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JAMR
10,3
Effectiveness of volatility models
in option pricing: evidence from
recent financial upheavals
352 Vipul Kumar Singh
Institute of Management Technology, Nagpur, India
Abstract
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Purpose The purpose of this paper is to explore the forecasting effectiveness of Black-Scholes (BS)
focussing parity analysis of time series econometric and implied volatility (IV) numerical techniques.
Design/methodology/approach To analyze the comparative competitiveness of econometric time
series and IV models this paper consolidated the study with their inter-relations leading toward
multilayered moneyness-maturity correlation of model and market option prices, thoroughly
determined the moneyness-maturity combinations of error metrics of Nifty index options.
Findings Out of six models tested and critically examined here, the paper procures only a single
model, IV, which best caters to the requirements of option traders and as a result the paper ended up
that only IV supports to multifarious moneyness-maturity dimension of option pricing of Nifty index
options. The analysis also confirms that the standard VIX is not a reliable tool for determining the
base price of Nifty index options (via BS). As the IV landmarks during the most dynamic phase of
Indian capital market which is a touchstone to justify the quality of any model, the paper can deduce
that IV could continue to perform in hardships of financial contraction par smoothly and effectively.
Practical implications The final outcome of this research which ended successfully in exploring
a dominant model, guided successfully through the most volatile period of Indian economy can be
used to safe guard investors faith and to figure a design which could compete on the canvass of
option pricing.
Originality/value As equity market is always subject to highly unpredictable conditions and may
keep on experiencing it through all times to come, the unified objective of research is to find out the
most impeccable volatility model to meet out the requirements of option practitioners, specifically
contributing upto the satisfaction and expected results during tumultuous period.
Keywords Financial forecasting, Data analysis, Derivatives, Econometrics, Option pricing,
Time series
Paper type Research paper
1. Introduction
The most important use of time-varying volatility models is to produce forecasts of
future volatility, which in turn used for numerous activities including derivative
asset pricing, measuring and managing risk, portfolio allocation across asset classes
and trading strategies. Therefore, it becomes highly essential to cross-examine the
effectiveness of such models underlying the dynamics of asset time series. Generally,
traders and practitioners measure the volatility in two ways, backward looking and
forward looking. Techniques namely implied volatility (IV) and volatility index (VIX)
is forward looking, reflects the future volatility of the underlying asset, obtained from
market option prices. Authors namely Day and Craig (1992), Edey and Elliot (1992),
Journal of Advances in Management Canina and Figlewski (1993), Christensen and Prabhala (1998), Ederington and Guan
Research
Vol. 10 No. 3, 2013
(2002) have advocated the use of IV as tool of volatility forecasting, because it reflects
pp. 352-375 future expectations about volatility. Whereas time series econometric methods such as
r Emerald Group Publishing Limited
0972-7981
m-windowed moving average historical volatility (HV), exponential weighted moving
DOI 10.1108/JAMR-11-2012-0048 average (EWMA) and generalized autoregressive conditional heteroskedasticity
(GARCH) are backward looking, as they all computes the HV from the time series Volatility models
data of financial assets (French et al., 1987), reflects the past realizations. Practitioners in option pricing
find that for the pricing of financial assets, future volatility is the relevant volatility,
not the HV. HV will only be helpful in forward pricing if the future remains like the
past, which is not the case in the real world (Schwert, 1989; Pagan, 1996).
Though future volatility is most relevant, but the random characteristics of
financial assets time series return data makes it highly difficult for researchers to 353
model it (Baillie and DeGennaro, 1990). Volatility of financial factors makes modeling
of financial assets highly cumbersome (Taylor, 1986; Engle and Patton, 2001), as
the same is always subject to state of high uncertainty and thus, modeling and
forecasting performance of hypothecated volatility models are always exposed to the
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risk of failure (Glosten et al., 1993). However, to ensure the forecasting success,
econometric models namely GARCH family models tried their level best, incorporated
the financial characteristics of asset returns into volatility (Cumby et al., 1993;
McKenzie and Mitchell, 2004).
