This article was downloaded by: [Texas A & M International University]

On: 07 October 2014, At: 04:12

Publisher: Routledge
Informa Ltd Registered in England and Wales Registered Number: 1072954 Registered office: Mortimer
House, 37-41 Mortimer Street, London W1T 3JH, UK

Quantitative Finance
Publication details, including instructions for authors and subscription information:
http://www.tandfonline.com/loi/rquf20

The term structure of S&P 100 model-free

volatilities
a a
Kian-Guan Lim & Christopher Ting
a
Lee Kong Chian School of Business , Singapore Management University , 50 Stamford
Road, Singapore 178899
Published online: 20 Mar 2013.

To cite this article: Kian-Guan Lim & Christopher Ting (2013) The term structure of S&P 100 model-free volatilities,
Quantitative Finance, 13:7, 1041-1058, DOI: 10.1080/14697688.2012.751493

To link to this article: http://dx.doi.org/10.1080/14697688.2012.751493

PLEASE SCROLL DOWN FOR ARTICLE

Taylor & Francis makes every effort to ensure the accuracy of all the information (the “Content”) contained
in the publications on our platform. However, Taylor & Francis, our agents, and our licensors make no
representations or warranties whatsoever as to the accuracy, completeness, or suitability for any purpose of
the Content. Any opinions and views expressed in this publication are the opinions and views of the authors,
and are not the views of or endorsed by Taylor & Francis. The accuracy of the Content should not be relied
upon and should be independently verified with primary sources of information. Taylor and Francis shall
not be liable for any losses, actions, claims, proceedings, demands, costs, expenses, damages, and other
liabilities whatsoever or howsoever caused arising directly or indirectly in connection with, in relation to or
arising out of the use of the Content.
This article may be used for research, teaching, and private study purposes. Any substantial or systematic
reproduction, redistribution, reselling, loan, sub-licensing, systematic supply, or distribution in any
form to anyone is expressly forbidden. Terms & Conditions of access and use can be found at http://
www.tandfonline.com/page/terms-and-conditions
 Quantitative Finance, 2013
Vol. 13, No. 7, 1041–1058, http://dx.doi.org/10.1080/14697688.2012.751493

The term structure of S&P 100 model-free

volatilities
KIAN-GUAN LIM and CHRISTOPHER TING*
Lee Kong Chian School of Business, Singapore Management University, 50 Stamford Road, Singapore 178899

(Received 28 November 2010; in final form 8 November 2012)

Downloaded by [Texas A & M International University] at 04:12 07 October 2014

We develop an improved method to obtain the model-free volatility more accurately despite the lim-
itations of a finite number of options and large strike price intervals. Our method computes the
model-free volatility from European-style S&P 100 index options over a horizon of up to 450 days,
the first time that this has been attempted, as far as we are aware. With the estimated daily term
structure over the long horizon, we find that (i) changes in model-free volatilities are asymmetrically
more positively impacted by a decrease in the index level than negatively impacted by an increase
in the index level; (ii) the negative relationship between the daily change in model-free volatility
and the daily change in index level is stronger in the near term than in the far term; and (iii) the
slope of the term structure is positively associated with the index level, having a tendency to display
a negative slope during bear markets and a positive slope during bull markets. These significant
results have important implications for pricing and hedging index derivatives and portfolios.

Keywords: Volatility modelling; Empirical finance; Options volatility; Options; Applied econo-
metrics
JEL Classification: C1, C13, G1, G13

1. Introduction their approach, the underlying price process is not restricted

Investors pay considerable attention to the forecasts of
future stock price and stock index volatility. If the forecast
for the future volatility is high, investors might demand a
higher return as compensation for bearing a higher risk in
the future. Thus, the volatility forecast over a specified
future period is important to many market players, and a
large literature has developed in the estimation of ex ante
volatility. Sheikh (1989), Day and Lewis (1992), Harvey
and Whaley (1992), and Christensen and Prabhala (1998),
for example, employ the Black–Scholes (1973) model to
generate the implied volatilities of stock index returns as
market forecasts of future volatility.
While the Black–Scholes implied volatilities continue to
be a subject of interest, as exemplified by studies such as
Bliss and Panigirtzoglou (2004) and Bollen and Whaley
(2004), fresh research such as that of Andersen and
Bondarenko (2007) has moved on to the study of model-
free volatility. This is the expected volatility obtained from
option prices without using any option pricing model.
Britten-Jones and Neuberger (2000) were among the earliest
to show that the model-free volatility can be expressed as
the weighted sum of a continuum of call option prices. In
*Corresponding author. Email: christophert@smu.edu.sg
Ó 2013 Taylor & Francis
to the log-normal diffusion, thus making the model-free vol-
atility much more appealing than the Black–Scholes implied
volatility. Jiang and Tian (2005) extend the analysis of
Britten-Jones and Neuberger (2000) to encompass asset
prices with jumps. They arrive at the same conclusion as
Derman et al. (1999) and Carr and Wu (2006), that
jumps are higher-order terms and hence negligible in the
calculation of model-free volatility.
Due to its ease of implementation and, more impor-
tantly, its theoretical underpinning, model-free volatility has
become an industry standard for constructing volatility
indexes, known on the streets as the barometers of fear. In
2003, the Chicago Board Options Exchange (CBOE)
switched from the Black–Scholes implied volatility
approach to the model-free methodology to calculate the
VIX index. Following the wide acceptance of the revamped
VIX for the S&P 500 index, CBOE introduced other
model-free volatility indexes for the Dow Jones Industrial
Average index (VXD), the NASDAQ 100 index (VXN),
and the Russell 2000 index (RVX). The European markets
have also established volatility indexes based on the same
model-free approach. The VDAX-NEW volatility index for
the Deutsche Börse’s DAX index, VSMI for Swiss
Exchange’s SMI index, and VSTOXX for the Dow Jones
Euro STOXX 50 index are some of the key European
 1042 K.-G. Lim and C. Ting
examples. More recently, futures and options written on the
volatility indexes have been launched and the trading vol-
umes of these derivative products are rising.
However, the VIX index and most of the other volatility
indexes are constructed with only the most active near term
and next near term index options, and thus are indexes of
only 30-day horizon. Moreover, although the index formula
is clearly explained in most official sites of the exchanges,
there is typically some ambiguity as to which actively traded
options are actually selected by the exchange for construct-
ing the index, or which options are left out of the computa-
tion. Given the increasing importance of the volatility index,
we propose an improved method to calculate the model-free
volatility for up to a distinctly longer horizon of 450 days.
The longer horizon would enable the pricing of index-based
derivatives with maturities much longer than 30 days.
Downloaded by [Texas A & M International University] at 04:12 07 October 2014
Using the market prices of S&P 100 index options, this
paper constructs the model-free volatility term structure with
constant maturities of 30 days, 60 days, 90 days, 120 days,
180 days, 360 days, and 450 days. Our method improves on
the discretized approximation used by the CBOE’s formula
on VIX and others, and implements a set of interpolation
procedures to produce model-free estimates that are exact
with respect to the theoretical formula. In our method, we
employ all put options with strike prices below the forward
price, and all call options with strike prices above the for-
ward price, as long as these options have bid and ask price
quotes. The theoretical formula comprises integrals over a
continuum of strike prices, and we improve on the CBOE’s
discrete interval approximation by a smooth spline function
connecting all option prices at the discrete strike price
points, and subjecting the spline parameters to conform with
no-arbitrage conditions. The smooth cubic spline that we
use enables an exact and closed-form numerical integration
over the continuum of strike prices that is required in the
theoretical formula for model-free volatility.
With the exception of Jiang and Tian (2005), who focus
on the information content, most papers in the literature of
model-free volatility, such as Bollerslev et al. (2004) and
Carr and Wu (2006), directly use CBOE’s VIX index. This
volatility index has a constant maturity of 30 days, and a
study of longer-term model-free volatilities is not feasible.
Our method enables a study of the constant-maturity term
structure of model-free volatilities up to 450 days, and we
use the estimated term structure to examine its relation to
the underlying S&P 100 index.
In our study of the term structure of model-free volatili-
ties, we provide new insights into the asymmetric correla-
tion of the model-free volatility at near term and also at far
term with the underlying index level. Our model-free results
offer a different perspective and can be compared with
existing results using implied volatilities, such as Whaley
(2000). This second main contribution of our paper is dif-
ferent from Heynen et al. (1994), who examine the
GARCH-like models to fit the asset prices and the term
structure of implied volatilities, Campa and Chang (1995),
Byoun et al. (2003), and Mixon (2007), who test the
yWe thank one of the referees for suggesting the use of pooled regressions to analyse the model-free volatilities across different
maturities and time.
rational expectations hypothesis, and Xu and Taylor (1994),
who focus on the dynamics of the term structure and
whether the foreign exchange options overreact, as in Stein
(1989). In all these papers, Black–Scholes implied
volatilities are used. But implied volatilities from the
Black–Scholes model (or any other specific option pricing
model), being implicit functions of the price model, may
introduce model bias.
The rest of the paper is organized as follows. In section
2, we describe our improved method as well as the
implementation procedures in detail. In section 3, we
discuss the motivation in our choice of the S&P 100 index
option and provide descriptive statistics for the data sample.
Summary statistics on the volatility estimates are also
reported. Furthermore, intuition on the contribution of our
method is discussed. Section 4 provides a panel regressiony
or cross-sectional time series regression approach to analyse
the economic relationships between the estimated term
structure of model-free volatilities and the underlying stock
index dynamics, thus providing a better understanding of the
fear gauge. The corresponding empirical results are also
reported. Section 5 contains the conclusions.
2. Method
This section is devoted to discussing a generic method as
well as the procedures that allow us to obtain a reliable
model-free volatility estimate, even from thinly traded
options. The method is based on the ideas of Derman et al.
(1999), and is model-free as it is independent of any option
pricing model such as the popular Black–Scholes (1973).
The model-free approach was also developed by Carr and
Madan (1998) and Britten-Jones and Neuberger (2000).
More recently, Carr and Wu (2006) show that the VIX
index calculated by CBOE can be synthetically created by a
static position in European options plus a dynamic position
in the futures market. A common motif running through
these papers is the concept of local volatility originally
developed by Dupire (1993, 1994) and Neuberger (1994),
who show that the implied volatility can be obtained from
the option market prices without using any option pricing
formula, and is hence model-free.
The inputs to the model-free formula are minimal. Only
the observed option prices and the risk-free rate are needed.
Even if the underlying asset pays dividends, the formula
does not require the information about dividend amounts
and their ex-dates. In this regard, it is straightforward to
calculate the model-free volatility from the formula.
Another feature of the model-free formula is that it gives
one volatility forecasts for a given maturity with many
option prices and different strike prices. By contrast, the
volatility implied from a particular pricing model is
empirically observed to be different for each option with a
different strike price, thus giving rise to many volatility
forecasts for a given maturity.
 Term structure of S&P 100 model-free volatilities
The model-free formula is essentially an integration of
option prices over a continuum of strike prices. The accu-
racy of the resulting volatility estimate is dependent on the
number of available option prices, and the size of the dis-
crete strike interval. If the number of available option prices
is small or the strike interval is large, then the approximation
of the model-free formula will have a larger approximation
error, which could be economically significant. Therefore,
there is good reason to establish a method and implementa-
tion that yields accurate estimates under realistic conditions
of a finite number of options and large strike price intervals.
We propose an interpolation and extrapolation technique
that generates a continuum of synthetic option prices from
a limited number of observed prices. In contrast to the
existing implementations in the literature, our procedures
observe the principle of no riskless arbitrage. The resulting
Downloaded by [Texas A & M International University] at 04:12 07 October 2014
continuum of option prices would provide no free lunch if
they were traded in the option market. After all, the model-
free formula is derived under a risk-neutral measure, which
implies no riskless arbitrage, and it is only fitting that the
option prices generated by the procedure leave no money
on the table.
2.1. Model-free formula
To fix the notation, PðX ; S0 ; T Þ and CðX ; S0 ; T Þ are, respec-
tively, the prices of European put and call options with the
same time to maturity T and strike price X on the underly-
ing security with current price S0 .
Proposition 2.1: Given that the underlying stock index St
evolves continuously and that the risk-free interest rate r is
constant, the expected value of the return variance V ð0; T Þ
realized from time 0 to time T under the risk-neutral
measure Q is
r2MF T  E0Q ½V ð0; T Þ
Z F0
Z H
PðX ; S0 ; T Þ CðX ; S0 ; T Þ
¼ 2erT dX þ dX :
L X2 F0 X2
Here, F0 is the expected value of ST conditional on the
information at time 0:
F0  E0Q ½ST  ¼ erT ðS0  PV ðDÞÞ;
where PV ðDÞ is the present value of the sum D of dividends
with ex-dates prior to the options’ expiry date. Further,
L < F0 is a small number and H > F0 a large number that
the underlying ST may attain at time T , such that
Prob ðST \LÞ ¼ 0 and Prob ðST > HÞ ¼ 0:
The proof of proposition 2.1 is presented in appendix A.
Equation (1) is the formula that enables us to calculate the
volatility forecast rMF from a continuum of option
prices. This formula is model-free because it uses option
prices directly without having to use any option pricing
formula.
We note that although D appears in F0 , which delineates
the range of integration, it is not necessary to know the
1043
details of the dividends. The reason for this is that F0 can
be directly obtained from the put–call parity,
CðX ; S0 ; T Þ  PðX ; S0 ; T Þ ¼ S0  PV ðDÞ  erT X : ð3Þ
Given a continuum of options and because the put
(call) price is a monotonically increasing (decreasing)
function of X , there exists a unique strike price XH
such that CðXH ; S0 ; T Þ ¼ PðXH ; S0 ; T Þ. From equation
(3), we have
XH ¼ erT ðS0  PV ðDÞÞ; ð4Þ
which is F0 in equation (2).
Now, a note on the model-free formula, equation (1),
versus the Black–Scholes implied volatility is in order. As in
most option pricing studies, the underlying (index) price pro-
cess is an Itô process, which is very general and is defined as a
Rt
stochastic process of the form: St ¼ S0 þ 0 lðu; Su Þdu
Rt
þ 0 rðu; Su ÞdWu . Here Wu is a Wiener process at time u, and
S0 is a given non-random underlying index price at time 0.
The drift lðu; Su Þ and diffusion rðu; Su Þ are adapted stochas-
tic processes at time u.
Depending on how the local volatility function rðu; Su Þ is
explicitly specified, a specific no-arbitrage option pricing
model is obtained (Dupire 1994, Derman and Kani 1994).
For example, if the local volatility function is the
Constant Elasticity of Variance (CEV) model, namely
rðu; Su Þ ¼ rSub=2 for b < 2, then the CEV option pricing
model is obtained (Cox and Ross 1976). If b ¼ 2, i.e. the
instantaneous return has constant variance r2 , and if
the return drift is also a constant r, then we obtain a very
specific or special case of the Itô process: St ¼ S0 þ r
Rt Rt
0 Su du þ r 0 Su dWu , which is more familiarly written as a
 stochastic differential equation: dSt ¼ rSt dt þ rSt dWt : This
is none other than the risk-neutral geometric Brownian
motion, which is the underlying price process assumed by
Black and Scholes (1973) to obtain the closed-form formulas
ð1Þ
to price a European call option CBS ðT ; S0 ; Xi ;r; rÞ and a put
option PBS ðT ; S0 ; Xi ;r; rÞ. The Black–Scholes implied
volatilities rBS are then obtained by solving the implicit
equations Pi ¼ PBS ðT ; S0 ; Xi ;r; rBS Þ and Ci ¼ CBS ðT ; S0 ; Xi ;
r; rBS Þ given market prices Pi and Ci , and strike prices Xi .
ð2Þ
By contrast, equation (1) is ‘model-free’ in the sense that
it is not necessary to assume any explicit functional form
of the volatility function rðu; Su Þ for the underlying price
process.
As shown in appendix A, the interesting result is that we
can obtain the expected future integrated variance
RT
E0Q ½V ð0; T Þ ¼ E0Q ½ 0 ðdSt =St Þ2  for the generic rðu; Su Þ of
the Itô’s process. Moreover, Dupire (1994) shows that there
is a unique risk-neutral distribution with such rðu; Su Þ for
each u, and rðu; Su Þ can be obtained from the convergent
numerical scheme on the market option prices. The
integrated variance, namely E0Q ½V ð0; T Þ, can thus be
obtained to form the term structure of volatility rMF for
each maturity T .
 1044 K.-G. Lim and C. Ting

