics and Engle’s Lagrange multiplier ARCH tests. 1995. which tests the normal hypothesis by means of the sample skewness and kurtosis. The high volatility of the daily returns relative to the mean return causes the deviation of the mean return from zero to be statistically insigniﬁcant.6%. This makes a (G)ARCH model with GED disturbances a natural candidate for forecasting DAX index return volatility. The highly signiﬁcant excess kurtosis and the marginally signiﬁcant negative skewness of the daily DAX returns match stylized facts associated with ﬁnancial return data and indicate that the normal distribution is an inappropriate assumption for the DAX returns. since it is of limited interest here. for example.
9
. Another stylized fact.

yields a clearly insigniﬁcant χ2 –value of 0.e. However. Xu and Taylor (1995) found evidence in support of the eﬃcient market hypothesis for currency options data from the Philadelphia stock exchange.1 clearly indicate the rejection of the normal assumption (i. α + β. This indicates that the IVs derived from the DAX index options reﬂect the information contained in past DAX return and supports the eﬃcient market hypothesis for the DAX options market.5 for the tail–thickness parameter.5% level. This suggests that an integrated GARCH (IGARCH) model could be appropriate. ν. These studies suggest that both IVs and GARCH components have incremental explanatory power for conditional variances. γ. A standard likelihood–ratio test against the unrestricted model (1) would reject the IGARCH hypothesis at the 5% level. A likelihood–ratio test of the restriction ν = 2 against the unrestricted model (1) clearly supports this conclusion with a test value of 26.0255. We observe a sharp drop in the GARCH coeﬃcient–sum.9795 with standard errors .08.6545 for the IV coeﬃcient.9802 and . gives a χ2 –value of 17. Using the same methodology. which is signiﬁcant even at the 0. α + β. with the standard errors around 0.40. For each of the currencies under investigation they could not reject the 10
. This ﬁnding diﬀers from the results reported by Day and Lewis (1992) for the conditional volatility of the S&P100 index returns and those of Lamoureux and Lastrapes (1993) for individual stock returns.46.0282 and . equal to . respectively. Model (5) includes the VDAX as an exogenous variable in the conditional variance equation. Figure 1 compares the kernel–estimated empirical density of the DAX returns with the estimated normal density and the GED density for ν = 1. Reestimation of the IGARCH restriction α + β = 1 leads only to a small decrease of the maximum likelihood value.9802 to 0.. On the other hand. constraining the IV parameter to zero. all parameters in the variance equation turn out to be insigniﬁcant.1459 and a relatively high estimate of 0.of volatility shocks with the persistence measure. Point estimates of about 1. which is signiﬁcant even at the 0. ν = 2). indicating a serious identiﬁcation problem when combining the two information sources.5 and illustrates that the GED represents a more appropriate distributional assumption than the normal density. testing model (5) against model (6). which constrains the GARCH parameters α and β to zero.5% level. A likelihood–ratio test of model (5) against model (1). from 0. but not at the 1% level.

1994 through December 29. In accordance with this. By doing so. . dt = 1) by 69.hypothesis that the GARCH component contains no additional information. VT +1. i. is based on models estimated from sample rt . 1995. For each horizon.695. This is consistent with the 75. we chose a length of 250 trading days for the rolling standard deviation of past returns. . The forecasts for the one–. This conclusion is supported again by a likelihood–ratio test of the restricted model (1) against model (4) signiﬁcant at the 0.
8
Since the sample period starts at February 3. Model (4) suggests signiﬁcant weekend and holiday volatility eﬀects with a t– value of 4. which means t that the model estimates Monday variances to exceed the return variance of any other pair of adjacent trading days (i. we evaluate the forecasting performance for one–.e...8 We recorded the forecasts of each model until December 30. we were left with 104 one–week. For a typical weekend (i. and then perform regressions. Both the GARCH forecasts and those of the autoregressive model for squared returns are based on rolling–sample estimates given by 250 trading days prior to the forecasting period. 52 two–week and 26 four–week forecasts for the two–year period from January 3. Below. we constructed sequences of nonoverlapping forecasting intervals. to derive the ﬁrst combined forecast.7% increase computed from the raw return data.e. .T +h . two– and four–week intervals start on January 4. 1) forecasts are based on
samples with less than 250 observations. 1993.
11
. the forecast anchored in period T .e. 1992 the ﬁrst 4 (2.5%. . 1993.58 for adjustment parameter δ. for each new forecasting period.. rt−1 . Of particular interest is the question of whether or not the suﬃciency of the IV information for the return history found in the in– sample results carries over to out–of–sample comparisons. two– and four–week horizons. With each new prediction the weights for combining forecast were updated.
4
Out–of–sample Comparison
We now consider the out–of–sample predictive power of the alternative forecasting models described in Section 2. dt = 3) we have dδ = 1. The models are reestimated for ˆ each period. rT −249 .5% level.