Volatility is now a tradable entity and traded successfully on the bourses of many
exchanges including India, thus precise estimation of same is highly crucial. In the
realm of option pricing the success of the Black-Scholes (1973) formula is because
of its simplicity, analytical tractability and closed form solution. Besides fulfilling
the core purpose of option pricing, from the past four decades the formula is also using
reciprocally to provide the quotes of volatility, coined as IV. Researchers reveals that,
since it not only incorporates inherent information of historical data of underlying
asset but also of market option prices, it has the forecast capability and is therefore
used extensively to forecast underlying assets (Beckers, 1981; Mayhew, 1995; Blair
et al., 2001). But from the time researchers and practitioners reveals that the volatilities
are often correlated with the underlying-asset price, stochastic volatility models
become a more realistic choice for modeling of dynamics of assets price of derivative
securities. Although, in last four decades several models have been introduced but only
a few, namely Hull and White (1987), Heston (1993) and Heston and Nandi (2000)
manages to retain the popularity amid computational complexity and poor analytical
tractability of other stochastic models. In series Dumas et al. (1998) also modeled the IV
as a set of quadratic combinations of moneyness-maturity, named it deterministic
volatility functions. The model was found to significantly improve the price bias
of Black-Scholes (BS). Therefore, in order to provide an all round taste and make this
research work complete, we tested the empirical efficiency of various versions of
volatility models ranging from time series econometric and implied volatilities.
As the equity market is always subject to highly unpredictable conditions and may
keep on experiencing it through all times to come, the unified objective of this research
is to find out the most impeccable volatility model to meet out the requirements of
option practitioners, specifically contributing upto the satisfaction and expected
results during tumultuous period. To measure the cross-competency of volatility
models in option pricing, we have simply embedded volatility models into the classical
BS model and tested the forecasting effectiveness of the two, together. Chronologically,
Pagan and Schwert (1990), Poon and Granger (2003) and Alberg et al. (2008) tested the
effectiveness of IV and GARCH models in option pricing and reveled that IV estimators
outperform GARCH family models.
Thus, to provide a fresh and focussed approach, this paper search out the most apt
volatility model for pricing of Nifty index options, the most heavily trading product of
National Stock Exchange (NSE) of India. In Figure 2 it is evident that Nifty index
JAMR options alone account three-fourth of the total trading volume of Future & Option
10,3 (F&O) segment of NSE, and is also among the top five traded instruments of the world,
in similar category. To testify, the hypothecated models are further inter-passed
through the recent waves of financial upheavals, spanning 2006-2011. This period not
only rows an extreme of phenomenal unpredictability but also ranging the high
and low tides of financial flux. Thus, this specific period provides the most apt
354 situation for testifying the applicability of volatility models. The relative price errors
of model produced in the said duration will probe out the most apt volatility model,
which will further explain option-pricing market in the most scientific terms. Since,
India VIX was launched toward the end of year 2007 on the bourse of NSE, data
of same are not available for the period of study mentioned above. Thus, to testify
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the applicability of VIX in option pricing this paper is divided in two time veins.
First consist of the window of year 2006-2011 while second encompass the period
of 2008-2011.
Along these lines, the paper is distributed in seven sections. Section 2 describes the
descriptive statistics of Nifty index and index options, financial characteristics of Nifty,
option categories and data screening procedure. Section 3 discusses the research
methodology. Section 4 gives a brief overview of BS and competing volatility models
(which will used as an input in BS). Section 5 reveals the result. Section 6 briefs
about the managerial implications of this research. Section 7 finally concludes the
research work.
300
355
Frequency
200
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100
Figure 1.
0 Non log-normality of
0.2000 0.1000 0.0000 0.1000 0.2000 Nifty index return
Return
3,50,000 80
Index Turnover
3,00,000 70
Turnover (Rs Billion)
20 -02
20 -03
20 -04
20 -05
20 -06
20 -07
20 -08
20 -09
20 -10
20 -11
2
-1
Business growth of
00
01
02
03
04
05
06
07
08
09
10
11
20
index options
Year
On the other hand, to correct the systematic price bias of self, the BS model establishes
forecasting applicability of implied volatilities across moneyness-maturities.
The forecasting performance of IV models highly depends on the choice of moneyness
because of smile (exhibited in Figure 5). To alleviate this, of the many versions of IV
discovered in last four decades, at-the-money (ATM) is the most popular one, but it
suffer from the drawback that it discards the incorporation of all potential information
contained in out-of-the and in-the-money options.
Figure 1 depicts that the return distribution of frequency of Nifty index is
non-lognormal, slightly skewed to the right and highly peaked toward the top and that
the right tail is thicker than the left tail, indicates that during the specific period,
probability of positive return is more probable as compared to that of negative return.