2.2. Implementation procedures We note that PðF0 ; S0 ; T Þ and CðF0 ; S0 ; T Þ are unknown
pricing functions in the model-free approach. In the discrete
The model-free formula requires a continuum of options.
world where prices are restricted to a fixed-interval price
However, in reality, the strike price is discrete and the
grid such as equation (5), however, we may take the
number of options available for trading and those that are
implied forward price F0 of the underlying as the strike
actually traded is limited. Near term options may be
price X0 ¼ X1 such that the absolute value jP0  C1 j is the
actively traded, but far term options may likely have thin or
minimum of all pairs of put and call options with the same
no trading at a particular time. Thus, if the term structure of
strike price. We may also find a synthetic set of no-arbi-
volatilities over a substantive horizon is the subject of inter-
trage prices P0 ¼ C1 such that their strike prices are at
est, it is necessary to calculate the model-free rMF with
X0 ¼ X1 ¼ F0 . In either case, the difference that a small
options that may have low trading volumes. Andersen and
deviation F0  X0 or X1  F0 makes to the overall
Bondarenko (2007) apply the framework of corridor
integration is negligible relative to the intervals Xjþ1  Xj .
implied volatility to address the problem arising from the
lack of reliable option prices with strikes in the tails of the
Proposition 2.2: In the discrete world where strike and for-
return distribution. Their approach encompasses the model-
ward prices are limited to the price grid defined by the
free implied volatility in the limit when the lower barrier is
prices in equation (5), a discrete version of equation (1) is
0 and the upper barrier is infinite. In the following, we !
Downloaded by [Texas A & M International University] at 04:12 07 October 2014

formulate the problem of discrete strike prices and solve the X1
Pi X n1
Cj
problem by deriving an exact representation of equation (1) ra T  2e DX
2 rT
þ
i¼mþ1 i
X 2 j¼2 Xj2
using splines and no-arbitrage conditions.    
Suppose there are m þ n þ 1 options whose strike prices P0 þ C1 Pm Cn
þ erT DX þ e rT
D X þ : ð9Þ
with a uniform strike interval DX are arranged in ascending X02 2
Xm Xn2
order as follows:
Moreover, as long as D X[0, we have
Xm\ Xmþ1\  \ X0  F0  X1\  \Xn : ð5Þ
ra > rMF : ð10Þ
The no-arbitrage pricing function PðX ; S0 ; T Þ for put
options is an unknown function in the model-free approach, Proof: Equation (9) is obtained from equation (8) by letting
but is assumed to be continuous in X . Each market price Pi F0 ¼ X0 ¼ X1 . To prove the inequality (10), we note that
is taken to be the discrete sample point at Xi , that is, PðX ; S0 ; T Þ is a strictly convex function of X . By Jensen’s
PðXi ; S0 ; T Þ ¼ Pi . With m þ 1 puts whose strike prices are inequality, the average of the upper and lower Riemann
less than or equal to F0 , the first integral in equation (1) is sums still has an upward bias. In the same vein, since
approximated by the lower Riemann sum CðX ; S0 ; T Þ is also strictly convex, the average of the two
corresponding Riemann sums also has an upward bias. 
Z X
1
F0
PðX ; S0 ; T Þ Pi P0 Proposition 2.2 suggests that ra has an upward bias rel-
2
dX  D X 2
þ ðF0  X0 Þ 2 ; ð6Þ
L X X
i¼m i
X0 ative to the model-free rMF . To obtain the unbiased estimate
for rMF, we need an additional procedure that is effective in
or the upper Riemann sum overcoming the problem of a discrete strike price. In other
words, to calculate the future volatility from equation (1)
Z F0 accurately, it is necessary to have a continuum of option
PðX ; S0 ; T Þ X 0
Pi PðF0 ; S0 ; T Þ prices f ðX Þ. For this purpose, a natural approach is to
dX  D X þ ðF0  X0 Þ :
L X2 i¼mþ1 i
X2 F02 obtain a piecewise polynomial spline from the observed
option prices. We denote the market price by Yi for an
ð7Þ
option struck at Xi . The smoothing spline is obtained by
minimizing the following cost function:
By definition, the lower Riemann sum has a downward bias
and its upper counterpart has an upward bias. We can Xn Z H  2 2
df
reduce the bias by taking the average of these two sums. a wi ðYi  f ðXi ÞÞ2 þ ð1  aÞ 2
dX ; ð11Þ
The same argument applies for a call with CðXj ; S0 ; T Þ ¼ Cj i¼1 L dX
and thus an appropriate approximation for the right-hand
where a is the smoothing parameter, wi is the weight
side of the model-free formula (equation (1)) is
! attached to the market data ðXi ; Yi Þ, and the range of strike
X1 Xn1  
P i C j P m C n prices is from L to H.
2erT DX 2
þ 2
þ erT DX 2
þ 2 To observe the principle of no risk-free arbitrage opportu-
X i Xj X m X n
i¼mþ1 j¼2
nities, options of different strike prices but of the same
DX þ F0  X0 DX þ X1  F0
þ erT 2
P0 þ C1 expiration date must satisfy a number of conditions. We
X0 X12
 note that given S0 and time to maturity T, options are
PðF0 ; S0 ; T Þ CðF0 ; S0 ; T Þ monotonic and convex functions of the strike price X . For
þ ðF0  X0 Þ þ ðX 1  F 0 Þ :
F02 F02 puts, the gradient of the price function with respect to X is
ð8Þ non-negative, smaller than one, and it increases with X or
remains constant. Conversely, the gradient of the price
 Term structure of S&P 100 model-free volatilities 1045

