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(George Petch International, Brussels and CIBEF**)

By Jason Laws and Andrew Gidman

Abstract

This paper examines the ability of GARCH(1,1) and GARCH(1,1) + Implied Volatility models to forecast stock market volatility on the FTSE100 index. Comparing the volatility forecasts with the implied volatility of the corresponding at-the-money index option contract, it is investigated whether successful volatility trading models can be developed. An at-the-money index call was bought/sold if the volatility forecast was above/below the implied volatility by a certain threshold. Eight different trading strategies were developed combining the different methods of forecasting, different activation thresholds and different weightings. The strategies were analysed and performance assessed in terms of the profit / loss generated. It was found that forecasting techniques that include both market based information and times series information produce better forecasts. The combined models also produced more profitable signals. On the evidence of the research presented in this paper, the conclusion is that options markets appear to be inefficient and/or the option pricing formulae used are incorrect. This is a direct inference from the fact that volatility forecasts have been used to identify mispriced options and profitable trading rules have been established based on the implied volatility of the option and the forecasted volatility of the corresponding index

Year: 2000
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