JAMR Nifty Index Movement
10,3 BS ATM IV (%)
100
7,000
90
06
07
08
09
10
11
Leverage effect of at-the-
n-
n-
n-
n-
n-
n-
money implied volatility
Ja
Ja
Ja
Ja
Ja
Ja
2-
2-
2-
2-
2-
2-
and Nifty index return
Date
0.20
0.15
Nifty Index Returns
0.10
0.05
0.00
0.05
Figure 4. 0.10
Volatility clustering of
Nifty index return 0.15
Date
where St is the current asset price, K is the strike price, r is the risk-free interest rate
and C(St, t) is the call price at time t, t is the time to maturity in year. Data not satisfying
the lower boundary condition were also ruled out. The final set of data figured into
Volatility models
in option pricing
0.40
357
Implied Volatility
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0.30
09
9.
0.20
76
4. 10
Mo 0 20
ne 0.0 3
yn 40 0
es 6 5
s( 5.2 60 0
% ys)
) 70 Da
11 9 80 ity (
11. 0 tur
Ma Figure 5.
Volatility smile pattern
Notes: Data of April 24, 2012, index price: 4999.85, volatility: 25 percent, of Nifty index options
risk free rate:7.43 percent is used to figure out the smile pattern
33,576 call options for first window and 26,497 for second window. Tables I and II,
display the descriptive statistics of raw and filtered data. The final set of remaining
data were then categorically placed in a matrix of three rows and five columns of time
to maturity and moneyness, defined as:
9 8
Short Maturity >
> >
> 45 and p30 Days
= <
Medium Maturity if Time to Maturity T 430 and p60 Days
>
> >
>
; :
Long Maturity 460 and p90 Days
9 8
deep out of the money DOTM >
> >
> X 0:15 ando 0:10
>
> >
>
>
> >
> X 0:10
out of the money OTM >
> >
> ando 0:05
= SK <
at the money ATM if Call Moneyness X 0:05 andp 0:05
>
> K >
>
>
> >
>
in the money ITM >
> >
> 4 0:05 andp 0:10
>
> >
>
; :
deep in the money DITM 4 0:10 andp 0:15
3. Research methodology
To analyze the comparative competitiveness of econometric time series and IV models,
this paper consolidated the study with their inter-relations leading toward multilayered
JAMR Years Sub-total
10,3 2006 2007 2008 2009 2010 2011 2006-2011
Total call contracts 44,555 38,890 72,494 93,860 95,008 179,695 524,502
Maturity
Short 2,511 3,287 8,169 1,498 607 16,072
7.48% 9.79% 24.33% 4.46% 1.81% 47.87%
Medium 1,737 2,706 6,049 1,011 259 11,762
5.17% 8.06% 18.02% 3.01% 0.77% 35.03%
Table II. Long 869 1,681 2,939 210 43 5,742
Nifty index call option 2.59% 5.01% 8.75% 0.63% 0.13% 17.10%
statistics for the years Total/sub-total 5,117 7,674 17,157 2,719 909 33,576
2006-2011 (post filtration) 15.24% 22.86% 51.10% 8.10% 2.71% 100.00%
1X k
MPE C Model CiMarket =CiMarket
K i1 i
1X k
MAPE CiModel CiMarket =CiMarket
K i1
where CModel
i and CMarket
i are the predicted and actual price of the options, respectively,
and i and k are the total number of observations. As understood, both the metrics find
the deviation of prices of model from the market, but whereas PME measures the
relative average deviation of model from the market MAPE measures the absolute
deviation of model from the market.
The volatility and its associated parameters (if any) were updated on a rolling basis, Volatility models
almost every day. Thus in total, volatility was obtained for 1,487 trading days. To in option pricing
testify the forecasting quality of volatility models focussing pricing imperfection of BS,
this paper simply looks at the relative error of the models related to the market.
Parameters of GARCH models are also estimated on a rolling window, one-year rolling
window is used to determine same, starting from the beginning of 2006 (2008) to the
end of 2011, for first and second window, respectively. 359
On the other hand, to infer option-related IV structural parameters from market
data, this paper employs the most simple but elegant again, least square (LS) loss
function (Chiarella et al., 2000; Christoffersen and Jacobs, 2004; Rouah and Vainberg,
2007). Further, the optimal set of parameters obtained, are then used to compute the
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models price. The methodologies of finding the volatility of all other models have been
discussed individually in the next section.
Finally, to interpret and evaluate the relative forecasting capability of volatility
models (relative to market) Theils U statistics has been employed. The value of U
statistic is bound between 0 and 1, defined as:
s
P n 2
CiModel CiMarket
i1
U s s
P n 2 P n 2
CiModel CiModel
i1 i1
The lower the value of U statistics, the more accurate the forecast is. The values closer
to 0 implies greater forecast accuracy and closer to 1 implies worst forecast.