e. This is consistent with the fact that the IGARCH hypothesis was not clearly rejected for the full sample. parameter δ capturing the weekend/holiday volatility eﬀect. Whereas the
hypothesis γ = 0 for the GARCH model (5) could be rejected for 101 of the 156 subsamples.4. 4 and 5 is that in terms of the MSE a combination of GARCH forecasts together with an IV variable seem to perform best. The ﬁrst plot in Figure 3 shows that the hypothesis of an insigniﬁcant weekend/holiday volatility eﬀect can be rejected for half of the sample (for 78 of 156 subsamples). GARCH speciﬁcation (5) with IV 12
. (D). ν. Looking now at the estimation results for the 156 weekly one–year rolling samples for the years 1993–1995 allows us to take a closer look at the appropriateness of the competing speciﬁcations over diﬀerent sub– periods.
4. This can be viewed as rolling likelihood– ratio tests.2
Out–of–sample Forecasting Results
The out–of–sample forecasting results are summarized in Tables 3. ˆ As an alternative way of comparing the diﬀerent GARCH speciﬁcations Figure 3 displays twice the diﬀerence between the log–likelihood values of three non–restricted models and their restricted counterparts. i. the hypothesis of insigniﬁcant GARCH components (i. and the tail–thickness parameter.1) model estimated from the entire data set. We employ three criteria to compare the volatility forecasts of the models: the mean prediction error (ME). Parameters of particular interest. plotted in Figure 2. For a long subperiod the estimates favor an IGARCH process. For all three forecast horizons. the mean squared prediction error (MSE). The fact that the informational content in IVs outweighs that contained in the GARCH components
2 σt−1 and 2 t−1
is reﬂected by the second and third plots of Figure 3. 4 and 5. of the volatility movements.. are the persistence measure α + β.. α = β = 0) could not be rejected for a single subsample. and the proportion of correctly predicted directions. The main conclusion to be drawn from Tables 3. The horizontal lines in these three plots represent the 95% critical value when testing the restricted against the unrestricted model. The ﬁrst plot in Figure 2 shows that shocks to volatility are highly persistent for a large part of the sample.1
Some General Results
In the previous section we presented in–sample ﬁts for alternative GARCH(1.e. The other two ˆ plots in Figure 2 exibit some variation in the behavior of δ and ν .

The GARCH–IV model makes use of IVs of short maturity options rather than the VDAX. indicates that processing information in
9
The forecast equations for the mixed GARCH model diﬀer from the forecast equations for the
pure GARCH model by adding γ IV2 /250 to the recursion (2). Compared to the pure GARCH model the mixed version leads to a remarkable improvement of the forecasting accuracy. only these GARCH forecasts are considered in the combinations of forecasts. This is in accordance with the in–sample results. The MA model can substantially improve forecast accuracy. indicating a high persistence in volatility expectations. Estimating an AR(1) model for the squared IVs the estimate for the AR coeﬃcient is 0.. Incorporating weekend and holiday eﬀects into the standard GARCH(1. This. This matches very closely the estimate of 0.9802 for the persistence measure. The results for the other individual forecasting methods can be summarized as follows.
ˆ2 an ARIMA approach and substituted IV2 /250 by IVt+s /250 for s > 1.as exogenous variable has the smallest MSE within the group of individual (i. The RW forecasts. together with the results for the RW model. despite this bias. whereas the exclusion of the IV information in a standard GARCH(1. but this did not improve t
13
.1) model entails a signiﬁcant drop in forecasting accuracy. Therefore.9731. α + β.9 This is even more remarkable in view of the poor performance of the purely IV–based forecasts which tend to overstate forward volatility.
The results show that the omission
of the GARCH components causes only a marginal loss in predictive power.e. though on average with the lowest bias. which models the conditional variance simply as a linear transformation
2 of the squared IVs without lagged σt−1 and 2 t−1 . IVs clearly contain relevant information about future volatility movements. For each forecast horizon the IV variables display an average absolute bias of about 3%. exhibit by far the highest MSE. in the estimated GARCH model (1b). This is indicated by the performance of the GARCH(0. We also computed IV forecasts by t the volatility forecasts. The dominance of the GARCH–IV forecasting model is mainly due to the inclusion of the IV information. but shows—apart from the two IV–based forecasts 4 and 5—the highest ME. because the former outperformed the latter for all horizons. which could be corrected by embedding the IV variable into the GARCH model.0)– IV model. uncombined) forecasting models. as shown in Tables 3–5.1) model reduces. the ME and MSE of the GARCH forecasts. However.