function for calls is non-positive, larger than minus one,
and it decreases with X or remains constant. Suppose three
strike prices Xa , Xb , and Xc are such that Xa \Xb < Xc ,
and let Pi  PðXi ; S0 ; T Þ and Ci  CðXi ; S0 ; T Þ for
i ¼ a; b; c. The conditions necessary for the absence of
arbitrage are
(I) Price monotonicity
by the splines from the first stage.y Throughout both stages,
we adjust the curve fit to ensure that riskless arbitrage
opportunities do not arise.
The resulting cubic spline is a set of four coefficients for
each sub-interval. In other words, the option price function
f ðX Þ generated by the Hermite cubic spline for any sub-
interval is of the following form:z
f ðX Þ ¼ c1 X 3 þ c2 X 2 þ c3 X þ c4 : ð15Þ

Pa  Pb ; Cb  Ca : ð12Þ With this polynomial, integration over each sub-interval of

the integrals in equation (1) admits a closed form given
by
(II) Gradient bounds
Z Xiþ1
f ðX Þ 2
Xiþ1  Xi2
dX ¼ c 1 þ c2 ðXiþ1  Xi Þ
Pb  Pa Cb  Ca Xi X2 2
   
Downloaded by [Texas A & M International University] at 04:12 07 October 2014

0  1; 1   0: ð13Þ Xiþ1 1 1
Xb  Xa Xb  Xa þ c3 log  c4  : ð16Þ
Xi Xiþ1 Xi

(III) Convexity Accordingly, we have the following proposition.

Proposition 2.3: Let there be M sub-intervals for the inte-

Pb  Pa Pc  Pb Cb  Ca Cc  Cb gration from L to F0 for puts, and N sub-intervals for the
 ;  : ð14Þ
Xb  Xa Xc  Xb Xb  Xa Xc  Xb integration from F0 to H for calls in the model-free
formula, equation (1). We obtain a representation of
We use these arbitrage-free conditions as constraints in equation (1) as follows:
interpolating the observed option prices. Thus, the shape of
the smoothing spline f ðX Þ is constrained to be strictly con-
X
1 2
Xiþ1  Xi2
vex and monotonic. r2MF T ¼ 2erT pi1 þ pi2 ðXiþ1  Xi Þ
We turn now to the range of integration, which is deter- i¼M
2
mined by L, F0 , and H. As mentioned earlier, F0 is    
Xiþ1 1 1
uniquely given by equation (4). The two values L and H þp3 log
i
 p4 i

Xi Xiþ1 Xi
constitute the range of ST , and the range should be as wide
as possibly allowed by the range of strike prices, as X
N 1
X 2  Xi2
þ 2erT ci1 iþ1 þ ci2 ðXiþ1  Xi Þ
arranged in equation (5). For a given time to maturity T, i¼0
2
suppose the smallest strike for a put is Xmp and that for a    
Xiþ1 1 1
call is Xmc . Then L is the smaller of these two strikes. By þc3 log
i
 c4
i
 : ð17Þ
Xi Xiþ1 Xi
the same token, H is taken to be the larger of the two
strikes, Xnp for put and Xnc for call.
Next, we use the intuition that the longer time to maturity Here, pi1 , pi2 , pi3 , and pi4 are the spline coefficients for put
T is, the wider is the range. This is because, with more options in the sub-interval Xi to Xiþ1 , with X0 ¼
time, the random variable ST can possibly assume a larger X1 ¼ XH ¼ F0 from the put–call parity in equation (4).
range of values. Thus, on a given trading day t, if there are Similarly, ci1 , ci2 , ci3 , and ci4 are the coefficients for call
Nt expiry dates, then let L be the smallest and H the largest options.
strike prices for the near term options. More specifically, in The formulation in equation (17) is an exact representa-
our implementation, we begin with the near term options tion of the theoretical value of model-free rMF in equation
and we have L ¼ Xm1 and H ¼ Xn1 . For the next near term (1) under reasonable conditions such as assuming the option
options, if Xm2 is larger than Xm1 , we use Xm1 instead. price functions have continuous derivatives at least up to
Similarly, if Xn2 is smaller than Xn1 , we use the larger Xn1 the third order and follow a polynomial curve. Note that the
for the next near term options. method does not require the estimation of future dividends
Having determined the range, which increases with time as we obviated the need to find a forward price.
to maturity, spline-fitting of the observed option prices pro- Our spline-fitting procedure applies directly on observed
ceeds in two stages. The first stage uses the cost function in option prices. This approach is different from the interpola-
equation (11) to obtain a cubic smoothing spline for calls, tion technique used by Campa et al. (1998) and Jiang and
and another for puts. In the second stage, we use the piece- Tian (2005, 2007). In the latter studies, interpolation is car-
wise Hermite cubic spline to fit the sample points generated ried out on the implied volatilities rather than on the option

yWe use the cubic smoothing spline routine csaps and the piecewise cubic Hermite interpolating polynomial pchip from Matlab.
zThe polynomial produced by Matlab’s spline is centered on the left breakpoint n : f ðX Þ ¼ a1 ðX  nÞ3 þ a2 ðX  nÞ2 þ a3 ðX  nÞ
þa4 : Thus; we have c1 ¼ a1 ; c2 ¼ 3a1 n þ a2 ; c3 ¼ 3a1 n2  2a2 n þ a3 ; and c4 ¼ a1 n3 þ a2 n2  a3 n þ a4 .
 1046 K.-G. Lim and C. Ting
Figure 1. An example of spline-fitted curves of put and call
options on the S&P 100 index. The figure shows the cubic spline-
fitted curves of put prices PðX ; S0 ; T Þ and call prices
Downloaded by [Texas A & M International University] at 04:12 07 October 2014
CðX ; S0 ; T Þ on December 10, 2003 within our sample period.
Their ticker symbol is XEO. The underlying index is the S&P
100 index. On this date, the closing value of this index was
525.33. A number of XEO put and call XEO options are
traded or have dealer quoted prices. For a subset of these
derivative contracts with maturity T on June 9, 2004, about
half a year later, the mid-points of bid and ask quotes for the
puts and calls are shown in the figure as filled circles. The cor-
responding X-axis number refers to the strike price X. The
option prices for any point in the range of X 2 ½370; 600 can
be obtained from the fitted smooth spline curves. None of the
prices on the curves violates the no-arbitrage conditions.
prices. Prior to interpolation, implied volatilities are backed
out from the observed option prices using the Black–Scholes
model. The volatility smile or smirk is then interpolated with
splines. Thereafter, the Black–Scholes model is applied
again to generate synthetic option prices from the implied
volatility curve. It may not be difficult to incorporate the
Figure 2. Example of model-free volatility estimation. This figure uses the example in figure 1 to provideRan illustrative explanation
estimation of model-free volatility in equation (1). Specifically, the objective is to compute numerically L 0 P=X 2 dX þ F0 C=X 2 dX, or
the area under the two curves that is bounded from below by the X-axis.
condition of price monotonicity in their approach. However,
the conditions of gradient bounds and convexity are harder
to implement with implied volatilities. If these three condi-
tions are not imposed, the option prices generated from the
implied volatility curve may give rise to riskless arbitrage
opportunities.
On the other hand, our spline-fitting procedure is similar
to well-documented approaches such as those of Bates
(1991, 2000). In these studies, Bates performs an analysis
of the options on S&P 500 index futures, and interpolation
is applied directly on the option prices, with no riskless
arbitrage conditions imposed as constraints.
Our approach, however, differs from Bates’ approach in
some important details. First, Bates uses observations
pooled from intra-day transaction data and he interpolates
the ratio of option price over futures price as a function of
moneyness, which is the ratio of strike price over futures
price. We use the end-of-day midpoint of the quotes and
the fitted curves are functions of the strike price. Second,
information on volume is unavailable in Bates’ data and
thus each option is treated equally in the interpolation. We
give more weight to options that attract higher volume. Our
interpolation is based on equation (11), where wi is the vol-
ume of the ith option, in terms of the number of contracts
traded for that day. For some options where there is no
trade but only a competitive average of bid and ask quotes
as price proxy, the volume or weight is fixed at half a con-
tract. Although this is somewhat arbitrary, it captures useful
price quote information, but by a relatively small weight
that is not zero. Third, Bates excludes the deepest in- and
out-of-the-money options. We not only include them but
also extend the range such that both put and call options
with the same maturity have the same strike range, and the
range does not decrease with maturity. Fourth, our interpo-
lation has two stages. The first stage increases the number
RH of the
F
 Term structure of S&P 100 model-free volatilities 1047

Table 1. Descriptive statistics for European-style options on the S&P 100 index. This table provides the descriptive statistics for the index option with ticker symbol XEO. The best bid and ask
of strike prices that are placed evenly over the extended

quotes, volume, and open interest are obtained from data vendor Optionmetrics. The sample period starts from July 23, 2001 and ends on December 30, 2011. The statistics are calculated as daily

22,332
28,385
297.9
263.6
267.7
2642
2365
2011
252
range, and the second stage ensures that there are no oscil-
lations for strikes that are deeply out-of-the-money.
To give a better intuition for our method, we provide fig-
ures 1 and 2. Figure 1 shows visually the spline fitted

49,624
51,276
option price curves over a large range of strike prices for a

324.6
269.2
292.9
2010

4614
4624
252
typical trade date.
Figure 2 provides a visual explanation of the estimation
of model-free volatility in equation (1).R Specifically,
F
the objective is to compute numerically L 0 P=X 2 dX þ

64,920
64,695
RH
330.8
287.8
282.2
2009

4559
4453
averages by taking the total number across all options of different maturities divided by the total number of trading days for the year.

