Journal of Advances in Management Research

Effectiveness of volatility models in option pricing: evidence from recent financial

upheavals
Vipul Kumar Singh
Article information:
To cite this document:
Vipul Kumar Singh , (2013)," Effectiveness of volatility models in option pricing: evidence from recent
financial upheavals ", Journal of Advances in Management Research, Vol. 10 Iss 3 pp. 352 - 375
Downloaded by Management and Science University At 07:30 06 February 2017 (PT)

Permanent link to this document:

http://dx.doi.org/10.1108/JAMR-11-2012-0048
Downloaded on: 06 February 2017, At: 07:30 (PT)
References: this document contains references to 41 other documents.
To copy this document: permissions@emeraldinsight.com
The fulltext of this document has been downloaded 202 times since 2013*
Users who downloaded this article also downloaded:
(2013),"Volatility in Asian stock markets and global financial crisis", Journal of Advances in Management
Research, Vol. 10 Iss 3 pp. 333-351 http://dx.doi.org/10.1108/JAMR-01-2013-0010
(2014),"Price discovery and volatility spillovers in futures and spot commodity markets: Some
Indian evidence", Journal of Advances in Management Research, Vol. 11 Iss 2 pp. 211-226 http://
dx.doi.org/10.1108/JAMR-09-2012-0039

Access to this document was granted through an Emerald subscription provided by emerald-srm:546288 []
For Authors
If you would like to write for this, or any other Emerald publication, then please use our Emerald for
Authors service information about how to choose which publication to write for and submission guidelines
are available for all. Please visit www.emeraldinsight.com/authors for more information.
About Emerald www.emeraldinsight.com
Emerald is a global publisher linking research and practice to the benefit of society. The company
manages a portfolio of more than 290 journals and over 2,350 books and book series volumes, as well as
providing an extensive range of online products and additional customer resources and services.
Emerald is both COUNTER 4 and TRANSFER compliant. The organization is a partner of the Committee
on Publication Ethics (COPE) and also works with Portico and the LOCKSS initiative for digital archive
preservation.

*Related content and download information correct at time of download.

 The current issue and full text archive of this journal is available at
www.emeraldinsight.com/0972-7981.htm

JAMR
10,3
Effectiveness of volatility models
in option pricing: evidence from
recent financial upheavals
352 Vipul Kumar Singh
Institute of Management Technology, Nagpur, India

Abstract
Downloaded by Management and Science University At 07:30 06 February 2017 (PT)

Purpose The purpose of this paper is to explore the forecasting effectiveness of Black-Scholes (BS)
focussing parity analysis of time series econometric and implied volatility (IV) numerical techniques.
Design/methodology/approach To analyze the comparative competitiveness of econometric time
series and IV models this paper consolidated the study with their inter-relations leading toward
multilayered moneyness-maturity correlation of model and market option prices, thoroughly
determined the moneyness-maturity combinations of error metrics of Nifty index options.
Findings Out of six models tested and critically examined here, the paper procures only a single
model, IV, which best caters to the requirements of option traders and as a result the paper ended up
that only IV supports to multifarious moneyness-maturity dimension of option pricing of Nifty index
options. The analysis also confirms that the standard VIX is not a reliable tool for determining the
base price of Nifty index options (via BS). As the IV landmarks during the most dynamic phase of
Indian capital market which is a touchstone to justify the quality of any model, the paper can deduce
that IV could continue to perform in hardships of financial contraction par smoothly and effectively.
Practical implications The final outcome of this research which ended successfully in exploring
a dominant model, guided successfully through the most volatile period of Indian economy can be
used to safe guard investors faith and to figure a design which could compete on the canvass of
option pricing.
Originality/value As equity market is always subject to highly unpredictable conditions and may
keep on experiencing it through all times to come, the unified objective of research is to find out the
most impeccable volatility model to meet out the requirements of option practitioners, specifically
contributing upto the satisfaction and expected results during tumultuous period.
Keywords Financial forecasting, Data analysis, Derivatives, Econometrics, Option pricing,
Time series
Paper type Research paper

Journal of Advances in Management
Research
Vol. 10 No. 3, 2013
pp. 352-375
r Emerald Group Publishing Limited
0972-7981
DOI 10.1108/JAMR-11-2012-0048
1. Introduction
The most important use of time-varying volatility models is to produce forecasts of
future volatility, which in turn used for numerous activities including derivative
asset pricing, measuring and managing risk, portfolio allocation across asset classes
and trading strategies. Therefore, it becomes highly essential to cross-examine the
effectiveness of such models underlying the dynamics of asset time series. Generally,
traders and practitioners measure the volatility in two ways, backward looking and
forward looking. Techniques namely implied volatility (IV) and volatility index (VIX)
is forward looking, reflects the future volatility of the underlying asset, obtained from
market option prices. Authors namely Day and Craig (1992), Edey and Elliot (1992),
Canina and Figlewski (1993), Christensen and Prabhala (1998), Ederington and Guan
(2002) have advocated the use of IV as tool of volatility forecasting, because it reflects
future expectations about volatility. Whereas time series econometric methods such as
m-windowed moving average historical volatility (HV), exponential weighted moving
average (EWMA) and generalized autoregressive conditional heteroskedasticity
 (GARCH) are backward looking, as they all computes the HV from the time series Volatility models
data of financial assets (French et al., 1987), reflects the past realizations. Practitioners in option pricing
find that for the pricing of financial assets, future volatility is the relevant volatility,
not the HV. HV will only be helpful in forward pricing if the future remains like the
past, which is not the case in the real world (Schwert, 1989; Pagan, 1996).
Though future volatility is most relevant, but the random characteristics of
financial assets time series return data makes it highly difficult for researchers to 353
model it (Baillie and DeGennaro, 1990). Volatility of financial factors makes modeling
of financial assets highly cumbersome (Taylor, 1986; Engle and Patton, 2001), as
the same is always subject to state of high uncertainty and thus, modeling and
forecasting performance of hypothecated volatility models are always exposed to the
Downloaded by Management and Science University At 07:30 06 February 2017 (PT)