A 15th –order autoregression for the squared returns leads to a marginal reduction of both the ME and MSE. This suggests that distributional assumptions are of secondary importance in volatility forecasting. However. 7) forecasts. in terms of the MSE. 1. even though the explanatory power of the GARCH model is strongly aﬀected by this assumption. Although.1) models (denoted by c.10 Specifying the conditional heteroskedasticity by either an AR(15) model for squared returns or a standard GARCH(1.1225 with a t–value of 3. as in Schwert (1989). An exception is the RW method. the combination of IV and GARCH forecasts outperforms the GARCH–IV forecasts in terms of the ME and MSE. 5. a much better performance. This way of combining the two sources of information seems to be even more eﬃcient than combining them within the GARCH framework. Only minor reductions. In fact. Finally. if any. A combination. displaying the forecasting results for the two–week horizon. 5. We also tried an autoregressive model for the absolute returns. All combined forecasts yield a smaller ME than each of the individual forecasting techniques. is again conﬁrmed by excluding the GARCH forecast from the combined model. because they are inferior to those of an autoregressive model for squared returns. can be obtained by simply combining IV and GARCH (c. occur in the forecast accuracy relative to the linear combination of the GARCH and IV forecast. For all three horizons. in Tables 3–5). Combining forecasts seems to introduce a substantial amount of noise. given the IV information. are very close to those derived from the GED–GARCH model. 3.
14
. compares reasonable well with GARCH–IV forecasts. the forecasts of a GARCH(1.past returns in a naive fashion yields inaccurate volatility forecasts. The results for the combined approach in Tables 3–5 indicate that an overall reduction of the mean bias of the forecasts can indeed be achieved by this method.1) model does not give rise to a dramatically diﬀerent forecast performance. RW. because the autocorrelation coeﬃcient for the squared returns at that
lag was highly signiﬁcant (ρ15 = 0. Turning now to the results for the combined forecasts (see Tables 3–5) we ﬁnd that combining forecasts does not automatically improve accuracy. the GARCH forecasts consistently outperform the autoregressive forecasts. which includes the MA. small improvements can be observed when omitting the GARCH model. IV and GARCH(1.70).1) model with a conditional normal distribution. The insigniﬁcance of the informational content in the GARCH forecasts. AR(15). which are not reported here. We do not report these results. 2.
10
Order 15 was chosen. 7. This is illustrated in Figures 4 and 5.