251

2
F0 C=X dX , or the area under the two curves that is
bounded from below by the X -axis. Note that there are five
put option prices with strike prices at, respectively, A, B, C,
D, and E, and three call option prices with strike prices at,
88,639
67,711
278.0
262.3
228.5
2008

5685
4513
251

respectively, F, G, and H. The CBOE method of computing

the model-free volatility is to find the area of the rectangu-
Downloaded by [Texas A & M International University] at 04:12 07 October 2014

lar blocks within the VXO range as shown in the figure.

The width of each block is equal to half the strike interval
82,793
60,646
232.2
203.1
215.5
2007

5950
5308
249

on one side plus half the strike interval on the other side of
that particular strike price. In the calculation of VIX, a
small adjustment to the difference between E and the
forward price F is also provided, as shown in the Chicago
108,913
47,257

Board of Options Exchange (2003) white paper. But the

166.7
129.3
151.2
2006

9621
5023
250

adjustment of ðF=E  1Þ2 is very small, of the order of

0.00001 relative to the area of order 0.4, and so may be
ignored.
However, the CBOE method produces a slightly larger
42,060
37,882
157.4
130.9
137.8
2005

3715
3623
252

number than the area within the VXO range due to the
approximation of the discrete blocks, and particularly has
an upward bias due to the two shaded triangular pieces on
the block at strike E. Our approximate estimate of model-
64,421
44,102
173.2
151.4
155.5
2004

3717
3257

free volatility in proposition 2.2 is given by the area of the

252

dotted (–––) triangular-shaped structure contained in the

dotted (     ) cluster of blocks. For visual convenience,
this cluster is shifted upward in the figure from the X -axis.
The blocks within the cluster have widths equal to the
67,401
52,155
159.0
141.9
142.5
2003

3935
3624
252

strike intervals. The area provided by our approximate for-

mula is smaller than that of the CBOE formula within the
VXO range by the upward bias mentioned earlier, but could
be larger since, unlike the CBOE formula that includes only
51,181
41,745
161.6
155.3
136.1
2002

3604
2991

‘selected’ liquidly traded options, the areas under the curves

252

in the extended range incorporating thinly traded options

are now added. Our exact estimate of the model-free vola-
tility in proposition 2.2 is obtained by refining the straight
23,360
14,479
135.0
131.0
122.4
2001

2371
1610

lines (–––) to be smooth convex cubic-splined curves, and

109

thus the exact estimates are necessarily smaller than the

approximate ones.
Call

Call

Call
Put

Put

Put

3. Choice of index option and data analysis

To demonstrate the practical usefulness of our method, we

Number of strike prices

chose the European-style options on the S&P 100 index.

The ticker symbol of this cash-settled index option is XEO.
and ask quotes

It is traded on the CBOE with expiration on the March

Contracts traded
Strikes with bid

quarterly cycle. The last trading day is the third Friday (or
Open interest
Trading days

Thursday if Friday is a non-business day) of the expiration

month.
Our choice of XEO is motivated mainly by three consid-
erations. First, we note that the strike interval of XEO is
 1048 K.-G. Lim and C. Ting
five index points apart for near term options that are near
the money, but deep out-of-the-money options have a coar-
ser interval of 10 or 20 index points. Moreover, the strike
intervals of far term options are at least 10 index points,
and 20 points for very far term options. Relative to the
S&P 100 index level, the strike interval may be economi-
cally significant. During our sample period from July 23,
2001 to December 30, 2011, the S&P 100 index ranged
from 322.13 to 729.79, and the average level was 549.43.
It follows that the 20-point strike interval is, on average,
3.64% of the underlying. Furthermore, since not every
strike has trades or quotes available, the strike interval is
actually much larger. The problem of approximating a con-
tinuum of option prices discussed in section 2 cannot be
ignored. In this regard, XEO provides a good test bed for
our method.
Downloaded by [Texas A & M International University] at 04:12 07 October 2014
Second, the underlying S&P 100 index itself is important
to many market players, such as investors of the S&P 100
index fund, which has a market capitalization of a few bil-
lion dollars. Moreover, in contrast to the S&P 500 index, a
model-free volatility index for S&P 100 has thus far not
been constructed.y Third, some papers such as Harvey and
Whaley (1992) and Fleming (1998) also use the S&P 100
index in the empirical analysis.
We obtain end-of-day option quotes, volume traded, and
open interest from Optionmetrics along with the zero-cou-
pon risk-free interest rate curve. Our sample period starts
from July 23, 2001 when the European-style XEO began
trading. After excluding November 3, 2004 as the data for
that day are diagnosed to be incorrect, we have a total of
2621 trading days by the end of December 2011 for our
sample.
Table 1 presents the descriptive statistics for our sample
by calendar year. Each day, we count the strike prices for
all expirations. The average daily total number of strike
prices varies from year to year. In 2001, for instance, the
average number is 135, and it increases to 297.9 in 2011.
For 2001, we do not have the full 252 trading days as the
sample period starts only from July.
After excluding weekly options, there are at least six
expiration dates for any trading day, and the shortest long-
term maturity is one year and four months in our sample.z
The best bid and ask quotes are updated each day for every
option maturity, although not all strikes for a given maturity
have quotes. The average number of strikes with quotes is
about 2.5 to 23% lower than the average total number. In
terms of the numbers of contracts traded and the open inter-
est, we note that put options have higher daily averages
than call options. We also note that, from 2001 to the end
of 2006, the average daily volume grew by four times to
9621 contracts for puts and by more than three times to
5023 contracts for calls. The trading volumes remained high
throughout the period since the start of the global financial
crisis in 2008 until 2010. Since then the market’s fear has
somewhat subsided and the fear gauge or volatility measure
yCBOE’s VXO is a volatility index for the S&P 100 index. But this index is model-dependent, as it is based on at-the-money implied
volatilities backed out using the Black–Scholes formula.
zWeekly options were introduced in March 2006. These options had an original maturity of one week.
has dropped. By 2011, the volumes of traded puts and calls
had stabilized at about the same levels as in 2002.
3.1. Model-free volatility estimates
Using proposition 2.2, an approximation of the model-free
volatility is obtainable directly from observed option prices.
With our method of spline-fitting in conjunction with
equation (4) for the implied forward price F0 , proposition
2.3 provides a formula to calculate the model-free volatility
accurately.
For any given day, we calculate rMF for each maturity
date. To obtain 30-day constant maturity rMF, we use the
convention of 365 days per year and the following linear
interpolation:
30 s2  30 2 30  s1 2
r2MF ¼ r1 s1 þ r s2 : ð18Þ
365 s2  s1 s2  s1 2
In this formula, r1 is calculated from the near term options
and r2 from the next term options. The days to maturity for
these two terms are s1 and s2 , respectively.
On a daily basis, we calculate the model-free volatility
for each maturity. To obtain the annualized volatility rMF
with constant maturity of z days, the general formula for
linear interpolation is
z s2  z 2 z  s1 2
r2MF ¼ r1 s1 þ r s2 ; ð19Þ
365 s2  s1 s2  s1 2
where s1  z  s2 . Using this interpolation, we are able to
obtain eight constant-maturity volatilities of 30, 60, 90,
120, 150, 180, 360, and 450 days. Constant maturity
obtained from linear interpolation is a popularly used tech-
nique to smooth out any irregularities that may arise when
options are about to expire. As an example, we plot the
term structure of constant maturity variances, and an OLS
fit for December 10, 2003, in figure 3.
We see that, on that day, the term structure is upward
sloping and the y-intercept has a value of 0.032, which
translates into a volatility of 17.89%. This OLS estimate
has 0 days to maturity and thus could be regarded as the
instantaneous variance.
Table 2 shows that the annualized model-free volatility
estimate re from equation (17) has an overall mean in the
range of 21.51 to 21.95 percentage points for eight different
constant maturities. It is noteworthy that the standard devia-
tion or variability of re decreases with longer constant
maturity.
Moreover, the mean of the difference between the
approximate estimate and the exact estimate, ra  re , is
3.19 percentage points for 30-day constant maturity. This
average difference is economically significant, as ra is
14.8% (¼ 3:19=21:51) higher than re . This finding is
consistent with the analysis of Jiang and Tian (2007) on the
VIX index. For each of the 2621 trading days in our sample
 Term structure of S&P 100 model-free volatilities 1049

0.039

0.038
2
σMT = 0.032103 + 0.000013 × T

0.037

0.036
Model−Free Variance σ2MT

0.035

0.034

0.033
Downloaded by [Texas A & M International University] at 04:12 07 October 2014

0.032

0.031

0.03
50 100 150 200 250 300 350 400 450 500
Days to Maturity T

Figure 3. An example of the term structure of model-free variances. This figure plots the model-free variances (square of volatility) with
respect to maturity. The trade date for the options used in calculating the constant maturity variances (eight data points as seen in the
graph) is December 10, 2003, as in figure 1. The straight line in the plot is the OLS fit. The variances shown are non-annualized
numbers.

Table 2. Summary statistics for model-free volatilities of eight different constant maturities. This table presents summary statistics for
the model-free volatility estimates re , in percentages on an annualized basis, calculated directly from option prices based on the
exact method (equation (17)). Eight constant maturities are obtained from linear interpolation over the sample period from July
23, 2001 to December 30, 2011. The means and standard deviations (Stdev) along with percentiles for the model-free volatility of
different constant maturities are reported. Summary statistics for the difference of exact-method estimates re from the approxi-
mate-method estimates ra are also tabulated. Three asterisks ⁄⁄⁄ indicate statistical significance at the 1% level under a null
hypothesis of a difference of +0.5 in re  ra .
30-day 60-day 90-day 120-day 150-day 180-day 360-day 450-day
re
Mean 21.51 21.78 21.95 21.85 21.73 21.62 21.55 21.57
Stdev 9.37 8.63 8.04 7.35 6.73 6.39 5.71 5.64
Minimum 8.64 9.41 10.23 10.69 10.88 11.11 12.26 12.53
5th 10.94 11.56 12.23 12.58 12.78 12.91 13.44 13.55
10th 11.92 12.38 12.97 13.24 13.39 13.51 14.10 14.30
25th 14.77 15.37 15.96 15.97 16.08 16.16 16.46 16.58
Median 19.70 20.38 20.76 20.92 21.03 21.12 21.32 21.41
75th 25.25 25.68 25.76 25.71 25.96 25.91 25.62 25.44
90th 34.42 33.20 32.00 31.43 30.73 29.79 28.95 28.70
95th 39.29 38.65 37.15 35.72 34.23 32.45 31.00 31.38
Maximum 75.38 67.97 60.89 56.72 45.48 45.35 40.32 41.02
ra  re
Mean 3.19⁄⁄⁄ 1.35 1.15 2.92⁄⁄⁄ 2.90⁄⁄⁄ 3.42⁄⁄⁄ 4.10 4.72
Stdev 1.28 1.61 4.08 1.30 0.67 1.38 4.89 5.23
Minimum 1.23 0.81 0.05 1.76 1.53 1.42 0.07 0.02
Maximum 9.89 4.04 5.93 6.44 2.98 5.67 10.21 14.52

period, we find that ra is larger than re for all maturities. significance for 30-day, 120-day, 150-day, and 180-day
t-Tests on this daily difference on a null of an economically maturities. The t-statistic strongly supports the alternative
significant difference of 0.05 (equivalent to about 2% hypothesis of ra  re > 0:05. Indeed, the mean of the
annualized return as 0:05=22  0:02) show statistical difference ra  re appears to increase as the maturity
 1050 K.-G. Lim and C. Ting

