Testing the Volatility Term Structure Using Option Hedging Criteria

Abstract

The volatility term structure (VTS) reflects market expectations of average asset volatility over different time horizons. Various stochastic volatility models provide forecasts of the VTS and how it shifts in response to changes in market conditions. This paper develops a methodology for testing VTS forecasts using option hedging performance. An innovative feature of the hedging approach is its increased sensitivity to several important forms of model misspecification relative to previous testing methods.

Hedging tests using S&P 500 index options indicate that the GARCH components with leverage VTS estimate is most accurate. The poorer hedging performance of the alternative models suggests that volatility term structure shifts are related to the magnitude and level of recent returns. Strong evidence is obtained for mean-reversion in volatility.