risk of failure (Glosten et al., 1993). However, to ensure the forecasting success,
econometric models namely GARCH family models tried their level best, incorporated
the financial characteristics of asset returns into volatility (Cumby et al., 1993;
McKenzie and Mitchell, 2004).
Volatility is now a tradable entity and traded successfully on the bourses of many
exchanges including India, thus precise estimation of same is highly crucial. In the
realm of option pricing the success of the Black-Scholes (1973) formula is because
of its simplicity, analytical tractability and closed form solution. Besides fulfilling
the core purpose of option pricing, from the past four decades the formula is also using
reciprocally to provide the quotes of volatility, coined as IV. Researchers reveals that,
since it not only incorporates inherent information of historical data of underlying
asset but also of market option prices, it has the forecast capability and is therefore
used extensively to forecast underlying assets (Beckers, 1981; Mayhew, 1995; Blair
et al., 2001). But from the time researchers and practitioners reveals that the volatilities
are often correlated with the underlying-asset price, stochastic volatility models
become a more realistic choice for modeling of dynamics of assets price of derivative
securities. Although, in last four decades several models have been introduced but only
a few, namely Hull and White (1987), Heston (1993) and Heston and Nandi (2000)
manages to retain the popularity amid computational complexity and poor analytical
tractability of other stochastic models. In series Dumas et al. (1998) also modeled the IV
as a set of quadratic combinations of moneyness-maturity, named it deterministic
volatility functions. The model was found to significantly improve the price bias
of Black-Scholes (BS). Therefore, in order to provide an all round taste and make this
research work complete, we tested the empirical efficiency of various versions of
volatility models ranging from time series econometric and implied volatilities.
As the equity market is always subject to highly unpredictable conditions and may
keep on experiencing it through all times to come, the unified objective of this research
is to find out the most impeccable volatility model to meet out the requirements of
option practitioners, specifically contributing upto the satisfaction and expected
results during tumultuous period. To measure the cross-competency of volatility
models in option pricing, we have simply embedded volatility models into the classical
BS model and tested the forecasting effectiveness of the two, together. Chronologically,
Pagan and Schwert (1990), Poon and Granger (2003) and Alberg et al. (2008) tested the
effectiveness of IV and GARCH models in option pricing and reveled that IV estimators
outperform GARCH family models.
Thus, to provide a fresh and focussed approach, this paper search out the most apt
volatility model for pricing of Nifty index options, the most heavily trading product of
National Stock Exchange (NSE) of India. In Figure 2 it is evident that Nifty index
 JAMR options alone account three-fourth of the total trading volume of Future & Option
10,3 (F&O) segment of NSE, and is also among the top five traded instruments of the world,
in similar category. To testify, the hypothecated models are further inter-passed
through the recent waves of financial upheavals, spanning 2006-2011. This period not
only rows an extreme of phenomenal unpredictability but also ranging the high
and low tides of financial flux. Thus, this specific period provides the most apt
354 situation for testifying the applicability of volatility models. The relative price errors
of model produced in the said duration will probe out the most apt volatility model,
which will further explain option-pricing market in the most scientific terms. Since,
India VIX was launched toward the end of year 2007 on the bourse of NSE, data
of same are not available for the period of study mentioned above. Thus, to testify
Downloaded by Management and Science University At 07:30 06 February 2017 (PT)

the applicability of VIX in option pricing this paper is divided in two time veins.
First consist of the window of year 2006-2011 while second encompass the period
of 2008-2011.
Along these lines, the paper is distributed in seven sections. Section 2 describes the
descriptive statistics of Nifty index and index options, financial characteristics of Nifty,
option categories and data screening procedure. Section 3 discusses the research
methodology. Section 4 gives a brief overview of BS and competing volatility models
(which will used as an input in BS). Section 5 reveals the result. Section 6 briefs
about the managerial implications of this research. Section 7 finally concludes the
research work.

2. Data characteristics of nifty index and index options

2.1 Data
Figure 2 clearly reveals that on the canvass of Indian capital market, the span of
2006-2011 has been the most dynamic and thus, the most apt for testing and justifying
the quality of volatility models. This specific period covers the extreme limits of the
whole range of Indian capital market, as during this period the Nifty touched the zenith
of its highest and lowest. This particular period gave rise to the roars of a host of
financial experts to estimate the forecasting effectiveness of financial and econometric
models. Therefore, we have also chosen this specific period to testify the applicability
of volatility models. As, the specific period encompasses the whole range of economic
cycle, it provides the best possible laboratory conditions to justify the forecasting
effectiveness of models measuring the various virtue and vices of options trading.
To ensure the accuracy for the purpose of this research, we collected the data of
Nifty index call option from the official data source of NSE. Figure 2 depicts that in
F&O segment, index options is the most popular trading instrument. The trading
popularity of index options has grown astronomically in the last few years and
now alone accounts for 75 percent of the total turnover of the F&O segment of NSE
(Figures 1 and 2).
This research work required the collection of historical data of parameters, namely
index price, strike price, time to maturity and interest rate (equal to yield of 91-day
T-Bill). Except the last one, all others were collected from the bourse of NSE. Whereas,
the 91-day T-bill yield rates were collected from the bourse of Reserve Bank of India
(RBI). In line with the theoretical and empirical underpinnings, Figures 1, 3 and 4
jointly provide the evidence, that for the specified period, Nifty index return also
exhibits the financial characteristics such as non-lognormal return distribution,
leverage effect and volatility clustering, which makes the applicability of econometric
time series volatility models more prominent.
 Histogram Volatility models
400 Mean = 3.29E-4 in option pricing
SD = 0.019
N = 1.486

300
355
Frequency

200
Downloaded by Management and Science University At 07:30 06 February 2017 (PT)

100

Figure 1.
0 Non log-normality of
0.2000 0.1000 0.0000 0.1000 0.2000 Nifty index return
Return

3,50,000 80
Index Turnover
3,00,000 70
Turnover (Rs Billion)

Derivative Segment Total Turnover 60

Index Percentage
2,50,000
Index Percentage 50
2,00,000
40
1,50,000
30
1,00,000 20
50,000 10
0 0
Figure 2.
20 -01

20 -02

20 -03

20 -04

20 -05

20 -06

20 -07

20 -08

20 -09

20 -10

20 -11

2
-1

Business growth of
00

01

02

03

04

05

06

07

08

09

10

11
20

index options
Year

On the other hand, to correct the systematic price bias of self, the BS model establishes
forecasting applicability of implied volatilities across moneyness-maturities.
The forecasting performance of IV models highly depends on the choice of moneyness
because of smile (exhibited in Figure 5). To alleviate this, of the many versions of IV
discovered in last four decades, at-the-money (ATM) is the most popular one, but it
suffer from the drawback that it discards the incorporation of all potential information
contained in out-of-the and in-the-money options.
Figure 1 depicts that the return distribution of frequency of Nifty index is
non-lognormal, slightly skewed to the right and highly peaked toward the top and that
the right tail is thicker than the left tail, indicates that during the specific period,
probability of positive return is more probable as compared to that of negative return.
 JAMR Nifty Index Movement
10,3 BS ATM IV (%)
100
7,000
90

Implied Volatility (%)

6,000
80

Nifty Index Level

5,000 70
4,000 60
356 3,000
50
40
2,000 30
20
1,000 10
0 0
Figure 3.
Downloaded by Management and Science University At 07:30 06 February 2017 (PT)

06

07

08

09

10

11
Leverage effect of at-the-
n-

n-

n-

n-

n-

n-
money implied volatility
Ja

Ja

Ja

Ja

Ja

Ja
2-

2-

2-

2-

2-

2-
and Nifty index return
Date

0.20

0.15
Nifty Index Returns

0.10

0.05

0.00

0.05

Figure 4. 0.10
Volatility clustering of
Nifty index return 0.15
Date

2.2 Data screening procedure

The call sample data collected from the bourse of NSE were then transformed through
various filtering channels to procure the best raw material for comparing and
contrasting of the models in question. The sample data were inter-passed through four
exclusionary filters on a daily basis. Data set not satisfying the following criteria was
excluded from the initial sample data set: Nifty index options with less than ten traded
contracts, contracts with maturity 490 and o3 days amid volatility price bias,
contracts with call moneyness ratio (S/K-1) greater/less than 715% i.e. very-deep
in-the-money (DITM) and very-deep-out-of-the-money (DOTM) options. Finally, the
remaining set of data were tested for lower boundary condition:
 
Max 0 ; St  KerTt pCMarket St ; t

where St is the current asset price, K is the strike price, r is the risk-free interest rate
and C(St, t) is the call price at time t, t is the time to maturity in year. Data not satisfying
the lower boundary condition were also ruled out. The final set of data figured into
 Volatility models
in option pricing