Table 3. Regression of ex-post realized volatility on model-free volatility and out-of-sample forecasts. This table presents results of the
regressions of ex-post realized volatility on the model-free volatility for eight constant maturities over the sample period from July 23,
2001 to December 30, 2011. Out-of-sample mean forecast errors and RMFE (root mean forecast errors) are also reported in comparison
with the GARCH method. Respectively, RV, MFV, and GV denote realized volatility, model-free volatility, and GARCH volatility
forecasts in annualized percentage terms. The asterisks ⁄⁄⁄, ⁄⁄, and ⁄ denote significance levels of 1%, 5%, and 10%, respectively, based
on two-tailed tests of a null of zero. Tests of difference in forecast between MFV and GV show no significant difference from zero in
all cases at the 10% significance level. Tests and forecasts for 360-day and 450-day horizons are not feasible due to fewer than
10 non-overlapping observations each.

Regression 30-day 60-day 90-day 120-day 150-day 180-day

⁄⁄⁄
Constant –0.058 –0.005 –0.023 0.007 0.022 0.042
(t-Value) (–3.066) (–0.181) (–0.585) (0.092) (0.265) (0.525)
Slope 1.142⁄⁄⁄ 0.879⁄⁄⁄ 0.978⁄⁄⁄ 0.858⁄⁄⁄ 0.757⁄⁄ 0.682⁄
(t-Value) (13.587) (7.034) (5.486) (2.509) (2.030) (1.89)
R2 0.602 0.452 0.436 0.249 0.186 0.166

Average RV 18.26 18.52 18.73 19.51 18.35 18.72

Mean (RV-MFV) –0.31 –0.62 –0.32 0.16 –0.44 –0.01
Mean (RV-GV) –0.34 –0.10 0.63 0.65 0.22 0.66
Downloaded by [Texas A & M International University] at 04:12 07 October 2014

RMFE (RV-MFV) 7.68 8.57 8.24 10.46 10.14 9.73

RMFE (RV-GV) 5.08 5.38 6.33 6.60 5.86 5.85

increases. This is likely due to the larger strike price inter-
vals in longer maturity options and hence more upward bias
in the approximate ra relative to the exact re .y
The results suggest that it is critical to interpolate the
discrete strike prices with cubic splines before calculating
the model-free volatility. Otherwise, there will be an
upward bias, and our analysis shows that this upward bias
represented by the difference ra  re is both statistically
and economically significant. The bias is more severe
when the strike interval is of a larger percentage of
the underlying index level. The spline-fitting procedure
that observes no riskless arbitrage allows us to calculate
rMF with equation (17) more accurately than using
equation (9).
Far term options have little or no trading activity, even
though market makers post quotes and stand ready to trade.
With the discrete formula in proposition 2.2, it is not possi-
ble to obtain a reliable approximation of model-free volatil-
ity. By contrast, the implementation procedure discussed in
section 2 enables us to go beyond options of shorter term.
Even for very far term options, we are still able to obtain
the model-free volatility using the formula in proposition
2.2. Henceforth, we use only equation (17) to obtain the
exact value of model-free rMF .
The model-free volatility captures information embedded
in the series of puts and calls traded or price-quoted on any
trading day. As the European-style puts and calls have a
maturity T, the volatility information is forward-looking
and provides a forecast of the aggregated daily volatility
from the trading day until T in the future. It is important to
note that the model-free volatility estimates are based on a
risk-neutral probability measure that is fundamentally differ-
ent from the empirical or physical probability measure.
Therefore, the estimates will differ from the physical
measure of future volatility by a quantity typically known
as the volatility risk premium. To the extent that the
volatility risk premium, or the difference between the risk-
neutral and the physical measures, is stationary, we may
find a proxy for it by a past mean of the difference and
thereby adjust the model-free volatility accordingly.
3.2. Information content of model-free volatility
This subsection examines the information content of the
model-free volatility. As noted earlier, it is intuitive to
think of the model-free volatility estimate as a forecast
of future realized volatility. Thus, our improved method
affords a forecast into a longer horizon. In particular,
we report empirical results on the regression of ex-post
(out-
of-sample) realized volatility on the model-free volatility.
Table 3 presents results of the regressions of ex-post real-
ized volatility on the model-free volatility for eight constant
maturities over the sample period July 23, 2001 to Decem-
ber 30, 2011. Out-of-sample mean forecast errors and
RMFE (root mean forecast errors) are also reported in
comparison with the GARCH forecasting method.
As we have eight different maturity periods, the realized
volatilities have to be computed separately. At time or day
t, the ex-post realized volatility for a horizon of s, e.g.
30 days, is computed as
vffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
u tþs
u1 X
RV ðt; sÞ  t ðlog Si =Si1 Þ2 :
s i¼tþ1
Daily mean drift is close to zero and noisy, so the mean
adjustment is often not added in the literature.
We denote the model-free volatility estimate at t up to
horizon s by rMF ðt; sÞ. We then perform the simple OLS
regression: RV ðt; sÞ ¼ a þ brMF ðt; sÞ þ t , where a and b
are the constants of the intercept and slope, respectively,
and t is a stationary zero mean noise uncorrelated with the
explanatory variable. To avoid the problem of stochastic
dependence between the dependent variable and the
explanatory variable, we use non-overlapping data. This is

yThis observation was suggested by one of the referees.

 Term structure of S&P 100 model-free volatilities 1051
Downloaded by [Texas A & M International University] at 04:12 07 October 2014

Figure 4. Time series of the S&P 100 index and constant-maturity model-free volatilities. This figure plots the time series of the S&P
100 index and annualized model-free volatilities in percentages for eight constant maturities. The horizontal axis shows the calender
years in two-digit convention. The sample period is from July 23, 2001 through December 30, 2011.

because stochastic dependence can lead to biased and ineffi-
cient forecast in small samples.
For s ¼ 30, we construct time series for the dependent
variable as RV ðt; 30Þ, RV ðt þ 30; 30Þ, RV ðt þ 60; 30Þ, etc.
Corresponding values for the explanatory variable as time
series are, respectively, rMF ðt; 30Þ, rMF ðt þ 30; 30Þ,
rMF ðt þ 60; 30Þ, etc. Similarly, for s ¼ 60, we obtain time
series for the dependent variable as RV ðt; 60Þ,
RV ðt þ 60; 60Þ, RV ðt þ 120; 60Þ, etc. Corresponding values
for the explanatory variable as time series are, respec-
 1052 K.-G. Lim and C. Ting
Downloaded by [Texas A & M International University] at 04:12 07 October 2014
Figure 4. (Continued).
tively, rMF ðt; 60Þ, rMF ðt þ 60; 60Þ, rMF ðt þ 120; 60Þ, etc.
Regression is then performed for s ¼ 30, 60, 90, 120,
150, and 180. Non-overlapping data implies fewer than 20
observations for the cases of s ¼ 360 and 450, so these
two cases are not reported in table 3.
It is evident from table 3 that all the slope estimates
are significantly positive at the 1% level for s ¼ 30, 60,
90 and 120, and significant at the 5% and 10% levels
for s ¼ 150 and 180, respectively. In all cases, tests
based on the null of the slope being one are not rejected
at the 5% level. Except for s ¼ 30, the p-values are all
large, above 0.3. Thus there is sufficient statistical evi-
dence that the model-free volatility contains information
and predictability about future realized volatility of the
index returns.
For comparison, we also compute an empirical measure
forecast using the GARCH method. As estimating accurate
GARCH parameters requires a long time series, we provide
one year of past daily returns data for each set of new
GARCH parameter estimates. The GARCH parameter
estimates are then utilized to construct the GARCH
forward-looking forecast of volatility. We follow the meth-
odology of Ederington and Guan (2005).
The GARCH future volatility estimate at t for horizon s
is denoted as GV ðt; sÞ. We estimate GV ðt; 30Þ, GV ðt; 60Þ,
GV ðt; 90Þ, GV ðt; 120Þ, GV ðt; 150Þ, and GV ðt; 180Þ for each
t ¼ 1, 180, 360, etc, i.e. on a half-yearly window rolling
forward in time. To find the first set of GARCH parameters,
we utilize an extra set of one-year daily index data over the
period July 3, 2000 to July 20, 2001. Again, we do not
use overlapping data. We pair each GV forecast GV ðt; sÞ at
a time-point t with an ex-post realized volatility RV ðt; sÞ
and a model-free forecast rMF ðt; sÞ. Across the time series
indexed by t for the respective matched pairs of RV  rMF
P
and RV  GV , we report the means T 1 Tt ðRV ðt; sÞ
P
rMF ðt; sÞÞ and T 1 Tt ðRV ðt; sÞ  GV ðt; sÞÞ, as well as
the square roots of the means of squares of the forecast
errors, or the root-mean-forecast-square error (RMFE). The
results in the last five rows of table 3 show that the means
of the errors are rather similar for both the model-free and
the GARCH volatility forecasts, although the GARCH
method has a lower RMFE.
 Term structure of S&P 100 model-free volatilities 1053

Table 4. Summary statistics for absolute changes in model-free volatilities of eight constant maturities. This table presents summary
statistics for the absolute changes in daily model-free volatilities. The model-free volatility estimates re , in percentages on an annual-
ized basis, are calculated directly from option prices based on the exact formula (equation (17)). Eight constant maturities are
obtained from linear interpolation over the sample period from July 23, 2001 to December 30, 2011. The means and standard
deviations (Stdev) along with percentiles for the absolute changes across the different maturities are reported.
30-day 60-day 90-day 120-day 150-day 180-day 360-day 450-day
Mean 1.30 0.92 0.71 0.61 0.55 0.50 0.34 0.31
Stdev 1.73 1.42 0.89 0.82 0.74 0.70 0.42 0.37
Minimum 0.00 0.01 0.00 0.00 0.01 0.00 0.00 0.00
5th 0.06 0.05 0.04 0.03 0.03 0.03 0.02 0.02
10th 0.13 0.10 0.08 0.07 0.06 0.06 0.04 0.04
25th 0.35 0.25 0.20 0.17 0.15 0.14 0.11 0.09
Median 0.81 0.53 0.43 0.37 0.34 0.31 0.23 0.20
75th 1.64 1.08 0.88 0.74 0.68 0.62 0.43 0.39
90th 2.88 2.02 1.56 1.34 1.21 1.08 0.74 0.67
95th 3.96 2.90 2.27 1.98 1.76 1.49 1.01 0.91
Maximum 27.26 23.44 12.29 10.27 11.21 13.22 8.20 6.06
Downloaded by [Texas A & M International University] at 04:12 07 October 2014