4. Volatility models
4.1 Time series econometric models
4.1.1 m-Windowed moving average HV. Rolling window of historical data is the most
simple and popular way of estimating the standard deviation of a financial assets
return. The method utilized past data to predict the future with a belief that the future
will remain like the past. The method is appropriate to the extent the hypothesis
remain true or to the extent history repeats itself. In practice, traders always
considered the future volatility relevant to estimate the prices of financial assets,
because for them the past is not important. What is important is the future and since
the future is uncertain, HV cannot be the right choice (Mixon, 2009). However, HV is
useful when the return of asset prices is found to be auto-correlated, but in that case,
performance of HV will be subject to the degree of autocorrelation. Since, Figure 6
clearly exhibits that Nifty index returns do not show significant autocorrelation, prima
facie discarding the forecasting uses of HV in option pricing.
The major flaw of using the m-windowed moving average is that its gives equal
weight to all the data within the window and eventually forget a particular event when
the specific date is moved out of the window. Figure 7 demonstrates the memory loss
effect of windowed moving average. On January 21 and 22, 2008, stock markets around
the world dipped in response to the sub-prime crisis and a series of failure of big
investment banks of America.
Figure 7 clearly depicts that immediately after the crash, volatility shifted to a new
high. The volatility level then remained high for a period of time, but the moment the
JAMR 0.10
10,3 0.08
0.06
Sample Autocorrelation
0.04
0.02
360 0.00
0.02 0 10 20 30 40 50 60 70
0.04
0.06
Figure 6.
0.08
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Autocorrelation of
Nifty index return 0.10
Lag, k
50
40
30
20
10
0
-08 ar-08 -08 ul-08 -08 -08 -09 ar-09 -09
an ay ep ov -Jan ay
1-J 1-M 1-M 1-J 1-S 1-N 1 1-M 1-M
Figure 7.
EWMA vs 20-day Date
rolling HV method
Note: EWMA is calculated using =0.95
crash date moved out of the 20-day window, the volatility level dropped suddenly, as
the 20-day window had forgotten the crash completely. While in practice, behaviorally
the effect of such crash remains for a longer period. For example, an investor who has
suffered a great loss in any crash, would not forgot the crash after a period. The same
pattern and effect was noted in January 2008, October 2008 and May 2009. On October
24, 2008, Nifty marked its multi year low, tank down 359.15 points (12.20 percent)
because of impeding global factors whereas on May 18, 2009, Nifty jumped up 651.5
points ( 17.74) because of positive sentiments aroused from the clear mandate
of generally assembly election of 2009. Thus, the financial characteristics of the
m-windowed moving average are contrary to intuition of traders and investors and are
not able to gauge the sentiments of traders with perfection. The formula is:
1X m
s2n u2
m i1 ni
where ui is the proportional change in the asset price during day i and gives
equal weights to all u2i s.
4.1.2 EWMA. The rolling variance approach is criticized by practitioners because it Volatility models
assigns equal weights to all the observations in the window, which was against the in option pricing
intuition of traders, that distant past observations (events and shocks) have lesser
impact on future volatility of assets compared to the recent past observations (events
and shocks), consequently EWMA was developed. EWMA is a special case of ARCH
model in which weights gi (1d)di1 of the model:
361
s2n ds2n1 1 du2n1
decreases exponentially form new to old data; hence it gives more weight to the more
recent observations and less to the older ones. The values of parameter d is a constant,
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whose value typically lies between 0 and 1 (0.9 odo1). As i increases the weights of
asset return uis decline at a rate d.
Figure 7 reveals that contrary to the 20-days windowed volatility, in EWMA
model, it does not drop suddenly after the period of crash, instead it decreases
gradually. Thus, it keeps the incident in its memory for a longer period compared
to its HV counterpart.
4.1.3 Discrete time GARCH volatility models. Since the ARCH model of Robert Engle
(1982) surfaced, numerous forms of ARCH models have been introduced and applied
in different areas of finance, ranging asset pricing, modeling of financial time-series
and risk management (Engle and Ng, 1993; Cumby et al., 1993; Bekaert and Wu, 2000;
McKenzie and Mitchell, 2002; Alberg et al., 2008; Harrison and Moore, 2012). Engle
modeled the variance of a time series by conditioning it on the square of lagged
disturbances, error terms (shocks). Similar to EWMA, GARCH (Bollerslev, 1986) is the
generalized version of ARCH, GARCH. The GARCH (1,1) is the most successful
variant of GARCH family models. The most important specification of the model is
that it incorporates the four important financial characteristics of asset return data:
auto-regression, heteroskedasticity, excess kurtosis and volatility clustering,
simultaneously. Auto-regression is a feedback mechanism, which incorporates past
observations into the present, while conditional heteroskedasticity measures the time-
varying characteristic of volatility conditional to observations of the immediate past.
