Time to Maturity Volatility: An Application to Index Derivatives

39 Pages Posted: 23 Jun 2006

See all articles by Ian O'Connor

Ian O'Connor

University of Melbourne; Financial Research Network (FIRN)

Kim R. Sawyer

University of Melbourne - School of Historical and Philosophical Studies

Date Written: June 21, 2006

Abstract

The basic assumption of the Black-Scholes option pricing is that volatility is constant over the time to maturity of the option. We consider how the estimation of volatility is affected by the time to maturity. In particular, we consider the empirical distribution of volatility as a function of the time to maturity and propose a threshold estimator based on the reverting behavior of implied volatility towards the median of the empirical volatility distribution. This estimator is compared with implied and historical volatility estimators in a forecasting study of the Australian SPI 200 index futures contract. The new estimator generates smaller forecast errors of realized volatility and is the basis of a profitable trading strategy.

Keywords: Time to maturity, volatility distribution, threshold estimator

JEL Classification: C22, F3, Q49

Suggested Citation

O'Connor, Ian and Sawyer, Kim Russell, Time to Maturity Volatility: An Application to Index Derivatives (June 21, 2006). Available at SSRN: https://ssrn.com/abstract=910801 or http://dx.doi.org/10.2139/ssrn.910801

Ian O'Connor (Contact Author)

University of Melbourne ( email )

Faculty of Economics and Commerce
Parkville, Victoria 3010 3010
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Kim Russell Sawyer

University of Melbourne - School of Historical and Philosophical Studies ( email )

Melbourne
Australia

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