4. Analysis of the term structure

In this section, we study the relationship between the esti-
mated term structure of model-free volatilities and the
underlying stock index dynamics, thus providing a better
understanding of the fear gauge.
4.1. Relations to the underlying S&P 100 index
Figure 4 shows the time series of the S&P 100 index in
panel A and eight time series of constant-maturity volatili-
ties in the other eight panels B to I. It is noticeable that
when the S&P 100 index is on a down trend, the model-
free volatility is on the up trend, and vice versa. For exam-
ple, there is a sharp market decline in August 2001 and this
is accompanied by a sharp rise in the model-free volatility
from about 20% to more than 40% in panel B for 30-day
constant maturity. This sudden increase in volatility is smal-
ler for other maturities, yet still quite substantial with the
volatility reaching 25% and above. We also observe that, in
July 2008, the S&P 100 index drops to 320 points and at
the same time volatilities for various maturities rise to 40 to
over 70%. By the end of 2011, the index rises to 600 points
while model-free volatilities across all maturities fall to
about 20%. These observations suggest that a bullish (bear-
ish) market is accompanied by decreasing (increasing)
model-free volatility.
Panels B to I of figure 4 show that the pattern of the time
series of model-free volatilities for different constant maturi-
ties are qualitatively the same. Their average daily values are
also close to each other in a tight range, although the range
of values narrows as maturity increases, as discussed and
shown in table 2. The key observation is that there appears
to be an inverse relationship between the level of the S&P
100 index and the level of its model-free volatility.
In table 4 we report the summary statistics for jDrMF j.
There is a clear pattern of decreasing jDrMF j with increasing
days to maturity. For instance, the average jDrMF j is 1.30 per-
centage point for 30-day maturity, whereas it is a much smal-
ler value of 0.31 percentage point for 450-day maturity. The
standard deviations of the absolute changes of re also
decrease as maturity increases. These results are consistent
with the visual observation that the time series of model-free
volatilities in figure 4 appear to be smoother as the maturity
increases.
This smoothness is not due to the technique of spline
interpolation used in our paper, which seeks to improve the
accuracy of estimating model-free volatility according to
the theory expressed in equation (1). Theoretical option
pricing without specifying a particular pricing model has no
definitive result on whether the volatility of model-free vol-
atility should increase or decrease with maturity. Instead,
the time series properties of the model-free volatility itself
would give some clue. If, as in this case, model-free volatil-
ity with the shortest maturity is stationaryy and has a posi-
tive autoregressive coefficient (<1) on its first lag, then the
averaged model-free volatility over a longer horizon will
necessarily be smaller than the shorter maturity model-free
volatility. This result carries over universally to other sta-
tionary dynamic random variables and is most evident in
stationary autoregressive processes.
In table 5, we report the correlation between the day-
to-day change in the model-free volatility Drt;s (rewriting
rMF ðt; sÞ as rt;s ) and the day-to-day change in the S&P 100
index level DLt . Note that we drop the subscript MF to the
model-free volatility at time t to simplify notation. Table 5
also reports sample estimates of the first-order serial
correlation of Drt;s .
We find that Drt;s is negatively correlated with DLt for
all eight constant maturities. This evidence of the ‘fear
gauge’ is well documented for VIX and the S&P 500 index,
but is shown here for the first time for the S&P 100 index.
The contemporaneous correlation coefficients are significant
at the 1% level. The negative correlations for the various

yUnit root tests of the model-free volatilities for the eight different constant maturities of 30 days, 60 days, 90 days, 120 days, 150 days, 180
days, 360 days, and 450 days show augmented Dickey–Fuller statistics, respectively, of –4.884, –4.087, –3.077, –3.214, –3.096, –2.963,
–2.234, and –2.013. Except for the 360-day and 450-day maturities, the model-free volatility time series do not display non-stationarity and
the null of unit roots can be rejected at the 1% significance level for two maturity cases, and at the 5% significance level for four maturity
cases.
 1054 K.-G. Lim and C. Ting

Table 5. Correlation with change in the S&P 100 index and auto-correlation. Model-free volatility at eight constant maturities are
obtained from linear interpolation over the sample period from July 23, 2001 to December 30, 2011. The contemporaneous correlation
between the change in model-free volatility and the change in the S&P 100 index is presented in the second column. The first-lag auto-
correlations in the time series of changes in the model-free volatility for eight constant maturities are also shown. The symbols ⁄, ⁄⁄, and
⁄⁄⁄
indicate the 1%, 5%, and 10% levels of significance, respectively.

Constant maturity Correlation with DLt First-lag auto-correlation

30-day –0.655⁄⁄⁄ –0.202⁄⁄⁄
60-day –0.600⁄⁄⁄ –0.222⁄⁄⁄
90-day –0.708⁄⁄⁄ –0.176⁄⁄⁄
120-day –0.679⁄⁄⁄ – 0.117⁄⁄
150-day –0.629⁄⁄⁄ –0.123⁄⁄⁄
180-day –0.532⁄⁄⁄ –0.144⁄⁄⁄
360-day –0.596⁄⁄⁄ – 0.048⁄
450-day –0.650⁄⁄⁄ – 0.046⁄

constant maturities are in the range of 0.708 to 0.532, rt;s ¼ a0 þ a1 t þ a2 s þ a3 ½sLt  þ a4 Lt þ a5 rt1;s
and do not become weaker at longer term maturity. There is
þ a6 rt2;s þ t;s ; ð21Þ
Downloaded by [Texas A & M International University] at 04:12 07 October 2014

also evidence of a significant negative correlation with the

lagged change in model-free volatility, which ranges where a0 ¼ d0 , a1 ¼ d1 , a2 ¼ h0 , a3 ¼ h1 , a4 ¼ d3 ,
from 0.222 to 0.046 across the eight constant maturities. a5 ¼ d4 , a6 ¼ d5 . The term t;s ¼ ut þ svt has zero mean. It
These negative autocorrelations in Drt;s reduce in magni- is stochastically independent of Lt and the process rt;s for
tude when the maturity increases above 180 days. all t and s.
The panel data has trading days t ¼ 1; 2; . . . ; T
(T ¼ 2622) during the sample period from July 23, 2001 to
4.2. Panel regressions and the slope of the volatility term December 30, 2011. For each trading day t, there are cross-
structure sectional data associated with each of the constant maturities,
s ¼ 30=360; 60=360; . . . ; 450=360. The time-series cross-
The preliminary evidence in table 5 indicates that the daily
sectional or panel regression of equation (21) has dependent
change in model-free volatility, Drt;s , co-varies negatively
variable values stacked as
in a significant way with the daily change in index level,
DLt . For each trading day, we could form an OLS estimate 0
r1;1
1
of the slope of the model-free volatility term structure by B r1;2 C
B C
regressing the volatility on the term. This is a crude esti- B .. C
B . C
mate as the number of observations per day in the regres- B C
B r1;8 C
B C
sion is small at only eight data points. We run an OLS B r2;1 C
B C
regression of the slope estimates on the index levels across B r2;2 C
B C
all the trading days. The OLS estimate of this slope of B . C
¼B . C
Y8T 0 1 B . C;
slopes is a positive 0.00010 with a standard error of Br C
B 2;8 C
0.00014. Thus, there is some preliminary evidence that the Br C
B 3;1 C
B . C
slope of the volatility term structure varies positively with B .. C
B C
index level. When the stock market is bullish (bearish), it B . C
B .. C
appears that the slope of the volatility term structure B C
@ rT 0 ;8 A
becomes slightly positive (negative).
To obtain the slope estimates in a more rigorous fashion, 0 1 30 30 1
1 L
365 1
L1 r1;1 r0;1
we first run the following panel regression to determine a
365 365
B1 1 60 60
L L1 r1;2 r0;2 C
B 365 365 365 1 C
linear relationship of model-free volatility with index level B .. .. .. .. .. .. .. C
B. . . . . . . C
and other relevant explanatory variables: B C
B1 1 450 450
L L1 r1;8 r0;8 C
B 1365 365 365 1 C
B1 2 30 30
L L2 r2;1 r1;1 C
B 365 365 365 2 C
B1 2 60 60
L L2 r2;2 r1;2 C
rt;s ¼ d0 þ d1 t þ d2 s þ d3 Lt þ d4 rt1;s þ d5 rt2;s þ ut ; B 365 365 365 2 C
B. .. .. .. .. .. .. C
X8T 0 7 ¼B
B.
. . . . . . . C;
C
ð20Þ B1 2 450 450 C
B 365 2
L L2 r2;8 r1;8 C
B1 365 365
C
where s takes the various annualized values of 30/365, B 3 30 30
365 3
L L3 r3;1 r2;1 C
B. 3365
..
365
.. .. .. .. .. C
60/365, 90/365, 120/365, 150/365, 180/365, 360/365, and B. C
B. . . . . . . C
B. .. .. .. .. .. .. C
450/365, t is the number of days into the sample divided B .. . . . . . . C
B C
by 365, and ut is a zero mean noise that is independent of @1 T 450 450
L LT rT 1;8 rT 2;8 A
365 365 365 T
Lt and the process rt;s for all t and s.
Furthermore, we specify d2 ¼ h0 þ h1 Lt þ vt, where h0
and h1 are constants, and vt is a zero mean noise that is inde- with parameter vector B71 ¼ ða0 a1 a2 a3 a4 a5 a6 Þ0, and
pendent of Lt and the process rt;s for all t and s. The other where T 0 ¼ T  1.
coefficients d0 , d1 , d3 , d4 , and d5 are constants. Substituting In the regression, Y ¼ XB þ E where E8T 0 1 ¼
the dynamics of d2 into equation (20), we obtain ð1;1 1;2    1;8 2;1 2;2    2;8 3;1    T 0 ;8 Þ, and E has
 Term structure of S&P 100 model-free volatilities 1055

Table 6. Panel regression results explaining changes in model-free volatilities. This table presents panel regression results based on
equations (21), (22), and (23), with model-free volatility as dependent variable in panel A regressions, and with daily change in model-
free volatility as dependent variable in panel B and panel C. The model-free volatilities are obtained from linear interpolation over the
sample period July 23, 2001 to December 30, 2011. The symbols ⁄, ⁄⁄, and ⁄⁄⁄ indicate test significance levels at 1%, 5%, and 10%,
respectively. Durbin–Watson (DW) statistics and unit root tests of the fitted regression residuals based on augmented Dickey–Fuller
(ADF) statistics are also reported. Null of the unit root is strongly rejected with p -values smaller than 0.01 for all panel regressions.