In order to predict the future volatility, GARCH incorporates serial dependence of HV
i.e. volatility persistency. Figures 3, 4 and 8 jointly advocates the applicability of the
GARCH model to forecast Nifty. Whereas, Figure 8 strongly advocates the applicability
0.200
0.180
0.160
0.140
Autocorrelation
0.120
0.100
0.080
0.060
0.040
0.020 Figure 8.
0.000 Autocorrelation of
squared of Nifty
0.020 0 10 20 30 40 50 60 70
index return
Lag, k
JAMR of GARCH (exhibits a strong positive autocorrelation between square of Nifty index
10,3 return at various lags), Figure 9 support it weakly, exhibits moderate autocorrelation
between the ratio of square of Nifty index return and GARCH volatility, at certain
lags only.
The GARCH(q, p) forecast of volatility for time t 1, based on values observed at
time t, is given by mean and variance equation defined as:
362 Mean Equation
r t f et
Variance Equation
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X
q X
p
s2t1 Z gi e2t1i lj s2t1j
i1 j1
where q is the order of ARCH process and p is the order of GARCH. e2t 11 (the
ARCH term) incorporates news about volatility from the previous period, measured as
the lag of the squared residuals from the mean equation, s2t 1j is the past period
forecast variance (the GARCH term), and Z, gi and lj are parameters that are all 40
(i 1, y , q and j 1, y , p). Error, et is assumed to be normally distributed with zero
mean and conditional variance, s2t .
4.2 EGARCH model
EGARCH is the refined version of the GARCH model introduced by Nelson (1991).
In addition of the GARCH risk-return tradeoff, EGARCH incorporates the leverage
effect of financial assets. Figure 3 exhibits the leverage effect of Nifty index, implies
whenever market/equity moves up, volatility goes down and vice versa. To ensure the
basic framework of GARCH; the conditional variance s2t of asset return (rt) at any point
of time (t) cannot be negative, EGARCH model expressed s2t as a linear combination
(with positive weights) of positive random variables, defined as:
Mean Equation
rt f yst et
0.10
0.08
0.06
Sample Autocorrelation
0.04
0.02
0.00
11 21 31 41 51 61 71
Figure 9. 0.02
Autocorrelation of ratio
of squared of the Nifty 0.04
index return and its
GARCH volatility 0.06
Lag, k
Variance Equation Volatility models
et et in option pricing
log s2t1 Z l log st g d
2
st st
Because of the logarithmic form of conditional variance, the model is popularly known
as exponential-GARCH model, and implies that the leverage effect is exponential 363
(Engle and Ng, 1993). The statistical significance of the leverage effects can be test by
formulating the hypothesis d!0 and da0, also an indicator of the asymmetric
impact of volatility. But opposite to the GARCH, it not imposes any nonnegative
constraints on the coefficients of model parameters. Brandt and Jones (2006) and Li and
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4.3 IV models
4.3.1 BS ATM IV. BS ATM IV is the most popular among the numerous implied
volatilities. Researchers acclaimed that the ATM volatility of BS is virtually unbiased,
as the formula is nearly linear in sigma for ATM options (Feinstein, 1989; Fleming,
1998; Fengler, 2012). The IV is the value, which when embedded back in BS formula,
yields the observed option price. This means that ATM implied volatilities are
important because they constitute a forward-looking estimate of the volatility of the
underlying asset.
The BS model hardly requires any introduction. Due to its closed form solution,
computational simplicity and analytical tractability the model is most popular and
despite well-known shortcomings still used extensively for fixing the base price of
European options underlying various financial assets. The Black and Scholes (1973)
formula for pricing European call options on a stock paying no dividends is:
CBS SN d1 Kert N d2
where
lnS=K r 0:5s2 t
d1 p
s t
lnS=K r 0:5s2 t p
d2 p d1 s t
s t
C is the option price of call option, S is the price of underlying assets (Nifty here), K is
the exercise price, t is the time to maturity in years, r is the risk-free rate of return
(equal to 91-day T-bill yield), N(d) is the standard normal distribution function, and s2
is the variance of asset returns.