0.40
357

Implied Volatility
Downloaded by Management and Science University At 07:30 06 February 2017 (PT)

0.30

09
9.
0.20
76
4. 10
Mo 0 20
ne 0.0 3
yn 40 0
es 6 5
s( 5.2 60 0
% ys)
) 70 Da
11 9 80 ity (
11. 0 tur
Ma Figure 5.
Volatility smile pattern
Notes: Data of April 24, 2012, index price: 4999.85, volatility: 25 percent, of Nifty index options
risk free rate:7.43 percent is used to figure out the smile pattern

33,576 call options for first window and 26,497 for second window. Tables I and II,
display the descriptive statistics of raw and filtered data. The final set of remaining
data were then categorically placed in a matrix of three rows and five columns of time
to maturity and moneyness, defined as:
9 8
Short Maturity >
> >
> 45 and p30 Days
= <
Medium Maturity if Time to Maturity T 430 and p60 Days
>
> >
>
; :
Long Maturity 460 and p90 Days

9 8
deep  out  of  the  money DOTM >
> >
> X  0:15 ando  0:10
>
> >
>
>
> >
> X  0:10
out  of  the  money OTM >
>  >
> ando  0:05
= SK <
at  the  money ATM if Call Moneyness X  0:05 andp 0:05
>
> K >
>
>
> >
>
in  the  money ITM >
> >
> 4 0:05 andp 0:10
>
> >
>
; :
deep  in  the  money DITM 4 0:10 andp 0:15

3. Research methodology
To analyze the comparative competitiveness of econometric time series and IV models,
this paper consolidated the study with their inter-relations leading toward multilayered
 JAMR Years Sub-total
10,3 2006 2007 2008 2009 2010 2011 2006-2011
Total call contracts 44,555 38,890 72,494 93,860 95,008 179,695 524,502

Criteria Data rejected

No trading volume/open
358 interest 35,304 29,052 56,835 75,785 76,514 157,009 430,499
No. of traded contractsp50 5,182 4,163 7,216 9,137 6,481 7,394 39,573
Moneyness4 15% 170 366 211 1,459 1,055 1,132 4,393
Moneyness o15% 84 9 1,866 738 263 2,673 5,633
Maturity490 days 0 2 543 390 1,533 2,029 4,497
Maturityo3 days 385 490 551 486 502 520 2,934
Downloaded by Management and Science University At 07:30 06 February 2017 (PT)

No arbitrage relationship 584 573 123 196 932 989 3,397

Rejected data 41,709 34,655 67,345 88,191 87,280 171,746 490,926
Rejected data (%) 93.61 89.11 92.90 93.96 91.87 95.58 93.60
Table I. Remaining data 2,846 4,235 5,149 5,669 7,728 7,949 33,576
Filter statistics Remaining data (%) 6.39 10.89 7.10 6.04 8.13 4.42 6.40

Call moneyness ((S/K)1)

DOTM OTM ATM ITM DITM Total/sub-total

Maturity
Short 2,511 3,287 8,169 1,498 607 16,072
7.48% 9.79% 24.33% 4.46% 1.81% 47.87%
Medium 1,737 2,706 6,049 1,011 259 11,762
5.17% 8.06% 18.02% 3.01% 0.77% 35.03%
Table II. Long 869 1,681 2,939 210 43 5,742
Nifty index call option 2.59% 5.01% 8.75% 0.63% 0.13% 17.10%
statistics for the years Total/sub-total 5,117 7,674 17,157 2,719 909 33,576
2006-2011 (post filtration) 15.24% 22.86% 51.10% 8.10% 2.71% 100.00%

moneyness-maturity correlation of models and market option prices, thoroughly

determining the moneyness-maturity combinations of error metrics of Nifty index
options. For the same, this paper employed two simple and elegant error metrics
namely mean percentage error (MPE) and mean absolute pricing error (MAPE),
defined as:

1X k
MPE C Model  CiMarket =CiMarket
K i1 i

1X k  
MAPE CiModel  CiMarket =CiMarket
K i1

where CModel
i and CMarket
i are the predicted and actual price of the options, respectively,
and i and k are the total number of observations. As understood, both the metrics find
the deviation of prices of model from the market, but whereas PME measures the
relative average deviation of model from the market MAPE measures the absolute
deviation of model from the market.
 The volatility and its associated parameters (if any) were updated on a rolling basis, Volatility models
almost every day. Thus in total, volatility was obtained for 1,487 trading days. To in option pricing
testify the forecasting quality of volatility models focussing pricing imperfection of BS,
this paper simply looks at the relative error of the models related to the market.
Parameters of GARCH models are also estimated on a rolling window, one-year rolling
window is used to determine same, starting from the beginning of 2006 (2008) to the
end of 2011, for first and second window, respectively. 359
On the other hand, to infer option-related IV structural parameters from market
data, this paper employs the most simple but elegant again, least square (LS) loss
function (Chiarella et al., 2000; Christoffersen and Jacobs, 2004; Rouah and Vainberg,
2007). Further, the optimal set of parameters obtained, are then used to compute the
Downloaded by Management and Science University At 07:30 06 February 2017 (PT)

models price. The methodologies of finding the volatility of all other models have been
discussed individually in the next section.
Finally, to interpret and evaluate the relative forecasting capability of volatility
models (relative to market) Theils U statistics has been employed. The value of U
statistic is bound between 0 and 1, defined as:
s
P n  2
CiModel  CiMarket
i1
U s s
P n  2 P n  2
CiModel CiModel
i1 i1

The lower the value of U statistics, the more accurate the forecast is. The values closer
to 0 implies greater forecast accuracy and closer to 1 implies worst forecast.

4. Volatility models
4.1 Time series econometric models
4.1.1 m-Windowed moving average HV. Rolling window of historical data is the most
simple and popular way of estimating the standard deviation of a financial assets
return. The method utilized past data to predict the future with a belief that the future
will remain like the past. The method is appropriate to the extent the hypothesis
remain true or to the extent history repeats itself. In practice, traders always
considered the future volatility relevant to estimate the prices of financial assets,
because for them the past is not important. What is important is the future and since
the future is uncertain, HV cannot be the right choice (Mixon, 2009). However, HV is
useful when the return of asset prices is found to be auto-correlated, but in that case,
performance of HV will be subject to the degree of autocorrelation. Since, Figure 6
clearly exhibits that Nifty index returns do not show significant autocorrelation, prima
facie discarding the forecasting uses of HV in option pricing.
The major flaw of using the m-windowed moving average is that its gives equal
weight to all the data within the window and eventually forget a particular event when
the specific date is moved out of the window. Figure 7 demonstrates the memory loss
effect of windowed moving average. On January 21 and 22, 2008, stock markets around
the world dipped in response to the sub-prime crisis and a series of failure of big
investment banks of America.
Figure 7 clearly depicts that immediately after the crash, volatility shifted to a new
high. The volatility level then remained high for a period of time, but the moment the
 JAMR 0.10
10,3 0.08
0.06

Sample Autocorrelation
0.04
0.02

360 0.00
0.02 0 10 20 30 40 50 60 70

0.04
0.06
Figure 6.
0.08
Downloaded by Management and Science University At 07:30 06 February 2017 (PT)

