Testing the volatility term structure using option hedging criteria

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 meanreversion 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.