Except volatility, all other parameters of the model are directly observable from the
market. The same can be estimated inversely by inverting the formula, but since the
formula cannot be directly inverted algebraically, different numerical techniques such
as simulation, optimization, Newton Raphson and Bi-section methods need to be
employed to estimate the same. For estimating the ATM IV, this paper utilized
Newton Raphson Method.
JAMR 4.3.2 Parametric IV. Though, the BS ATM IV is considered to be the most popular
10,3 tool for the forecast of future volatility, but as implied volatilities exhibits a smile/skew
pattern, the choice of moneyness become highly important for calculating the
non-skewed IV. To circumvent this, the practitioner uses ATM IV for forecasting.
Though, ATM alleviates the smile/smirk problem, but at the same time it discards
the uses of all potential information contained in the rest of the option prices
364 (available across moneyness and maturities). Therefore, to include information content
of all option prices, we employed the method of LS, which incorporates the whole
cross-section of option prices including ATM. This method implied the volatility from
the set of market data. Employing the technique of optimization (LS, already discussed
in previous section), this method minimizes the price difference of the model (BS) and
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X
n
2
f s min Cobs;i K; T CBS;i s; K; T
s
i1
where n is the number of observation in a day, Cobs is a market-observed call price and
CBS is theoretical BS call price. The process is computationally intensive and complex,
as achieving a universal gradient is not an easy task. The process will be iterated
for the entire sample on a daily basis.
4.3.2 VIX. The VIX is actually a modeled free advance version of BS ATM IV. It is
more liberalized than its ATM counterpart and it incorporates the wide range of
moneyness. In India, VIX was introduced toward the end of year 2007 with the
objective of providing a premier barometer of market volatility to investors. Since VIX
infer volatility from the market option prices directly, it provides an apt value for
estimating the forecast of Nifty index and the associated instruments, measures the
markets expectation of 30-day S&P CNX Nifty index volatility. Traders can make their
decision based on this, as they presumed that it gauges the market volatility. VIX is
figured out from the best bid-ask quotes of short and medium term Nifty index options
contracts. Computational methodology of India VIX is the same as of CBOE with little
modifications (for details visit www.nseindia.com).
Short term
DOTM Average 6.2 18.0 18.3 11.7 15.6 14.0 5.1
SD 10.1 34.9 36.6 26.4 26.6 26.7 11.2 365
OTM Average 17.4 38.0 38.2 29.5 34.6 34.9 16.1
SD 22.1 58.1 60.3 50.0 40.1 53.0 22.6
ATM Average 106.5 126.9 127.7 119.2 127.8 127.5 103.4
SD 76.8 91.7 94.2 86.2 82.2 87.9 75.0
ITM Average 352.2 351.3 352.5 342.9 359.1 350.6 346.3
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higher than the implied counterparts. Prima facie, the econometric models are found to
either highly overvalue or undervalue Nifty index options, as compared to IV models.
Second, there is an apparent trend, in all the cases volatility increases monotonically in
either way moving from ATM to DITM or DOTM. This behavior of volatility is widely
known as smile and since all the variants of volatility exhibit this pattern, it indicates
that all the models would misprice Nifty index options. Thus, the only point of concern
is to find out the model exhibiting the lowest price error across moneyness-maturity.
Also, compared to short and medium-maturity options, long-maturity options exhibit
a lower variation from DOTM to DITM. This indicates that the price variation of
JAMR Maturity statistics
10,3 Models
BS (HV) BS (EWMA) BS (GARCH) BS (EGARCH) BS (ATM) BS (IV)
Short term
DOTM Average 0.30 0.30 0.27 0.32 0.29 0.23
366 SD 0.15 0.16 0.11 0.13 0.13 0.10
OTM Average 0.29 0.29 0.26 0.30 0.28 0.22
SD 0.14 0.15 0.11 0.13 0.12 0.09
ATM Average 0.26 0.26 0.24 0.27 0.26 0.20
SD 0.13 0.14 0.10 0.12 0.11 0.08
ITM Average 0.28 0.28 0.25 0.28 0.29 0.22
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short- and medium-term options is likely to be higher than the long-maturity options,
which implies that the estimation of pricing of short- and medium-maturity options is
likely to be difficult as compared to the long-term options.