Panel A ^
a0 ^
a1 ^
a2 ^
a3 ^
a4 ^
a5 ^
a6
⁄⁄⁄ ⁄⁄⁄ ⁄⁄⁄ ⁄⁄⁄
Estimate 0.95052 0.00099 –0.13853 0.00025 –0.00128 0.88464 0.10013⁄⁄⁄
(t-Value) (6.309) (7.696) (– 1.271) (1.268) (– 4.812) (128.75) (14.593)
Adjusted R2 0.99
DW statistic 2.39
ADF statistic –90.85

Panel B ^
b0 ^
b1 ^
b2 ^
b3 ^
b4
Estimate 0.0014 0.0398⁄⁄⁄ –0.0957⁄⁄⁄ –0.0947⁄⁄⁄ –0.0005
(t-Value) (0.351) (22.479) (–44.792) (–16.105) (–0.931)
Adjusted R2 0.291
DW statistic 2.28
ADF statistic –90.59
Downloaded by [Texas A & M International University] at 04:12 07 October 2014

Panel C ^c0 ^c1 ^c2 ^c3 ^c4 ^c5

Estimate –0.0361⁄⁄⁄ 0.0400⁄⁄⁄ –0.0874⁄⁄⁄ –0.1033⁄⁄⁄ –0.0995⁄⁄⁄ –0.0055
(t-Value) (–6.709) (22.644) (–38.038) (–45.819) (–16.896) (–0.939)
Adjusted R2 0.294
DW statistic 2.27
ADF statistic –90.88

covariance matrix IT 0 T 0 R88 , where R is the covariance consider if asymmetric changes in Lt may impact changes
matrix of t;s , and has its ijth element given by in the model-free volatility differently. To model this asym-
cov ðut þ si vt ; ut þ sj vt Þ. Note that we assume t;s has het- metry, we separate DLt into its positive and negative parts,
eroskedasticity, but that tþk;s and t;s are not correlated for resulting in
any k – 0 and any s.
The best linear unbiased estimate B ^ 0 ¼ ð^
a0 ^
a1 ^a2 ^a3 ^a4 Drt;s ¼ c0 þ c1 ½sDLt  þ c2 DLþ 
t þ c3 DLt þ c4 Drt1;s
^a5 ^
a6 Þ is found via generalized least squares (GLS) as
þ c5 Drt2;s þ gt;s ; ð23Þ

^ ¼ ðX 0 ½I R1 ÞX 0 ½I R1 Y : where DLþ 

B
The estimates B ^ are reported in panel A of table 6. The
table also reports the Durbin–Watson (DW) statistics, indi-
cating for all cases no autocorrelation or the non-rejection
of any correlation at the 5% significance level. To ensure
the regressions are not spurious due to the presence of unit
roots, we also test the fitted residuals for unit roots using
the Augmented Dickey–Fuller (ADF) test statistic. In all
cases, the presence of unit roots is rejected at the less than
1% significance level, indicating stationarity in the
regression or else a cointegrating relationship that renders
OLS to be an appropriate tool.
Next, we perform a second regression to confirm the
results by taking the first difference of equation (21) as
follows:
Drt;s ¼ b0 þ b1 ½sDLt  þ b2 DLt þ b3 Drt1;s
þ b4 Drt2;s þ nt;s ;
where b0 ¼ d1 , b1 ¼ h1 , b2 ¼ d3 , b3 ¼ d4 , b4 ¼ d5 , and
nt;s ¼ Dt;s .
We apply similarly a GLS regression on equation (22),
and the results are shown in panel B of table 6. Finally, we
t ¼ maxðDLt ; 0Þ and DLt ¼ minðDLt ; 0Þ. The
results of this regression are reported in panel C of table 6.
The results in table 6 show strong evidence of negative
contemporaneous relations between daily changes in index
level and changes in the model-free volatility across all
maturities. Specifically, estimates ^b2 in panel B and esti-
mates ^c2 and ^c3 in panel C are all significantly negative at
significance levels of less than 1%. The results are consis-
tent with a significantly negative ^a4 in panel A. This result
for S&P 100 is new, and consistent with results using
implied volatilities on S&P 500, such as those of Fleming
et al. (1995) and Whaley (2000).
In panel C, we see that ^c2 ¼ 0:0874 while
^c3 ¼ 0:1033. Their average is about the same as estimate
^b2 in panel B. The results indicate that a 1% decrease in
the index level is associated with a larger positive increase
in the fear gauge or model-free volatility of 0.1033% than a
1% increase in the index level, which is associated with a
smaller decrease of 0.0874% in model-free volatility. This
asymmetric impact is tested under the null of H0 : c2 ¼ c3 .
ð22Þ
Using the covariance matrix of estimates obtained in panel
C, the t-statistic for the difference in the coefficient is
0:0159=0:00158 ¼ 10:07. Thus, ^c2 is significantly different
from ^c3 .
When we combine the estimated coefficients ^c1 ½sDLt 
þ^c2 DLþt in panel C, the negative impacts on model-free
 1056 K.-G. Lim and C. Ting
Downloaded by [Texas A & M International University] at 04:12 07 October 2014

Figure 5. Time series of the S&P 100 index and estimated slope of the model-free volatility term structure. This figure plots the time
series of the S&P 100 index and the time series of the estimated slopes of the model-free volatility term structure obtained from the
panel regression results in equation (21) and table 6. The horizontal axis shows the calender years in two-digit convention. The sample
period is from July 23, 2001 through December 30, 2011.