and in 102 of 104 cases it is smaller than 1%. indicating the insigniﬁcant incremental information content in GARCH forecasts given IV information. In all cases. which appear to become obsolete with the arrival of new information. derived either from observed option prices or from time series models such as GARCH models. whereas the diﬀerences between the GARCH(0. This is caused by the smoothing eﬀects of the GARCH model. Figure 5 also shows the change in volatility forecasts. one
15
. seem to be better in explaining the frequent changes in volatility than the smoothed GARCH–based forecasts. We have focused on the problem of whether or not implied volatility information. two– or four–week ahead realized volatility must be rejected. The diﬀerences between the combined and the IV forecasts are quite stable.
5
Summary
In this paper we have investigated the suitability of several forecasting techniques for the volatility of the returns of the German DAX index and examined whether or not the German DAX–index options market is informational eﬃcient. Market expectations. our in–sample ﬁtting and out–of–sample forecasting results give strong support for the hypothesis that historic returns contain no information beyond the market’s volatility expectation that is reﬂected in DAX–index option prices. are useful in predicting future return volatility. are displayed in Figure 5. It tends to overstate the actual volatility of DAX–index returns. The diﬀerences between the IV forecasts and the bias–corrected IV forecasts.An obvious fact revealed in Figure 4 is the relative smoothness of all time series forecasts relative to the IV forecasts. which are almost all positive. By combining both sources of information. following the lines of Granger and Ramanathan (1984). The two top plots in Figure 5 show that the IVs’ tendency to overstate the true volatility can be corrected by either embedding an IV variable within a conditional–variance GARCH equation. if we rely only on the bias–corrected IV information instead of using a combination of GARCH and IV information. By including the implied volatility information into the GARCH equation or by combining the implied volatility forecast with a constant term. or by combining forecasts in the sense of Granger and Ramanathan (1984). this diﬀerence is smaller than 2%.0)–IV and IV forecasts ﬂuctuate considerably. However. the hypothesis that implied volatility is an unbiased estimate for one–.

Altogether. we conclude that implied volatility is a biased but highly informative predictor for future volatility. In summary.
16
.can correct for this mean bias. Moreover. implied volatilities are informationally eﬃcient relative to other historic volatility information sources. our ﬁndings support the eﬃcient market hypothesis for the DAX–index options market.

R. A Theoretical and Empirical Investigation of the Black– Scholes Implied Volatility.M. Bollerslev. Stock Market Volatility and the Information Content of Stock Index Options. The Information Content of Option Prices and a Test of Market Eﬃciency. A. 307–327. in Engle. Index–Option Pricing with Stochastic Volatility and the Value of Accurate Variance Forecasts. T.. Hong.Y.. 213–234. and Manaster. Baillie. R. and Lewis. ARCH Modeling in Finance. Engle. Journal of Econometrics. C. 5–59. Econometrica.F.K. A. 62. Kane. Engle.P. and McFadden. (1994).References
Agiakloglou. 139–157. Chiras.. Generalized Autoregressive Conditional Heteroskedasticity. D. (1982). Day. Bollerslev. Autoregressive Conditional Heteroskedasticity with Estimates of the Variance of the U. R. 31.V. Empirical Evidence on Dickey–Fuller– Type Tests. and Nelson. 6. R. and Kroner. D. 1. Yale University. Journal of Time Series Analysis. S. 203–214. P. Chou. 52. editors. Advanced Futures and Options Research.F.. Arbitrage Valuation of Variance Forecasts. 55–80. 6. (1978). (1989). New Haven. J.P.. Akgiray. 13. 471–483. Elsevier Science B. C. (1992). 267–287.. (1990).
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. Dissertation. Engle. Journal of Financial Economics.. Journal of Buisness. 987–1008. (1992).T. R. The Netherlands. and Noh. 25. R.E. T. Handbook of Econometrics. ARCH Models. R.B. volume 4. chapter 49. Bollerslev. and Noh.F. Stock Returns and Volatility. (1991). K. V. Journal of Financial and Quantitative Analysis. Conditional Heteroskedasticity in Time Series of Stock Returns: Evidence and Forecasts. J. Kane. D. 50. CT. Review of Derivatives Research.P. S. Journal of Econometrics. Inﬂation.F. Engle. 393–415.F. Feinstein. Amsterdam. (1989). Journal of Econometrics. (1996). T. T. and DeGennaro. R.. 52. T. (1992). and Newbold. (1986).

