Forecasting Volatility in the Presence of Limits to Arbitrage

Lu Hong, Tom Nohel and Steven Todd

Journal of Futures Markets, 2015, vol. 35, issue 11, 987-1002

Abstract: In this article, we develop a novel model to forecast the volatility of S&P 500 futures returns by considering measures of limits to arbitrage. When arbitrageurs face constraints on their trading strategies, option prices can become disconnected from fundamentals, resulting in a distortion that reflects the limits to arbitrage. The corresponding market based implied volatility will therefore also contain these distortions. Our contributions are both conceptual and empirical. Conceptually, the limits to arbitrage framework can shed light on relative asset prices as exemplified by this particular study. Empirically, our volatility forecasting model explains 71% of the variation in realized volatility, a substantial improvement over a naive forecast based only on lagged realized volatility, which produces an R-super-2 of 53%. © 2014 Wiley Periodicals, Inc. Jrl Fut Mark 35:987–1002, 2015

Date: 2015
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