The Economic Significance of the Forecast Bias of S&p 100 Index Option Implied Volatility

A number of recent papers find that the volatility implied by index option prices significantly overstates future stock market volatility. We investigate whether this bias is purely due to measurement error and model misspecification, or whether the bias is also apparent in option market prices. We accomplish this by examining the profits for trading strategies designed to exploit the apparent bias. Ignoring transaction costs, the strategies consistently earn significant positive profits which indicates the bias is indeed a function of option prices. The degree of bias, however, does not signal market inefficiency because the profits disappear once we impose bid/ask transaction costs. Our analysis also reveals that the bias is too large to be explained by skewness preference, but that it may be the result of market imperfections (e.g., transaction costs) and/or a premium demanded for volatility risk. We also find that the bias apparent through the trading strategies emerged only after the 1987 stock market crash.