Journal of Forecasting. 6.W. P. Forecasting Stock–Return Variance: Toward an Understanding of Stochastic Implied Volatilities. A.T.J. 31. Schwert.. 369–382. S. Discussion paper 93–32(R). C. D. and Ramanathan. Engle. and Tandon. Edison.L. K. (1987). 3. 45. West. 377–392. 535–546. Journal of Banking and Finance. Forecasting Volatility and Option Prices of the S&P 500 Index. Noh. (1989). Predicting Currency Return Volatility.J.J. University of California.. Improved Methods of Combining Forecasts. (1993). Taylor. 23–45. (1986). Journal of Finance. 1129–1155. 13. (1989). J. Shastri. Granger. (1986). G. (1993).. W. 281–300. K.Gemmill. Journal of International Economics. H. and Lastrapes. (1994).H. D. and Kane. A. A.D. R. Latane. K. G. The Forecasting Performance of Stock Options on the London Traded Options Market. and Tucker. Hull. A Utility Based Comparison of Some Models of Exchange Rate Volatility. G. 183–204. R. 18
. 293–326. 42. (1994). and White. Lamoureux. E. Journal of Financial and Quantitative Analysis.G.J. San Diego. Journal of Finance. 13. (1990). 838–851. Schwert. Mathematical Finance.J. Scott. The Pricing of Options on Assets with Stochastic Volatilities. Modeling Stochastic Volatility: A Review and Comparative Study. 10. Standard Deviation of Stock Price Ratios Implied by Option Premia. Heteroskedasticity in Stock Returns. and Rendleman. 44. and Cho. (1984). C. Why does Stock Market Volatility Change over Time?. 197–204.W.F.D. Journal of Finance. R. Journal of Business Finance and Accounting.W. J. 4. and Seguin. 1115–1154. An Empirical Test of a Valuation Model for American Options on Futures Contracts. Journal of Finance. The Review of Financial Studies. (1976). 35.

J. X. 803-821. X. Xu.Xu. 57–74.J. S. (1994).
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. 29. S. The Term Structure of Volatility Implied by Exchange Options. Journal of Banking and Finance. and Taylor. (1995). Journal of Financial and Quantitative Analysis. and Taylor. 19. Conditional Volatility and Informational Eﬃciency of the PHXL Currency Options Market.

0002951 (.5485 (0.0002944) h 16
skewness -.1563) |rt | p Jarque and Bera normality test 100.15 1.16 89.757 1.000 .63 12 28.000 1.55 8 13.56 151.15 92.
20
.995 a Standard errors are given in parentheses.1115 (0.09 .891 32 37.0782)
Ljung–Box Test 2 rt rt
26.955 1.000 ARCH–Test T R2
mean .000 1.009225 excess kurtosis 1.000 . Marginal signiﬁcance levels are given without parentheses.57 0.Table 1: Summary statistics for daily returns on the DAX indexa standard deviation .73 56.

09 20.0959) -1259.2948 (0.9208 (0.0024) 0.0181) 0.52 χ2 26.4805 (0.1) Estimation Results Conditional variance equations:
(1) (5) (6) (4) (7)
2 σt = ω + α 2 σt = ω + α
2 t−1 2 t−1
2 + β σt−1 2 + β σt−1 + γ VDAX2 /250 t−1
2 σt = ω + γ VDAX2 /250 t−1 2 σt = dδ [ω + d−δ (α t t−1 2 t−1 2 + β σt−1 )]
2 2 σt = dδ [ω + d−δ (αε2 + βσt−1 + γ VDAX2 /250)] t t−1 t−1 t−1 t
with
∼ GED(ν) b (1) — 0.0231 (0.9432 (0.6545 (0.74 -1269.21 -1280.0318) 0.5484 (0.0158 (0.5674 (0.0095) 0.0638) 0.1347)
2 1.4945 1. χ2 –values correspond to LR–tests against the case given in the subsequent row.05 (.1457) 0.
21
.0029) 0.41 -1278.0924) -1267.0363) f (4) — 0.9302 (0.5957 (0.06 g (7) — 0.0293) 0.08 b d.9309 (0.05 (.0318) c (1) α+β =1 0.0493 (0.0084) 0.1050) 1.0325 (0.2010) 0.30 5.0104 (0.0021) 0.Table 2: GARCH(1.0470) 0.0130) 0.0186 (0.1070) (0.f b d a Standard deviations are given in parentheses.99 (9.01) and 5. 22.5319 – (0.0177 (0.0513 (0.0564) Case d (5) — 0.06 0.7515) e (6) — 0.01).0055 (0.63) for χ2 (1) and α = .5340 1. Critical values: 3.0090) 0.0841) (0.46.21) for χ2 (2) and α = .5980 (0.78 d
Model Restriction ω × 104 α β γ δ ν
a (1) ν=2 0.48 -1269.0493 (0.84 (6. The χ2 –statistics are distributed as χ2 (1) for models (1) and χ2 (2) for model (6).0247 (0.1355 (0.0971) (0.0025) 0.3295) 1.0355 (0.0249)
0.0281) 0.0895) log-lik -1291.40 17.7604 (0.0568 (0.4480 1.