Autocorrelation of
Nifty index return 0.10
Lag, k

100 20 Day Rolling HV

90
EWMA
80
70
60
Volatility

50
40
30
20
10
0
-08 ar-08 -08 ul-08 -08 -08 -09 ar-09 -09
an ay ep ov -Jan ay
1-J 1-M 1-M 1-J 1-S 1-N 1 1-M 1-M
Figure 7.
EWMA vs 20-day Date
rolling HV method
Note: EWMA is calculated using =0.95

crash date moved out of the 20-day window, the volatility level dropped suddenly, as
the 20-day window had forgotten the crash completely. While in practice, behaviorally
the effect of such crash remains for a longer period. For example, an investor who has
suffered a great loss in any crash, would not forgot the crash after a period. The same
pattern and effect was noted in January 2008, October 2008 and May 2009. On October
24, 2008, Nifty marked its multi year low, tank down 359.15 points (12.20 percent)
because of impeding global factors whereas on May 18, 2009, Nifty jumped up 651.5
points ( 17.74) because of positive sentiments aroused from the clear mandate
of generally assembly election of 2009. Thus, the financial characteristics of the
m-windowed moving average are contrary to intuition of traders and investors and are
not able to gauge the sentiments of traders with perfection. The formula is:
1X m
s2n u2
m i1 ni
where ui is the proportional change in the asset price during day i and gives
equal weights to all u2i s.
 4.1.2 EWMA. The rolling variance approach is criticized by practitioners because it Volatility models
assigns equal weights to all the observations in the window, which was against the in option pricing
intuition of traders, that distant past observations (events and shocks) have lesser
impact on future volatility of assets compared to the recent past observations (events
and shocks), consequently EWMA was developed. EWMA is a special case of ARCH
model in which weights gi (1d)di1 of the model:
361
s2n ds2n1 1  du2n1

decreases exponentially form new to old data; hence it gives more weight to the more
recent observations and less to the older ones. The values of parameter d is a constant,
Downloaded by Management and Science University At 07:30 06 February 2017 (PT)

whose value typically lies between 0 and 1 (0.9 odo1). As i increases the weights of
asset return uis decline at a rate d.
Figure 7 reveals that contrary to the 20-days windowed volatility, in EWMA
model, it does not drop suddenly after the period of crash, instead it decreases
gradually. Thus, it keeps the incident in its memory for a longer period compared
to its HV counterpart.
4.1.3 Discrete time GARCH volatility models. Since the ARCH model of Robert Engle
(1982) surfaced, numerous forms of ARCH models have been introduced and applied
in different areas of finance, ranging asset pricing, modeling of financial time-series
and risk management (Engle and Ng, 1993; Cumby et al., 1993; Bekaert and Wu, 2000;
McKenzie and Mitchell, 2002; Alberg et al., 2008; Harrison and Moore, 2012). Engle
modeled the variance of a time series by conditioning it on the square of lagged
disturbances, error terms (shocks). Similar to EWMA, GARCH (Bollerslev, 1986) is the
generalized version of ARCH, GARCH. The GARCH (1,1) is the most successful
variant of GARCH family models. The most important specification of the model is
that it incorporates the four important financial characteristics of asset return data:
auto-regression, heteroskedasticity, excess kurtosis and volatility clustering,
simultaneously. Auto-regression is a feedback mechanism, which incorporates past
observations into the present, while conditional heteroskedasticity measures the time-
varying characteristic of volatility conditional to observations of the immediate past.
In order to predict the future volatility, GARCH incorporates serial dependence of HV
i.e. volatility persistency. Figures 3, 4 and 8 jointly advocates the applicability of the
GARCH model to forecast Nifty. Whereas, Figure 8 strongly advocates the applicability

0.200
0.180
0.160
0.140
Autocorrelation

0.120
0.100
0.080
0.060
0.040
0.020 Figure 8.
0.000 Autocorrelation of
squared of Nifty
0.020 0 10 20 30 40 50 60 70
index return
Lag, k
 JAMR of GARCH (exhibits a strong positive autocorrelation between square of Nifty index
10,3 return at various lags), Figure 9 support it weakly, exhibits moderate autocorrelation
between the ratio of square of Nifty index return and GARCH volatility, at certain
lags only.
The GARCH(q, p) forecast of volatility for time t 1, based on values observed at
time t, is given by mean and variance equation defined as:
362 Mean Equation
r t f et

Variance Equation
Downloaded by Management and Science University At 07:30 06 February 2017 (PT)

X
q X
p
s2t1 Z gi e2t1i lj s2t1j
i1 j1

where q is the order of ARCH process and p is the order of GARCH. e2t 11 (the
ARCH term) incorporates news about volatility from the previous period, measured as
the lag of the squared residuals from the mean equation, s2t 1j is the past period
forecast variance (the GARCH term), and Z, gi and lj are parameters that are all 40
(i 1, y , q and j 1, y , p). Error, et is assumed to be normally distributed with zero
mean and conditional variance, s2t .
4.2 EGARCH model
EGARCH is the refined version of the GARCH model introduced by Nelson (1991).
In addition of the GARCH risk-return tradeoff, EGARCH incorporates the leverage
effect of financial assets. Figure 3 exhibits the leverage effect of Nifty index, implies
whenever market/equity moves up, volatility goes down and vice versa. To ensure the
basic framework of GARCH; the conditional variance s2t of asset return (rt) at any point
of time (t) cannot be negative, EGARCH model expressed s2t as a linear combination
(with positive weights) of positive random variables, defined as:
Mean Equation
rt f yst et

0.10

0.08

0.06
Sample Autocorrelation

0.04

0.02

0.00
11 21 31 41 51 61 71
Figure 9. 0.02
Autocorrelation of ratio
of squared of the Nifty 0.04
index return and its
GARCH volatility 0.06
Lag, k
 Variance Equation Volatility models
 
 et  et in option pricing
log s2t1 Z l log st g  d
2
st st

Because of the logarithmic form of conditional variance, the model is popularly known
as exponential-GARCH model, and implies that the leverage effect is exponential 363
(Engle and Ng, 1993). The statistical significance of the leverage effects can be test by
formulating the hypothesis d!0 and da0, also an indicator of the asymmetric
impact of volatility. But opposite to the GARCH, it not imposes any nonnegative
constraints on the coefficients of model parameters. Brandt and Jones (2006) and Li and
Downloaded by Management and Science University At 07:30 06 February 2017 (PT)

Hong (2011) demonstrated the importance of volatility forecasting of range-based long

memory specifications of EGARCH.

