Robert F Engle, Joshua Rosenberg
ABSTRACT
The volatility term structure (VTS) reflects market expectations of
asset volatility over different horizons. These expectations change over
time, giving dynamic structure to the VTS. This paper evaluates volatility
models on the basis of their performance in hedging option price changes
due to shifts in the VTS. An innovative feature of the hedging approach
is its increased sensitivity to several important forms of model misspecification
relative to previous testing methods. Volatility hedge parameters are derived
for several volatility models incorporating different predicted VTS dynamics
and information variables. Hedging tests using S&P500 index options
indicate that the GARCH components with leverage VTS estimate is most accurate.
Evidence is obtained for mean-reversion in volatility and correlation between
VTS shifts and S&P500 returns. While a convexity hedge dominates the
volatility hedges for the observed sample, this result appears to be due
to sample selection bias.
Subject: Hedging, Investments/Volatility of Asset Prices, Investments/Econometrics (Empirical, theoretical)
Engle: (619) 534-4553 rengle@weber.ucsd.edu
http://www.weber.ucsd.edu/~mbacci/engle.html
Rosenberg: (212) 998-0311 jrosenb0@stern.nyu.edu
http://www.stern.nyu.edu/~jrosenb0
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