The Relation Between Implied And Realized Volatility In The Danish Option And Equity Markets

We show that the conclusions to be drawn concerning the informational efficiency of illiquid options depend critically on whether one is careful to recognize and appropriately deal with the econometrics of the errors-in-variables problem. This paper examines the information content of options on the Danish KFX share index. We consider the relation between the volatility implied in an option's price and the subsequently realized index return volatility. Since these options are traded infrequently and in low volumes, the errors-in-variables problem is potentially large. We address the problem directly using instrumental variables techniques. We find that when measurement errors are controlled for, call option prices even in this very illiquid market contain information about future realized volatility over and above the information contained in historical volatility.