On the Relationship between Implied Volatility Index and Realized Return Volatility

Abstract

The volatility estimation based on historical return now became least preferred tools in line of ex-ante option implied volatility based forecast. The aim of this study is to analyze the relation between realized volatility and volatility forecast using implied volatility index and forecast based on historical returns. The competing volatility forecasts are obtained for 10 -day and 22 -day forward-looking horizon, and the estimation is presented in ARCH/GARCH in-sample and out-of sample framework.. The empirical result evidence that implied volatility is the unbiased forecast of realized volatility, while Risk Metrics and GJR forecast remain biased estimate of realized volatility. DM-test explains that implied volatility is the best candidate in explaining future volatility for 10-day horizon. The practical implication of the study holds importance in the volatility estimation and portfolio risk assessment using forward-looking volatility forecasts.