253 3.5 72.104 1.307 3.184 2.693 2.574 2.564 3.8 68.099 2.107 0.
22
.348 3.152 2.062 3.7 66.8 72.9 0.994 3.572 0.0 72.243 2.7 66.425 2.210 1.138 2.5 76.747 66.017 68.244 1.1.287 70.923 2.7 64.823 0.748 2.108 -0.756 2.9 69.600 0.206 4.302 1.8 71.7 0 64.7 66.538 5.359 4.8 70.7 c.655 3.7 c.932 3.Table 3: Results for one–week forecasts 01/03/94 – 12/29/95 ME MSE D (%) 1 2 3 4 5 6 7 8 9 10 MA RW AR(15) VDAX IV G11 G11(δ) G00–IV G11–IV G11(δ)–IV combined: c.777 3.7 70.095 3.423 1.6 66.354 1.3.312 -0.980 7.9 74.918 2.792 2.934 2.4 78.889 2.903 -0.503 0.450 0.804 1.8 71.6 66.878 0.729 3.931 5.5 74.884 4.208 2.5 74.7 1.7 70.5.5 78.8 71.515 0.5 72.126 2.205 0.871 3.656 3.431 3.5.5 c.466 0.506 0.776 3.8 71.2.8 62.145 2.387 3.7 58.330 1.5 72.672 3.003 3.912 2.4 76.185 1.5
The ME (MSE) entries must be multiplied by 10−2 (10−3 ).915 1.465 0.6 1.5 74.908 2.639 3.6 68.9 74.698 0.425 3.526 3.9 01/04/94 – 12/30/94 ME MSE D (%) 0.7 01/02/95 – 12/29/95 ME MSE D (%) 2.127 0.9 66.344 4.244 2.0 68.101 2.693 1.284 1.932 2.825 0.5 76. The results for the best individual forecasts for a criterion are printed in bold–face.

092 0.166 3.199 1.0 84.191 62.667 0.127 0.601 3.265 2.785 2.457 -1.0 72.270 -0.207 0.0
The ME (MSE) entries must be multiplied by 10−2 (10−3 ).0 0 64.899 2.0 72.967 1.684 1.651 1.466 2.0 60.5 76.0 80.7 c.0 76.443 1.652 1.415 2.931 1.0 0 56.814 2.240 -0.683 1.975 2.204 0.451 2.0 84.7 66.829 1.830 2.433 2.002 2.0 84.740 2.893 0.599 3.0 76.0 88.711 -0.821 1.282 2.016 2.3.5.517 3.653 1.239 0.5 78.0 64.007 2. The results for the best individual forecasts for a criterion are printed in bold–face.6 74.133 0.936 -0.5.0 80.313 0.100 -0.323 2.386 0.0 72.7 64.803 2.988 2.091 0.839 1.5 76.650 1.210 1.428 0.1.904 2.5 01/04/94 – 12/30/94 ME MSE D (%) -0.0 64.312 3.0 68.0 72.
23
.0 72.0 68.867 0.0 01/02/95 – 12/29/95 ME MSE D (%) 2.0 68.044 1.489 1.366 0.7 c.018 -0.7 0 58.731 1.0 80.836 1.285 -0.848 1.744 1.2.034 0.622 1.722 4.712 0.601 2.141 2.512 64.787 0.272 1.024 1.233 1.667 1.681 2.4 76.0 80.5 c.0 60.8 64.076 0.7 68.Table 4: Results for two–week forecasts 01/03/94 – 12/29/95 ME MSE D (%) 1 2 3 4 5 6 7 8 9 10 MA RW AR(15) VDAX IV G11 G11(δ) G00–IV G11–IV G11(δ)–IV combined: c.044 2.869 64.5 72.5 76.081 2.7 1.

2
0.3
0.1
0 −4
−3
−2
−1
0
1
2
3
4
Figure 1: Comparison of Estimated and Empirical Kernel Densities
24
.5
: fitted normal : fitted GED
0.4
: Kernel estimate
0.0.