4.3 IV models
4.3.1 BS ATM IV. BS ATM IV is the most popular among the numerous implied
volatilities. Researchers acclaimed that the ATM volatility of BS is virtually unbiased,
as the formula is nearly linear in sigma for ATM options (Feinstein, 1989; Fleming,
1998; Fengler, 2012). The IV is the value, which when embedded back in BS formula,
yields the observed option price. This means that ATM implied volatilities are
important because they constitute a forward-looking estimate of the volatility of the
underlying asset.
The BS model hardly requires any introduction. Due to its closed form solution,
computational simplicity and analytical tractability the model is most popular and
despite well-known shortcomings still used extensively for fixing the base price of
European options underlying various financial assets. The Black and Scholes (1973)
formula for pricing European call options on a stock paying no dividends is:

CBS SN d1  Kert N d2

where
lnS=K r 0:5s2 t
d1 p
s t

lnS=K r  0:5s2 t p
d2 p d1  s t
s t

C is the option price of call option, S is the price of underlying assets (Nifty here), K is
the exercise price, t is the time to maturity in years, r is the risk-free rate of return
(equal to 91-day T-bill yield), N(d) is the standard normal distribution function, and s2
is the variance of asset returns.
Except volatility, all other parameters of the model are directly observable from the
market. The same can be estimated inversely by inverting the formula, but since the
formula cannot be directly inverted algebraically, different numerical techniques such
as simulation, optimization, Newton Raphson and Bi-section methods need to be
employed to estimate the same. For estimating the ATM IV, this paper utilized
Newton Raphson Method.
 JAMR 4.3.2 Parametric IV. Though, the BS ATM IV is considered to be the most popular
10,3 tool for the forecast of future volatility, but as implied volatilities exhibits a smile/skew
pattern, the choice of moneyness become highly important for calculating the
non-skewed IV. To circumvent this, the practitioner uses ATM IV for forecasting.
Though, ATM alleviates the smile/smirk problem, but at the same time it discards
the uses of all potential information contained in the rest of the option prices
364 (available across moneyness and maturities). Therefore, to include information content
of all option prices, we employed the method of LS, which incorporates the whole
cross-section of option prices including ATM. This method implied the volatility from
the set of market data. Employing the technique of optimization (LS, already discussed
in previous section), this method minimizes the price difference of the model (BS) and
Downloaded by Management and Science University At 07:30 06 February 2017 (PT)

market across moneyness-maturities. The optimization function is:

X
n
2
f s min Cobs;i K; T  CBS;i s; K; T
s
i1

where n is the number of observation in a day, Cobs is a market-observed call price and
CBS is theoretical BS call price. The process is computationally intensive and complex,
as achieving a universal gradient is not an easy task. The process will be iterated
for the entire sample on a daily basis.
4.3.2 VIX. The VIX is actually a modeled free advance version of BS ATM IV. It is
more liberalized than its ATM counterpart and it incorporates the wide range of
moneyness. In India, VIX was introduced toward the end of year 2007 with the
objective of providing a premier barometer of market volatility to investors. Since VIX
infer volatility from the market option prices directly, it provides an apt value for
estimating the forecast of Nifty index and the associated instruments, measures the
markets expectation of 30-day S&P CNX Nifty index volatility. Traders can make their
decision based on this, as they presumed that it gauges the market volatility. VIX is
figured out from the best bid-ask quotes of short and medium term Nifty index options
contracts. Computational methodology of India VIX is the same as of CBOE with little
modifications (for details visit www.nseindia.com).

5. Performance statistics and results

Tables III-VIII substantiate this empirical research work, providing descriptive
statistics of model prices, volatility and error metrics. Cross-sectional and multilayered
co-relational study of above mentioned tables will reveal the comparative
competitiveness of the models. Tables III-VI provide the descriptive statistics of
options prices, volatility and errors of the window 2006-2011, while Tables VII and VIII
depict the error statistics of second window 2008-2011.
Table III reports the moneyness-maturity statistics of option prices of the model and
market. Results of Table III are in line with the theoretical fundamentals that prices of
the long-maturity call options are higher than the short- and medium-maturity options.
Also, price of call options increases with the increase in maturity and the prices of
DOTM options are lower than ATM and DITM options. The maturity and moneyness
price sequence can be depicted as short maturityomediumolong maturity and
DOTMoOTMoATMoITMoDITM options.
Table IV depicts the moneyness-maturity statistics of volatility of econometric and
implied techniques. It reveals that the volatility of econometric time series methods is
 Maturity statistics
Volatility models
Models BS BS BS BS BS BS in option pricing
Market (HV) (EWMA) (GARCH) (EGARCH) (ATM) (IV)

Short term
DOTM Average 6.2 18.0 18.3 11.7 15.6 14.0 5.1
SD 10.1 34.9 36.6 26.4 26.6 26.7 11.2 365
OTM Average 17.4 38.0 38.2 29.5 34.6 34.9 16.1
SD 22.1 58.1 60.3 50.0 40.1 53.0 22.6
ATM Average 106.5 126.9 127.7 119.2 127.8 127.5 103.4
SD 76.8 91.7 94.2 86.2 82.2 87.9 75.0
ITM Average 352.2 351.3 352.5 342.9 359.1 350.6 346.3
Downloaded by Management and Science University At 07:30 06 February 2017 (PT)

SD 89.7 102.6 104.5 102.0 89.6 98.9 87.5

DITM Average 539.2 525.9 528.2 518.1 536.2 523.3 530.6
SD 121.4 129.4 130.6 131.8 117.9 127.1 119.8
Sub-total Average 111.9 127.7 128.4 120.0 128.2 126.6 109.0
SD 142.4 144.7 146.3 142.0 142.0 143.0 140.2
Medium term
DOTM Average 21.9 52.0 49.1 46.2 58.6 48.7 23.2
SD 26.6 62.5 62.3 45.7 52.6 56.0 30.6
OTM Average 47.7 85.8 83.3 88.3 94.2 85.1 50.1
SD 39.0 73.1 73.5 54.0 62.7 66.4 41.4
ATM Average 171.1 205.5 204.4 214.8 215.5 208.2 170.1
SD 83.7 100.8 103.4 89.7 95.0 94.7 83.1
ITM Average 396.5 415.5 413.9 414.9 422.7 416.1 393.9
SD 86.5 95.5 96.8 96.0 91.8 92.2 85.3
DITM Average 549.2 557.5 555.7 547.8 554.4 554.6 543.0
SD 121.5 134.2 134.6 138.4 124.8 129.1 122.7
Sub Total Average 148.4 181.1 179.3 185.3 189.7 181.8 148.3
SD 137.2 144.6 146.0 138.6 140.0 141.7 135.8
Long term
DOTM Average 27.7 60.7 57.0 89.4 89.0 65.7 31.0
SD 25.3 50.3 46.7 34.0 53.2 48.1 28.5
OTM Average 64.3 104.7 103.0 154.8 133.7 110.7 68.5
SD 36.8 65.3 64.8 47.5 68.9 59.0 39.7
ATM Average 201.1 240.5 239.9 295.8 267.0 249.6 203.1
SD 79.2 94.2 96.2 84.1 94.7 87.9 79.9
ITM Average 462.6 481.0 479.2 521.3 493.0 493.8 461.3
SD 98.2 96.5 96.5 109.1 102.7 100.9 96.5
DITM Average 656.6 654.7 651.2 679.8 654.3 668.8 644.5 Table III.
SD 144.1 136.8 139.1 159.2 154.3 147.3 147.4 Price statistics of Nifty
Sub-total Average 147.8 185.4 184.0 234.4 212.2 193.2 150.4 index call options (years
SD 124.3 131.6 132.5 128.6 130.2 130.1 123.5 2006-2011)

higher than the implied counterparts. Prima facie, the econometric models are found to
either highly overvalue or undervalue Nifty index options, as compared to IV models.
Second, there is an apparent trend, in all the cases volatility increases monotonically in
either way moving from ATM to DITM or DOTM. This behavior of volatility is widely
known as smile and since all the variants of volatility exhibit this pattern, it indicates
that all the models would misprice Nifty index options. Thus, the only point of concern
is to find out the model exhibiting the lowest price error across moneyness-maturity.
Also, compared to short and medium-maturity options, long-maturity options exhibit
a lower variation from DOTM to DITM. This indicates that the price variation of
 JAMR Maturity statistics
10,3 Models
BS (HV) BS (EWMA) BS (GARCH) BS (EGARCH) BS (ATM) BS (IV)