volatility are, respectively, 0.0841, 0.0808, 0.0775,
0.0743, 0.0710, 0.0677, 0.0480, and 0.0381 for the
various maturities of s ¼ 30= 365; . . . ; 450=360. Similarly,
when we combine the estimated coefficients ^c1 ½sDLt 
þ^c3 DLt in panel C, the negative impacts on model-free
volatility are, respectively, 0.1001, 0.0967, 0.0934,
0.0902, 0.0869, 0.0836, 0.0639, and 0.0540 for the
various maturities of s. Thus, it is seen that the negative par-
tial correlations between changes in index levels, whether
positive or negative, and changes in model-free volatilities,
become weaker as the maturity horizon increases.
Finally, we see that the expected slope of the term struc-
ture conditional on information at time t is Et ðd2 Þ ¼ h^0
þh^1 Lt ¼ 0:1385 þ 0:00025Lt (from panel A) at time t.
Thus, for an index level higher than 0:1385=0:00025
¼ 554, the conditional expected term structure of the
model-free volatility slope is positive. Conversely, for an
index level below 554, the conditional expected term
structure of the model-free volatility slope is negative. This
finding suggests that an upward-sloping term structure
occurs during a bullish market, which is characterized by
low volatility and more days with positive daily returns. On
the contrary, a downward-sloping term structure of model-
free volatility tends to be associated with bearish markets.
These implications are similar to those of the interest rate
yield curve.
The time series of S&P 100 index levels together with
the estimated volatility term structure slope h^0 þ h^1 Lt are
plotted in figure 5. The figure shows that the estimated vol-
atility term structure slope tends to move in tandem with
the index price level. During the period July 2001 to March
2003, in the aftermath of 9/11, the Enron scandal, and the
Second Gulf War in the spring of 2003, the S&P 100 index
stayed on the low side of 500 and below 500 for the most
part while the daily volatility term structure estimated
slopes were mostly negative. During the boom period or
easy credit period from mid-2003 until July 2008, the S&P
100 rose steadily past 600 while the volatility term structure
slope became highly positive. Thus there is clear evidence
that an upward-sloping volatility term structure occurred
during boom times. The collapse of the U.S. housing mar-
ket and the subsequent global financial crisis from August
2008 ushered in a bear market, which saw the index plunge
below 500 and the volatility term structure slope slipping
into negative territory. From March 2009, there had been
some stabilization and cautious recovery in the market,
before the onslaught of the European debt crisis, and the
index had climbed back above 500 while the volatility
slope turned positive.
5. Conclusions
This paper adds to the new strand of research on model-free
volatility, which is a theoretically superior alternative to the
Black–Scholes implied volatility. We present an improved
method to obtain the model-free volatility accurately,
despite the limitations of a small number of available option
prices and large strike price intervals.
With the improved method, we construct model-free vola-
tilities of eight different constant maturities on a daily basis,
and then perform an empirical analysis on the properties and
dynamics of the volatility term structure. Using the
European-style option on the S&P 100 index with the sample
period from July 23, 2001 through December 30, 2011, our
empirical analysis shows that the volatility calculated with
the discrete approximation of the model-free formula
 Term structure of S&P 100 model-free volatilities
contains an economically significant upward bias of several
percentage points. It is therefore important to smooth-spline
the option prices or interpolate the discrete strike prices
before calculating the model-free volatility so as to obtain a
more accurate model-free volatility estimate.
Our method is applied to the S&P 100 index, and we are
able to estimate model-free volatility based on the XEO
options of up to a long horizon of 450 days. This is perhaps
the first time that a study has come up with a viably accu-
rate and long-term structure of model-free volatilities, and
on the S&P 100 index that has no exchange quoted model-
free volatility.
Using our estimated long-term structure of model-free
volatilities, we are able to study the dynamic properties of
the volatility term structure under the risk-neutral measure.
Specifically, we find that (i) the changes in model-free vola-
Downloaded by [Texas A & M International University] at 04:12 07 October 2014
tilities are asymmetrically more positively impacted by a
decrease in the index level than negatively impacted by an
increase in the index level; (ii) the negative relationship
between the daily change in model-free volatility and the
daily change in index level is stronger in the near term than
in the far term; and (iii) the slope of the term structure is
positively associated with the index level, having a ten-
dency to display a negative slope during bear markets and a
positive slope during bull markets.
We also find that the model-free volatility provides sig-
nificant information about future realized volatility based on
the empirical measure. This may be important to market
participants who need to forecast the market condition
(Gregory 2007).
These significant results have important implications for
pricing index derivatives as well as hedging equity portfo-
lios. To the extent that the model-free volatility up to a par-
ticular horizon within 450 days can be accurately modeled
and predicted, volatility derivatives such as futures and
options can be priced off the predicted volatility term struc-
ture curve for both trading and hedging purposes. It is well
known in the financial market that volatility derivatives
such as VIX futures offer beneficial diversification for hold-
ers of large S&P stock portfolios. For example, when there
is fear of a systemic plunge in stock prices, investors could
take long positions in the volatility futures since the latter is
negatively correlated with movements in the underlying
assets. Knowing how index levels and volatilities of
different horizons are differentially correlated as we find in
this study, one can formulate a more robust and effective
hedging policy that uses volatility derivatives of different
maturities. Moreover, our paper also finds that while the
model-free volatility itself is a ‘fear gauge’ (Whaley 2000),
steeper term structures correlate with bullish sentiments and
thus the slope of the volatility term structure may serve as a
‘calm gauge’ of market condition. Hence, both the level of
model-free volatility as well as its slope have something to
say about possible changes in index prices.
Acknowledgements
The authors thank the anonymous referees for their
insightful comments and suggestions to improve the paper.
1057
References
Andersen, T.G. and Bondarenko, O., Construction and interpretation
of model-free implied volatility. Working paper, NBER, 2007.
Bates, D.S., The crash of ‘87: was it expected? The evidence from
options markets. J. Finance, 1991, 46, 1009–1044.
Bates, D.S., Post-’87 crash fears in the S&P 500 futures option
market. J. Econometr., 2000, 94, 181–238.
Black, F. and Scholes, M., The pricing of options and corporate
liabilities. J. Polit. Econ., 1973, 81, 637–654.
Bliss, R.R. and Panigirtzoglou, N., Option-implied risk aversion
estimates. J. Finance, 2004, 59, 407–446.
Bollen, N.P. and Whaley, R.E., Does net buying pressure affect the
shape of implied volatility functions? J. Finance, 2004, 59, 711–753.
Bollerslev, T., Gibson, M. and Zhou, H., Dynamic estimation of
volatility risk premia and investor risk aversion from option-
implied and realized volatilities. Working paper, Federal Reserve
Board, 2004.
Britten-Jones, M. and Neuberger, A., Option prices, implied pro-
cesses, and stochastic volatility. J. Finance, 2000, 55, 839–866.
Byoun, S., Kwok, C.C.Y. and Park, H.Y., Expectations hypothesis
of the term structure of implied volatility: evidence from foreign
currency and stock index options. J. Financ. Econometr., 2003,
1, 126–151.
Campa, J.M. and Chang, P.K., Testing the expectations hypothesis
on the term structure of volatilities in foreign exchange options.
J. Finance, 1995, 50, 529–547.
Campa, J.M., Chang, P.K. and Reider, R.L., Implied exchange rate
distributions: evidence from otc option markets. J. Int. Money
Finance, 1998, 17, 117–160.
Carr, P. and Madan, D., Towards a theory of volatility trading. In
Volatility: New Estimation Techniques for Pricing Derivatives,
edited by R. Jarrow, pp. 417–427, 1998 (Risk Books: London).
Carr, P. and Wu, L., A tale of two indices. J. Deriv., 2006, 13, 13–29.
Chicago Board of Options Exchange, VIX: CBOE volatility index.
White Paper, 2003.
Christensen, B. and Prabhala, N., The relation between implied
and realized volatility. J. Financ. Econ., 1998, 50, 125–150.
Cox, J.C. and Ross, S.A., The valuation of options for alternative
stochastic processes. J. Financ. Econ., 1976, 3, 145–166.
Day, T.E. and Lewis, C.M., Stock market volatility and the information
content of stock index options. J. Econometr., 1992, 52, 267–287.
Derman, E., Demeterfi, K., Kamal, M. and Zou, J., A guide to
volatility and variance swaps. J. Deriv., 1999, 6, 9–32.
Derman, E. and Kani, I., Riding on a smile. Risk, 1994, 7, 32–39.
Dupire, B., Model art. Risk, 1993, September, 118–124.
Dupire, B., Pricing with a smile. Risk, 1994, 7, 18–20.
Ederington, L.H. and Guan, W., Forecasting volatility. J. Fut.
Mkts, 2005, 25, 465–490.
Fleming, J., The quality of market volatility forecasts implied by S&P
100 index option prices. J. Empir. Finance, 1998, 5, 317–345.
Fleming, J., Ostdiek, B. and Whaley, R.E., Predicting stock market
volatility: a new measure. J. Financ. Mkts, 1995, 15, 265–302.
Gregory, K., Trading VIX futures and VIX options. Working
paper, Goldman Sachs Options Research, 2007.
Harvey, C.R. and Whaley, R.E., Market volatility prediction and
the efficiency of the S&P 100 index option market. J. Financ.
Econ., 1992, 31, 43–73.
Heynen, R., Kemma, A. and Vorst, T., Analysis of the term
structure of implied volatilities. J. Financ. Quantit. Anal., 1994,
29, 31–56.
Jiang, G.J. and Tian, Y.S., The model-free implied volatility and its
information content. Rev. Financ. Stud., 2005, 18, 1305–1342.
Jiang, G.J. and Tian, Y.S., Extracting model-free volatility from
option prices: an examination of the vix index. J. Deriv., 2007,
14, 35–60.
Mixon, S., The implied volatility term structure of stock index
options. J. Empir. Finance, 2007, 14, 333–354.
Neuberger, A., The log contract: a new instrument to hedge vola-
tility. J. Portfol. Mgmt, 1994, 20, 74–80.
 1058 K.-G. Lim and C. Ting
 
Sheikh, A.M., Stock splits, volatility increases, and implied volatil- ST
ities. J. Finance, 1989, 44, 1361–1372. r2MF T  E0Q ½V ð0; T Þ ¼ 2ðr  qÞT  2E0Q log : ðA9Þ
S0
Stein, J., Overreactions in the options market. J. Finance, 1989,
244, 1011–1023.
Whaley, R.E., The investor fear gauge. J. Portfol. Mgmt, 2000, 26, For the second term on the right-hand side of equation (A6),
12–27. we consider a quantity F0 known at time t ¼ 0, and we express
Xu, X. and Taylor, S.J., The term structure of volatility implied by for- logðST =F0 Þ as
eign exchange options. J. Financ. Quantit. Anal., 1994, 29, 57–74.
ST 1 1 ST
log ¼ log ST  log F0  ST ð  Þ þ  1
F0 F 0 ST F0
Appendix A: Z ST Z ST
1 1 ST
¼ dX  ST 2
dX þ  1
We assume that the underlying asset St evolves continuously F0 X F0 X F0
with drift lðt; St Þ and volatility rðt; St Þ as an Itô process. For Z ST
ease of exposition, we write lt  lðt; St Þ and rt  rðt; St Þ. ST  X ST
¼ dX þ  1: ðA10Þ
The stochastic differential equation for St is as follows: F0 X 2 F0
dSt
¼ lt dt þ rt dWt ; ðA1Þ For any z[  1, logð1 þ zÞ is a strictly concave function and
St logð1 þ zÞ\z. The left-hand side of equation (A10) is
logð1 þ zÞ with z  ST =F0  1. It follows that the integral
Downloaded by [Texas A & M International University] at 04:12 07 October 2014

R ST
where dWt is any stochastic process that has a continuous
F0 ½ðST  X Þ=X dX equals ðlogð1 þ zÞ  zÞ and hence is
2
sample path almost surely. strictly positive. We can then rewrite the integral as
By Itô’s formula, the function log St evolves according to
Z ST Z ST Z F0
  ST  X ST  X ST  X
dX ¼ 1 S [F dX  1 S \F dX
1 X 2 T 0
X 2 T 0
X2
dðlog St Þ ¼ lt  r2t dt þ rt dWt : ðA2Þ F0 F0
Z ST
ST
Z F0
2 ST  X X  ST
¼ 1ST[F0 2
dX þ 1 S T \F 0
dX
F0 X ST X2
It follows that Z H þ Z þ
ðST  X Þ F0
ðX  ST Þ
¼ 2
dX þ 2
dX :
F0 X L X
dSt 1
 dðlog St Þ ¼ r2t dt: ðA3Þ ðA11Þ
St 2
In the last step, we have used the fact that the asset price ST ,
Next, we consider the integrated variance V ð0; T Þ, defined as which is unknown at time t ¼ 0, can potentially attain a low value
Z denoted by L, or appreciate substantially to a high value H.
T
In view of equation (A11), equation (A10) becomes, under
V ð0; T Þ  r2t dt: ðA4Þ the risk-neutral measure Q,
0
  Z H
ST CðS0 ; X ; T Þ
The variance V ð0; T Þ is the sum of instantaneous variances E0Q log ¼ erT dX
r2t realized over time 0 to time T . From equation (A3), we F0 F0 X2
Z F0  
obtain PðS0 ; X ; T Þ Q ST
e rT
dX þ E0 1
Z  L X2 F0
T
1 ST Z H
V ð0; T Þ ¼ 2 dSt  log : ðA5Þ CðS0 ; X ; T Þ
0 St S0 ¼ erT dX
F0 X2
Z F0
Thus, we just need to prove that PðS0 ; X ; T Þ
 erT dX ; ðA12Þ
L X2
Z T 
E0Q ½V ð0; T Þ ¼ 2E0Q dSt =St  logðST =S0 Þ ðA6Þ where CðS0 ; X ; T Þ and PðS0 ; X ; T Þ are respectively the Euro-
0
pean call and put prices, with strike price X , underlying index
price S0 , and maturity T .
equals the right-hand side of equation (1). To arrive at this result, E0Q ½ST  ¼ F0 has been applied.
Finally, we write
To proceed with the proof, we note that, in the risk-neutral
setting, the expected return is the continuously compounded ST ST F0
risk-free rate r when there is no dividend, or r  q when the log ¼ log þ log ; ðA13Þ
S0 F0 S0
dividend rate is q. This continuous dividend rate is defined by
and substituting equation (A12) into equation (A9), we
eqT S0  S0  PV ðDÞ: ðA7Þ obtain Z H
CðS0 ; X ; T Þ
The first term on the right-hand side of equation (A6) is r2MF T ¼ 2ðr  qÞT þ 2erT dX
F0 X2
Z F0 
Z  PðS0 ; X ; T Þ F0
T
1 þ 2
dX  2 log : ðA14Þ
E0Q dSt ¼ ðr  qÞT ; ðA8Þ L X S0
St
0 In view of equation (A7), we have F0 ¼ eðrqÞT S0 . The first
and last terms cancel out and proposition 2.1 is obtained.
and we obtain