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Implied Volatility with Time-Varying Regime Probabilities

Markku Lanne and Katja Ahoniemi

MPRA Paper from University Library of Munich, Germany

Abstract: This paper presents a mixture multiplicative error model with a time-varying probability between regimes. We model the implied volatility derived from call and put options on the USD/EUR exchange rate. The daily first difference of the USD/EUR exchange rate is used as a regime indicator, with large daily changes signaling a more volatile regime. Forecasts indicate that it is beneficial to jointly model the two implied volatility series: both mean squared errors and directional accuracy improve when employing a bivariate rather than a univariate model. In a two-year out-of-sample period, the direction of change in implied volatility is correctly forecast on two thirds of the trading days.

Keywords: Implied volatility; option markets; multiplicative error models; forecasting (search for similar items in EconPapers)
JEL-codes: C32 C53 G13 (search for similar items in EconPapers)
Date: 2008-12
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