Short term
DOTM Average 0.30 0.30 0.27 0.32 0.29 0.23
366 SD 0.15 0.16 0.11 0.13 0.13 0.10
OTM Average 0.29 0.29 0.26 0.30 0.28 0.22
SD 0.14 0.15 0.11 0.13 0.12 0.09
ATM Average 0.26 0.26 0.24 0.27 0.26 0.20
SD 0.13 0.14 0.10 0.12 0.11 0.08
ITM Average 0.28 0.28 0.25 0.28 0.29 0.22
Downloaded by Management and Science University At 07:30 06 February 2017 (PT)

SD 0.14 0.15 0.11 0.11 0.11 0.08

DITM Average 0.32 0.32 0.28 0.29 0.32 0.25
SD 0.16 0.17 0.13 0.12 0.13 0.10
Sub-total Average 0.28 0.28 0.25 0.28 0.27 0.21
SD 0.14 0.14 0.10 0.12 0.12 0.09
Medium term
DOTM Average 0.28 0.28 0.27 0.30 0.28 0.22
SD 0.14 0.14 0.10 0.12 0.13 0.10
OTM Average 0.26 0.25 0.26 0.27 0.26 0.20
SD 0.13 0.13 0.08 0.12 0.12 0.09
ATM Average 0.24 0.24 0.25 0.25 0.24 0.19
SD 0.12 0.12 0.08 0.11 0.10 0.08
ITM Average 0.26 0.26 0.26 0.27 0.26 0.21
SD 0.13 0.13 0.09 0.11 0.11 0.08
DITM Average 0.32 0.31 0.29 0.29 0.32 0.26
SD 0.15 0.15 0.11 0.11 0.12 0.09
Sub-total Average 0.25 0.25 0.26 0.27 0.25 0.20
SD 0.13 0.13 0.08 0.11 0.11 0.08
Long term
DOTM Average 0.22 0.21 0.25 0.25 0.23 0.17
SD 0.09 0.08 0.04 0.08 0.08 0.06
OTM Average 0.20 0.20 0.25 0.23 0.21 0.16
SD 0.08 0.08 0.04 0.08 0.07 0.06
ATM Average 0.20 0.20 0.25 0.22 0.21 0.16
SD 0.08 0.08 0.04 0.08 0.07 0.05
ITM Average 0.20 0.20 0.25 0.22 0.22 0.17
SD 0.09 0.09 0.05 0.08 0.08 0.06
Table IV. DITM Average 0.22 0.21 0.26 0.21 0.24 0.20
Implied volatility statistics SD 0.09 0.09 0.04 0.06 0.07 0.06
of Nifty index call options Sub Total Average 0.20 0.20 0.25 0.23 0.21 0.16
(years 2008-2011) SD 0.08 0.08 0.04 0.08 0.07 0.06

short- and medium-term options is likely to be higher than the long-maturity options,
which implies that the estimation of pricing of short- and medium-maturity options is
likely to be difficult as compared to the long-term options.
The Tables V and VI exhibit the descriptive statistics of the mean percentage and
the mean absolute percentage price error of Nifty index options. The call options
values are inferred from the classical BS model computed with econometric and
implied volatilities as input. Conjoint analysis of data of Tables V and VI reveal the
following interesting facts: First, except IV, all tend to overprice the Nifty index call
options across moneyness-maturity. The degree of pricing error of HV and EWMA is
 Maturity statistics
Volatility models
Models in option pricing
BS BS BS BS BS BS No. of
(HV) (EWMA) (GARCH) (EGARCH) (ATM) (IV) observations

Short term
DOTM Average 1.50 1.53 0.88 1.55 1.07 0.56 2,511 367
SD 6.90 6.93 6.56 2.91 6.50 0.61
OTM Average 1.24 1.27 0.95 1.51 1.18 0.24 3,287
SD 4.09 4.12 4.01 2.09 3.96 0.57
ATM Average 0.32 0.33 0.25 0.41 0.36 0.03 8,169
SD 0.75 0.81 0.72 0.69 0.71 0.22
Downloaded by Management and Science University At 07:30 06 February 2017 (PT)

ITM Average 0.01 0.01 0.02 0.02 0.00 0.02 1,498

SD 0.17 0.18 0.16 0.08 0.15 0.03
DITM Average 0.02 0.01 0.03 0.00 0.02 0.02 607
SD 0.14 0.15 0.13 0.04 0.13 0.02
Sub-total Average 0.65 0.67 0.46 0.76 0.59 0.15 16,072
SD 3.38 3.41 3.23 1.67 3.20 0.43
Medium
term
DOTM Average 1.77 1.70 2.51 3.47 1.69 0.06 1,737
SD 1.90 2.20 2.61 3.18 1.85 0.46
OTM Average 0.97 0.96 1.76 1.63 1.04 0.06 2,706
SD 1.06 1.24 2.03 1.65 0.91 0.29
ATM Average 0.25 0.24 0.37 0.35 0.28 0.00 6,049
SD 0.37 0.40 0.45 0.44 0.31 0.09
ITM Average 0.05 0.05 0.05 0.07 0.05 0.01 1,011
SD 0.13 0.14 0.12 0.11 0.11 0.04
DITM Average 0.02 0.02 0.00 0.01 0.01 0.01 259
SD 0.12 0.13 0.11 0.05 0.10 0.03
Sub-total Average 0.62 0.60 0.97 1.07 0.63 0.00 11,762
SD 1.09 1.21 1.68 1.88 1.02 0.24
Long term
DOTM Average 1.46 1.33 3.68 3.18 1.76 0.12 869
SD 1.28 1.40 3.10 2.32 1.41 0.42
OTM Average 0.70 0.69 2.09 1.36 0.85 0.08 1,681
SD 0.71 0.79 1.85 1.09 0.61 0.23
ATM Average 0.23 0.22 0.58 0.39 0.28 0.01 2,939
SD 0.30 0.32 0.44 0.38 0.23 0.09
ITM Average 0.05 0.04 0.13 0.07 0.07 0.00 210
SD 0.09 0.10 0.08 0.09 0.07 0.04 Table V.
DITM Average 0.00 0.01 0.03 0.01 0.02 0.02 43 Mean percentage price
SD 0.05 0.05 0.05 0.06 0.04 0.04 error statistics of Nifty
Sub-total Average 0.54 0.52 1.47 1.08 0.66 0.05 5,742 index call options (years
SD 0.80 0.83 1.97 1.49 0.85 0.22 2006-2011)

somewhat similar, may be because of the fact that EWMA is only a refined version of
HV. The pricing error of DOTM, OTM and ATM is higher compared to ITM and DITM
options, the reason being that the traders are more biased toward them amidst low
price and leverage. On the contrary, amidst high prices and low leverage, ITM and
DITM options are less popular (Table II), together they account only 11 percent of total
tradable liquid Nifty index options.
 JAMR Maturity statistics
10,3 Models
BS BS BS BS BS BS No. of
(HV) (EWMA) (GARCH) (EGARCH) (ATM) (IV) observations

Short term
368 DOTM Average 2.18 2.25 1.68 2.07 1.73 0.70 2,511
SD 6.72 6.74 6.40 2.56 6.36 0.45
OTM Average 1.57 1.65 1.37 1.73 1.43 0.48 3,287
SD 3.97 3.99 3.89 1.91 3.87 0.39
ATM Average 0.42 0.45 0.37 0.46 0.41 0.13 8,169
SD 0.70 0.75 0.67 0.65 0.68 0.18
Downloaded by Management and Science University At 07:30 06 February 2017 (PT)