The Tables V and VI exhibit the descriptive statistics of the mean percentage and
the mean absolute percentage price error of Nifty index options. The call options
values are inferred from the classical BS model computed with econometric and
implied volatilities as input. Conjoint analysis of data of Tables V and VI reveal the
following interesting facts: First, except IV, all tend to overprice the Nifty index call
options across moneyness-maturity. The degree of pricing error of HV and EWMA is
Maturity statistics
Volatility models
Models in option pricing
BS BS BS BS BS BS No. of
(HV) (EWMA) (GARCH) (EGARCH) (ATM) (IV) observations
Short term
DOTM Average 1.50 1.53 0.88 1.55 1.07 0.56 2,511 367
SD 6.90 6.93 6.56 2.91 6.50 0.61
OTM Average 1.24 1.27 0.95 1.51 1.18 0.24 3,287
SD 4.09 4.12 4.01 2.09 3.96 0.57
ATM Average 0.32 0.33 0.25 0.41 0.36 0.03 8,169
SD 0.75 0.81 0.72 0.69 0.71 0.22
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somewhat similar, may be because of the fact that EWMA is only a refined version of
HV. The pricing error of DOTM, OTM and ATM is higher compared to ITM and DITM
options, the reason being that the traders are more biased toward them amidst low
price and leverage. On the contrary, amidst high prices and low leverage, ITM and
DITM options are less popular (Table II), together they account only 11 percent of total
tradable liquid Nifty index options.
JAMR Maturity statistics
10,3 Models
BS BS BS BS BS BS No. of
(HV) (EWMA) (GARCH) (EGARCH) (ATM) (IV) observations
Short term
368 DOTM Average 2.18 2.25 1.68 2.07 1.73 0.70 2,511
SD 6.72 6.74 6.40 2.56 6.36 0.45
OTM Average 1.57 1.65 1.37 1.73 1.43 0.48 3,287
SD 3.97 3.99 3.89 1.91 3.87 0.39
ATM Average 0.42 0.45 0.37 0.46 0.41 0.13 8,169
SD 0.70 0.75 0.67 0.65 0.68 0.18
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The pricing performance of GARCH and EGARCH models decreases with the increase
in maturity, implying that the forecasting capacity of the models decreases with
the increase in the forecast period. BS-IV under prices (56 percent) short-term DOTM
options whereas, all other models overprice it. Both, EWMA and HV severely misprice
it with error percentage higher than 150 percent. The same set of pattern is repeated
for OTM and ITM options. However, the degree of error decreases with the increase
in moneyness. Table VI also supports the results of Table V. In line with the statistics
Maturity statistics
Volatility models
Models in option pricing
BS BS BS BS BS BS BS No. of
(HV) (EWMA) (GARCH) (EGARCH) (ATM) (IV) (VIX) observations
Short term
DOTM 0.88 0.95 0.35 1.45 0.56 0.55 1.74 2,322 369
2.36 2.7 1.95 2.87 1.74 0.63 2.74
OTM 0.82 0.87 0.64 1.47 0.85 0.22 2.17 2,791
1.57 1.78 1.69 2.11 1.18 0.59 2.16
ATM 0.31 0.32 0.22 0.45 0.32 0.02 0.65 5,003
0.51 0.63 0.53 0.73 0.42 0.23 0.92
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of Table V, Table VI also reveals that the pricing performance of models decreases
from DOTM to DITM and from short-maturity to long-maturity options, except in case
of GARCH and EGARCH model. The absolute price error of IV is lower across
moneyness-maturity.
VIX may be able to portray and replicate the real volatility of Nifty index and
incorporation of the same in BS will significantly improve its pricing bias. In this hope,
we did a thorough analysis of the same and compared its performance with versions of
JAMR Maturity statistics
10,3 Models
BS BS BS BS BS BS BS No. of
(HV) (EWMA) (GARCH) (EGARCH) (ATM) (IV) (VIX) observations
Short term
370 DOTM 1.61 1.72 1.19 2.00 1.24 0.7 2.16 2,322
1.94 2.29 1.59 2.52 1.34 0.46 2.42
OTM 1.19 1.28 1.08 1.69 1.10 0.49 2.29 2,791
1.32 1.51 1.45 1.93 0.95 0.41 2.04
ATM 0.36 0.39 0.31 0.49 0.34 0.13 0.66 5,003
0.47 0.58 0.48 0.7 0.40 0.18 0.91
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volatility models already discussed for the window spanning 2008-2011. To our
surprise, pricing performance of VIX is the most pitiful across moneyness-maturity,
evident from Tables VII and VIII. The degree of mispricing is even higher than the HV
and EWMA, being more than 200 percent for DOTM and OTM options.
