D. Toupin, M.H. Gagnon, G. Power: Forecasting Market Index Volatility Using Ross-Recovered Distributions

October 26, 2018

According to the Recovery Theorem (Ross, 2015), options data can reveal the market’s true, contemporaneous expectations about a specific future horizon. We implement empirically the theorem’s approach to separate implied (risk-neutral) volatility into 1) Ross-recovered true expected volatility and 2) a risk preference component, using Optionmetrics Ivy option data for the S&P500 index and four European indices (FTSE, CAC, SMI, DAX). This separation leads to better forecasts of realized volatility for all indexes in our sample compared to a traditional benchmark, implied volatility.