0 50.427 1.889 2.041 0.161 2.605 0.262 1.3 50.0 64.418 1.436 1.0 52.657 1.972 3.0 50.901 4.294 1.5.687 1.0 56.152 1.1.050 1.759 0.3.0 0 52.589 1.712 0.057 0.Table 5: Results for four–week forecasts 01/03/94 – 12/29/95 ME MSE D (%) 1 2 3 4 5 6 7 8 9 10 MA RW AR(15) VDAX IV G11 G11(δ) G00–IV G11–IV G11(δ)–IV combined: c.237 41.7 41.882 66.166 1.716 1.345 1.7 c.2.148 0.465 1.7 50.029 1.137 0.217 0.046 0.298 1.822 0.053 -0.569 1.089 1.0 64.770 2.0 66.5 c.560 52.293 1.0 44.0 56.554 1.0 48.115 1.666 2.0 44.114 1.662 1.7 0 41.072 -0.866 1.314 0.531 1.0 44.070 3.7 66.943 1.7
The ME (MSE) entries must be multiplied by 10−2 (10−3 ).0 52.456 2.0 50.591 1.7 c.888 1.038 1.241 0.7 41.290 -0.0 66.324 1.0 01/04/94 – 12/30/94 ME MSE D (%) -0.0 50.978 1.413 1.7 41.0 01/02/95 – 12/29/95 ME MSE D (%) 2.0 66.624 -0.208 1.027 1.0 50.178 1.7 50.3 50.045 0.022 3.001 1.303 1.140 -0.570 0.360 1. The results for the best individual forecasts for a criterion are printed in bold–face.7 1.026 1.7 0 66.7 66.251 1.218 1.7 50.949 2.0 52.7 66.204 0.095 3.323 1.583 0.166 1.738 0.
25
.141 1.884 1.7 58.0 50.5.0 58.202 1.919 2.239 1.

β..H : α.γ > 0
0 1
10 ....β.
LR−test statistic
95% critical value
5
0 040193
170593
041093
210294
110794
281194
180495
040995
220196
Figure 2: Rolling Likelihood-ratio Tests
26
.
LR−test statistic
95% critical value
5
0 040193
170593
041093
210294
110794
281194
180495
040995
220196
H : α = β = 0.β > 0..... γ > 0 versus H : α.γ > 0
0 1
10 . γ = 0 versus H : α...

iv] (dashed) 30
25
20
Volatility in %
15
10
5
0 030194
250494
101094
270295
170795
041295
030194
250494
101094
270295
170795
Figure 3: Comparison of Forecasting Models
27
.iv (solid) versus G00+iv (dashed) 30
25
20
Volatility in %
15
10
5
0 030194
250494
101094
270295
170795
041295
030194
250494
101094
270295
170795
iv (solid) versus [c.

CFS Working Paper Series:
No.ifk-cfs.
.de). 2001/06 2001/07 Author(s) Bernd Kaltenhäuser Guenter Beck Axel A. Weber Yunus Aksoy Tomasz Piskorski Elke Hahn Title Explaining the Dollar-Euro Rate: Do Stock Market Returns Matter? How wide are European borders? – New Evidence on the Integration Effects of Monetary Unions – Domestic Money and US Output and Inflation
2001/08
2001/09
Core Inflation in the Euro Area: Evidence from the Structural VAR Approach Private Benefits and Minority Shareholder Expropriation – Empirical Evidence from IPOs of German Family-Owned Firms Country-Specific and Global Shocks in the Business Cycle Trade Flows and the International Business Cycle
2001/10
Olaf Ehrhardt Eric Nowak Daniel Gross
2001/11
2001/12
Daniel Gross
2002/01
Stefan Feinendegen Daniel Schmidt Mark Wahrenburg Issam Hallak
Die Vertragsbeziehung zwischen Investoren und Venture Capital-Fonds: Eine empirische Untersuchung des europäischen Venture Capital-Marktes Price Discrimination on Syndicated Loans and the Number of Lenders: Empirical Evidence from the Sovereign Debt Syndication Money-Back Guarantees in Individual Pension Accounts: Evidence from the German Pension Reform Forecasting Stock Market Volatility and the Informational Efficiency of the DAX-index Options Market
2002/02
2002/03
Raimond Maurer Christian Schlag Holger Claessen Stefan Mittnik
2002/04
Copies of working papers are available at the Center for Financial Studies or can be downloaded (http://www.