ITM Average 0.09 0.09 0.07 0.05 0.07 0.03 1,498

SD 0.15 0.15 0.15 0.06 0.13 0.03
DITM Average 0.06 0.06 0.05 0.02 0.05 0.02 607
SD 0.13 0.13 0.13 0.03 0.12 0.02
Sub-total Average 0.89 0.93 0.74 0.92 0.78 0.28 16,072
SD 3.33 3.35 3.17 1.59 3.16 0.37
Medium
term
DOTM Average 1.88 1.84 2.55 3.52 1.74 0.36 1,737
SD 1.79 2.09 2.57 3.13 1.80 0.29
OTM Average 1.05 1.07 1.78 1.68 1.06 0.21 2,706
SD 0.98 1.15 2.01 1.60 0.88 0.20
ATM Average 0.31 0.32 0.40 0.39 0.30 0.06 6,049
SD 0.32 0.34 0.42 0.41 0.29 0.07
ITM Average 0.09 0.09 0.09 0.09 0.08 0.03 1,011
SD 0.11 0.12 0.09 0.09 0.09 0.03
DITM Average 0.06 0.06 0.05 0.04 0.05 0.02 259
SD 0.11 0.11 0.10 0.04 0.09 0.02
Sub-total Average 0.69 0.69 1.00 1.11 0.66 0.14 11,762
SD 1.05 1.16 1.66 1.85 1.01 0.19
Long term
DOTM Average 1.55 1.45 3.68 3.21 1.77 0.29 869
SD 1.16 1.27 3.10 2.28 1.40 0.32
OTM Average 0.79 0.80 2.09 1.39 0.86 0.16 1,681
SD 0.62 0.68 1.85 1.04 0.60 0.18
ATM Average 0.28 0.29 0.59 0.42 0.29 0.06 2,939
SD 0.25 0.26 0.43 0.35 0.22 0.06
ITM Average 0.07 0.07 0.14 0.09 0.08 0.03 210
Table VI. SD 0.08 0.08 0.07 0.08 0.07 0.03
Mean absolute percentage DITM Average 0.04 0.03 0.05 0.05 0.04 0.03 43
price error statistics of SD 0.04 0.04 0.03 0.04 0.03 0.03
Nifty index call options Sub-total Average 0.61 0.60 1.47 1.11 0.67 0.12 5,742
(years 2006-2011) SD 0.75 0.77 1.97 1.47 0.84 0.19

The pricing performance of GARCH and EGARCH models decreases with the increase
in maturity, implying that the forecasting capacity of the models decreases with
the increase in the forecast period. BS-IV under prices (56 percent) short-term DOTM
options whereas, all other models overprice it. Both, EWMA and HV severely misprice
it with error percentage higher than 150 percent. The same set of pattern is repeated
for OTM and ITM options. However, the degree of error decreases with the increase
in moneyness. Table VI also supports the results of Table V. In line with the statistics
 Maturity statistics
Volatility models
Models in option pricing
BS BS BS BS BS BS BS No. of
(HV) (EWMA) (GARCH) (EGARCH) (ATM) (IV) (VIX) observations

Short term
DOTM 0.88 0.95 0.35 1.45 0.56 0.55 1.74 2,322 369
2.36 2.7 1.95 2.87 1.74 0.63 2.74
OTM 0.82 0.87 0.64 1.47 0.85 0.22 2.17 2,791
1.57 1.78 1.69 2.11 1.18 0.59 2.16
ATM 0.31 0.32 0.22 0.45 0.32 0.02 0.65 5,003
0.51 0.63 0.53 0.73 0.42 0.23 0.92
Downloaded by Management and Science University At 07:30 06 February 2017 (PT)

ITM 0.04 0.04 0.01 0.03 0.03 0.01 0.05 1,146

0.08 0.09 0.06 0.07 0.05 0.03 0.06
DITM 0.01 0.02 0.00 0.00 0.01 0.01 0.01 508
0.05 0.06 0.03 0.04 0.03 0.02 0.04
Sub-total 0.50 0.53 0.31 0.83 0.45 0.17 1.14 11,770
1.38 1.57 1.26 1.80 1.04 0.47 1.88
Medium
term
DOTM 1.70 1.65 2.50 3.51 1.66 0.06 3.53 1,669
1.74 2.08 2.54 3.23 1.68 0.46 2.40
OTM 0.92 0.92 1.82 1.65 1.03 0.07 2.15 2,440
1.00 1.22 2.09 1.70 0.85 0.29 1.68
ATM 0.24 0.24 0.37 0.37 0.27 0.00 0.49 4,263
0.32 0.35 0.47 0.45 0.25 0.09 0.40
ITM 0.06 0.05 0.05 0.07 0.06 0.01 0.11 862
0.10 0.11 0.09 0.10 0.07 0.03 0.06
DITM 0.03 0.03 0.01 0.01 0.03 0.01 0.05 239
0.08 0.08 0.07 0.05 0.05 0.02 0.04
Sub-total 0.65 0.64 1.08 1.22 0.68 0.01 1.41 9,473
1.08 1.23 1.79 2.03 1.02 0.25 1.83
Long term
DOTM 1.45 1.33 3.69 3.18 1.77 0.12 3.33 865
1.28 1.4 3.11 2.32 1.41 0.42 1.91
OTM 0.70 0.68 2.12 1.37 0.85 0.08 1.71 1,646
0.71 0.78 1.86 1.09 0.60 0.23 1.05
ATM 0.23 0.23 0.60 0.42 0.28 0.01 0.53 2,499
0.29 0.32 0.46 0.39 0.22 0.09 0.30
ITM 0.04 0.04 0.12 0.07 0.07 0.00 0.13 199
0.09 0.10 0.08 0.09 0.07 0.04 0.07 Table VII.
DITM 0.00 0.01 0.03 0.01 0.02 0.02 0.05 43 Mean percentage price
0.05 0.05 0.05 0.06 0.04 0.04 0.04 error statistics of Nifty
Sub-total 0.57 0.54 1.56 1.16 0.69 0.05 1.34 5,252 index call options (years
0.82 0.85 2.04 1.53 0.87 0.23 1.44 2008-2011)

of Table V, Table VI also reveals that the pricing performance of models decreases
from DOTM to DITM and from short-maturity to long-maturity options, except in case
of GARCH and EGARCH model. The absolute price error of IV is lower across
moneyness-maturity.
VIX may be able to portray and replicate the real volatility of Nifty index and
incorporation of the same in BS will significantly improve its pricing bias. In this hope,
we did a thorough analysis of the same and compared its performance with versions of
 JAMR Maturity statistics
10,3 Models
BS BS BS BS BS BS BS No. of
(HV) (EWMA) (GARCH) (EGARCH) (ATM) (IV) (VIX) observations

Short term
370 DOTM 1.61 1.72 1.19 2.00 1.24 0.7 2.16 2,322
1.94 2.29 1.59 2.52 1.34 0.46 2.42
OTM 1.19 1.28 1.08 1.69 1.10 0.49 2.29 2,791
1.32 1.51 1.45 1.93 0.95 0.41 2.04
ATM 0.36 0.39 0.31 0.49 0.34 0.13 0.66 5,003
0.47 0.58 0.48 0.7 0.40 0.18 0.91
Downloaded by Management and Science University At 07:30 06 February 2017 (PT)