Tables VII and VIII depict the comparative statistics of MPE and MAPE
of econometric time series and IV models. MPE and MAPE depicts similar. From
Tables VII and VIII, we jointly deduced that out of all volatility models discussed here,
when put together and examined, IV is the only model which prices Nifty index options Volatility models
with lowest pricing error and stands firmly on the ground of comparative in option pricing
competiveness. Figure 10 graphically proves the same (generated randomly).
In the first window spanning 2006-2011, the average percentage pricing error of IV
model is significantly lower than HV, EWMA, GARCH, EGARCH and ATM models in
14 out of 15 categories of moneyness-maturity, while in the second window covering
2008-2011, it not only outperforms econometric models, but is also the most hyped 371
implied counterpart (VIX), across all moneyness groups. We find that the parametric
IV model, providing a significant improvement over econometric and IV models, is the
most reliable tool to make future predictions of Nifty index options.
Theils U statistics, depicted in Table IX, also positioned IV on the top followed
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Performance of ATM IV also shows trends similar to GARCH and EGARCH. But it is
also not surprising as short-term ATM IV is used to determine the medium and
long-term options. Ideally, one should use corresponding ATM IV for corresponding
options i.e. short for short and long for long, but doing so would lead to voluminous
5.0 BS EWMA
BS GARCH
4.0
BS ATM Price
3.0 BS IV Parameter
MPE
2.0 BS VIX
1.0 BS EGARCH
0.0
2 0 8 6 4 2 0 3 5 8 1 4 Figure 10.
1.00.1 0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.1 0.1 Price bias of
volatility models
2.0 Moneyness
JAMR Maturity statistics
10,3 Models
BS BS BS BS BS BS BS No. of
(HV) (EWMA) (GARCH) (EGARCH) (ATM) (IV) (IVX) observations
Short term
372 DOTM Average 0.53 0.57 0.41 0.49 0.39 0.19 0.55 2,322
OTM Average 0.38 0.41 0.29 0.36 0.28 0.14 0.39 2,791
ATM Average 0.13 0.14 0.10 0.13 0.09 0.04 0.13 5,003
ITM Average 0.04 0.05 0.03 0.03 0.02 0.02 0.04 1,146
DITM Average 0.02 0.03 0.02 0.02 0.01 0.01 0.02 508
Sub Total Average 0.09 0.10 0.06 0.08 0.06 0.03 0.09 11,770
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Medium term
DOTM Average 0.43 0.45 0.38 0.45 0.38 0.16 0.46 1,669
OTM Average 0.32 0.33 0.32 0.35 0.28 0.09 0.35 2,440
ATM Average 0.13 0.14 0.13 0.15 0.11 0.03 0.15 4,263
ITM Average 0.05 0.06 0.05 0.05 0.04 0.02 0.05 862
DITM Average 0.04 0.04 0.03 0.02 0.02 0.01 0.03 239
Subtotal Average 0.12 0.13 0.12 0.14 0.10 0.03 0.13 9,473
Long term
DOTM Average 0.40 0.39 0.51 0.52 0.41 0.15 0.48 865
OTM Average 0.29 0.30 0.42 0.39 0.28 0.09 0.35 1,646
Table IX. ATM Average 0.13 0.14 0.20 0.18 0.12 0.04 0.16 2,499
Theils U statistics of Nifty ITM Average 0.04 0.05 0.07 0.05 0.04 0.02 0.05 199
index call options DITM Average 0.02 0.03 0.03 0.03 0.02 0.02 0.03 43
(years 2008-2011) Sub-total Average 0.14 0.14 0.21 0.19 0.13 0.04 0.17 5,252
analysis. Despite of fact that the principal concept of ATM IV and IVX is same,
performance of IVX is worst. The reason could be its standardized determination
process which involves near month (short term) liquid contracts and next month
(medium term) illiquid contracts for inferring IV (visit www.nseindia.com for details).
As, EWMA is just an advance replication of HV, therefore suffers from common
weakness, replicates past into future, but thats not the case (Figure 4), therefore prices
options poorly.
The above results strongly suggest that in both windows, IV model is the only
model which yields values closer to the market prices, compared to others. But, so far
the quintessence of this research drive concerned, though IV dominate the rests in all
the categories of moneyness-maturity, but it is not able to replicate the market prices
completely.
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Corresponding author
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1. Vipul Kumar Singh National Institute of Industrial Engineering (NITIE), Mumbai, India . 2015. Pricing
competitiveness of jump-diffusion option pricing models: evidence from recent financial upheavals. Studies
in Economics and Finance 32:3, 357-378. [Abstract] [Full Text] [PDF]
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