Developing an option pricing model by including variable volatility

Abstract

Option prices are directly related to volatility of the underlier. Thus one can view volatility forecasts as being alternative estimates of option prices. A volatility forecast that is higher than the implied volatility implies underpricing of the option, and volatility forecast that is lower than the implied volatility implies overpricing of the option. There is important information in the cross-section of stock volatilities that leads to better forecasts of future volatility than those contained in the individual implied volatilities. This is the basic premise of the forecasting model being explored in this project. An option pricing strategy is constructed wherein the future change in implied volatility is predicted given the present implied volatility of the option and the realized volatility of the stock prices. This option-pricing model used to construct a trading strategy by taking directional positions in portfolios consisting of puts and calls. The evidence in the paper suggests that the information from the cross-section of volatility can be used to construct profitable trading strategies.