The Information Content of Corridor Implied Variances and Their Economic Difference in the DJX Options Market

Abstract

This paper investigates the ability of corridor implied variances (CIV) with different corridors to forecast conditional volatility of DJIA index returns, and compares their performance with a CBOE volatility index, VXD, by employing several GARCH models in a model-based out-of-sample context. Besides, it explores the reasons behind the differences in the forecasting ability of CIVs and VXD through a decomposition of the model-free implied volatility. In addition, it addresses the economic difference among aforementioned implied volatility measures in a simulated options market. We find that narrow-corridor CIVs outperform wide-corridor CIVs and VXD in terms of the forecasting ability, as wide-corridor CIVs and VXD impound information from deep out-of-the-money options whose prices contain large volatility risk premiums and may not reflect a fair market expectation of volatility. In the economic sense, wide-corridor CIVs and VXD outperform narrow-corridor CIVs in turbulent periods, while narrow-corridor CIVs outperform wide-corridor CIVs and VXD in medium-and low-volatility periods. The profitability pattern is consistent both in-sample and out-of-sample, before and after transaction costs are considered, and is also robust to option strategy choices.