Modelling the dynamics of implied volatility smiles and surfaces

"Smile-consistent" no-arbitrage stochastic volatility models take today's option prices as given, and they let them to evolve stochastically in such a way as to preclude arbitrage. This allows standard options to be priced correctly, and enables exotic options to be valued and hedged relative to them. We study how to model the dynamics of implied volatilities, since this is a necessary prerequisite for the implementation of these models. First, we investigate the number and shape of shocks that move implied volatility smiles, by applying Principal Components Analysis. The technique is applied to two different metrics: the strike, and the moneyness. Three distinct criteria are used to determine the number of components to retain. Subsequently, we construct a "Procrustes" type rotation in order to interpret them. Second, we use the same methodology to identify the number and shape of shocks that move implied volatility surfaces. In both cases, we find that the number of shocks is the same (two), in both metrics. Their interpretation is a shift for the first one, and a Z-shaped for the second. The results have implications for both option pricing and hedging, and for the economics of option pricing. Finally, we propose a new and general method for constructing a "smile-consistent" no-arbitrage stochastic volatility model: the simulation of the implied risk-neutral distribution. An algorithm for the simulation is developed when the first two moments change over time. It can be implemented easily, and it is based on the idea of mixture of distributions. It can also be generalized to cases where more complicated forms for the mixture are assumed

Are VIX futures prices predictable? An empirical investigation

This paper investigates whether volatility futures prices per se can be forecasted by studying the fast-growing VIX futures market. To this end, alternative model specifications are employed. Point and interval out-of-sample forecasts are constructed and evaluated under various statistical metrics. Next, the economic significance of the forecasts obtained is also assessed by performing trading strategies. Only weak evidence of statistically predictable patterns in the evolution of volatility futures prices is found. No trading strategy yields economically significant profits. Hence, the hypothesis that the VIX volatility futures market is informationally efficient cannot be rejected. (C) 2010 International Institute of Forecasters. Published by Elsevier B.V. All rights reserved

Can the dynamics of the term structure of petroleum futures be forecasted? Evidence from major markets

We investigate whether the daily evolution of the term structure of petroleum futures can be forecasted. To this end, the principal components analysis is employed. The retained principal components describe the dynamics of the term structure of futures prices parsimoniously and are used to forecast the subsequent daily changes of futures prices. Data on the New York Mercantile Exchange (NYMEX) crude oil, heating oil, gasoline, and the International Petroleum Exchange (IPE) crude oil futures are used. We find that the retained principal components have small forecasting power both in-sample and out-of-sample. Similar results are obtained from standard univariate and vector autoregression models. Spillover effects between the four petroleum futures markets are also detected. (c) 2007 Elsevier B.V. All rights reserved

Are VIX futures prices predictable? An empirical investigation

This paper investigates whether volatility futures prices per se can be forecasted by studying the fast-growing VIX futures market. To this end, alternative model specifications are employed. Point and interval out-of-sample forecasts are constructed and evaluated under various statistical metrics. Next, the economic significance of the forecasts obtained is also assessed by performing trading strategies. Only weak evidence of statistically predictable patterns in the evolution of volatility futures prices is found. No trading strategy yields economically significant profits. Hence, the hypothesis that the VIX volatility futures market is informationally efficient cannot be rejected. (C) 2010 International Institute of Forecasters. Published by Elsevier B.V. All rights reserved

Should investors include commodities in their portfolios after all? New evidence

This paper investigates whether an investor is made better off by including commodities in a portfolio that consists of traditional asset classes. First, we revisit the posed question within an in-sample setting by employing mean-variance and non-mean-variance spanning tests. Then, we form optimal portfolios by taking into account the higher order moments of the portfolio returns distribution and evaluate their out-of-sample performance. Under the in-sample setting, we find that commodities are beneficial only to non-mean-variance investors. However, these benefits are not preserved out-of-sample. Our findings challenge the alleged diversification benefits of commodities and are robust across a number of performance evaluation measures, utility functions and datasets. The results hold even when transaction costs are considered and across various sub-periods. Not surprisingly, the only exception appears over the 2005-2008 unprecedented commodity boom period