ITM 0.06 0.06 0.04 0.05 0.04 0.02 0.06 1,146

0.07 0.08 0.05 0.06 0.04 0.03 0.05
DITM 0.03 0.04 0.02 0.02 0.02 0.02 0.03 508
0.04 0.05 0.03 0.03 0.02 0.02 0.03
Sub-total 0.76 0.81 0.63 1.01 0.66 0.31 1.25 11,770
1.25 1.45 1.14 1.70 0.92 0.40 1.81
Medium
term
DOTM 1.82 1.79 2.54 3.56 1.71 0.36 3.54 1,669
1.61 1.96 2.50 3.17 1.63 0.29 2.39
OTM 1.00 1.04 1.84 1.70 1.05 0.22 2.15 2,440
0.92 1.13 2.07 1.65 0.82 0.21 1.67
ATM 0.29 0.29 0.4 0.41 0.27 0.06 0.49 4,263
0.28 0.31 0.45 0.42 0.24 0.06 0.40
ITM 0.07 0.08 0.07 0.09 0.07 0.02 0.11 862
0.09 0.09 0.07 0.08 0.06 0.02 0.06
DITM 0.05 0.05 0.04 0.04 0.04 0.02 0.05 239
0.07 0.07 0.06 0.04 0.04 0.02 0.04
Sub-total 0.72 0.72 1.11 1.26 0.70 0.15 1.41 9,473
1.04 1.18 1.77 2.01 1.00 0.21 1.82
Long term
DOTM 1.55 1.45 3.69 3.22 1.77 0.29 3.33 865
1.16 1.27 3.10 2.28 1.40 0.32 1.90
OTM 0.78 0.8 2.12 1.41 0.86 0.16 1.71 1,646
0.61 0.67 1.86 1.05 0.59 0.18 1.05
ATM 0.29 0.29 0.61 0.45 0.28 0.06 0.53 2,499
0.24 0.26 0.46 0.36 0.21 0.06 0.30
ITM 0.07 0.07 0.13 0.09 0.07 0.03 0.13 199
Table VIII. 0.07 0.08 0.07 0.08 0.06 0.03 0.07
Mean absolute percentage DITM 0.04 0.03 0.05 0.05 0.04 0.03 0.05 43
price error statistics of 0.04 0.04 0.03 0.04 0.03 0.03 0.04
Nifty index call options Sub-total 0.64 0.63 1.57 1.19 0.70 0.13 1.34 5,252
(years 2008-2011) 0.77 0.79 2.03 1.51 0.87 0.19 1.44

volatility models already discussed for the window spanning 2008-2011. To our
surprise, pricing performance of VIX is the most pitiful across moneyness-maturity,
evident from Tables VII and VIII. The degree of mispricing is even higher than the HV
and EWMA, being more than 200 percent for DOTM and OTM options.
Tables VII and VIII depict the comparative statistics of MPE and MAPE
of econometric time series and IV models. MPE and MAPE depicts similar. From
Tables VII and VIII, we jointly deduced that out of all volatility models discussed here,
 when put together and examined, IV is the only model which prices Nifty index options Volatility models
with lowest pricing error and stands firmly on the ground of comparative in option pricing
competiveness. Figure 10 graphically proves the same (generated randomly).
In the first window spanning 2006-2011, the average percentage pricing error of IV
model is significantly lower than HV, EWMA, GARCH, EGARCH and ATM models in
14 out of 15 categories of moneyness-maturity, while in the second window covering
2008-2011, it not only outperforms econometric models, but is also the most hyped 371
implied counterpart (VIX), across all moneyness groups. We find that the parametric
IV model, providing a significant improvement over econometric and IV models, is the
most reliable tool to make future predictions of Nifty index options.
Theils U statistics, depicted in Table IX, also positioned IV on the top followed
Downloaded by Management and Science University At 07:30 06 February 2017 (PT)

by ATM across moneyness-maturity. The sequence based on U statistics are arranged

as IV4ATM4GARCH4HV4EGARCH4EWMA4IVX. It also reveals that the
performance of GARCH and EGARCH deteriorates with respect to maturity, prices short
and medium-maturity contracts better than the long-maturity options contracts. This is
obvious, it is because of limitation of parametric frame, (1, 1) feature of GARCH and
EGARCH. To price long-term options one can try GARCH family models with higher
ARCH terms. But compared to its advance counterpart, performance of basic GARCH is
superior across moneyness-maturity. This is only possible if the fit of the GARCH is better
than the EGARCH. The values of Akaike information criterion (AIC) and Schwarz
information criterion (SIC) is primarily used to validate same. Lower the value of AIC and
SIC, better the fit is. Following is the AIC and SIC statistics of GARCH and EGARCH, for
period spanning 2008-2011.

Model Akaike info criterion Schwarz criterion

GARCH 5.371668 5.351832

EGARCH 5.405311 5.380515

Performance of ATM IV also shows trends similar to GARCH and EGARCH. But it is
also not surprising as short-term ATM IV is used to determine the medium and
long-term options. Ideally, one should use corresponding ATM IV for corresponding
options i.e. short for short and long for long, but doing so would lead to voluminous

6.0 BS 20 Day Rolling

5.0 BS EWMA
BS GARCH
4.0
BS ATM Price
3.0 BS IV Parameter
MPE

2.0 BS VIX

1.0 BS EGARCH

0.0
2 0 8 6 4 2 0 3 5 8 1 4 Figure 10.
1.00.1 0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.1 0.1 Price bias of
volatility models
2.0 Moneyness
 JAMR Maturity statistics
10,3 Models
BS BS BS BS BS BS BS No. of
(HV) (EWMA) (GARCH) (EGARCH) (ATM) (IV) (IVX) observations

Short term
372 DOTM Average 0.53 0.57 0.41 0.49 0.39 0.19 0.55 2,322
OTM Average 0.38 0.41 0.29 0.36 0.28 0.14 0.39 2,791
ATM Average 0.13 0.14 0.10 0.13 0.09 0.04 0.13 5,003
ITM Average 0.04 0.05 0.03 0.03 0.02 0.02 0.04 1,146
DITM Average 0.02 0.03 0.02 0.02 0.01 0.01 0.02 508
Sub Total Average 0.09 0.10 0.06 0.08 0.06 0.03 0.09 11,770
Downloaded by Management and Science University At 07:30 06 February 2017 (PT)

Medium term
DOTM Average 0.43 0.45 0.38 0.45 0.38 0.16 0.46 1,669
OTM Average 0.32 0.33 0.32 0.35 0.28 0.09 0.35 2,440
ATM Average 0.13 0.14 0.13 0.15 0.11 0.03 0.15 4,263
ITM Average 0.05 0.06 0.05 0.05 0.04 0.02 0.05 862
DITM Average 0.04 0.04 0.03 0.02 0.02 0.01 0.03 239
Subtotal Average 0.12 0.13 0.12 0.14 0.10 0.03 0.13 9,473
Long term
DOTM Average 0.40 0.39 0.51 0.52 0.41 0.15 0.48 865
OTM Average 0.29 0.30 0.42 0.39 0.28 0.09 0.35 1,646
Table IX. ATM Average 0.13 0.14 0.20 0.18 0.12 0.04 0.16 2,499
Theils U statistics of Nifty ITM Average 0.04 0.05 0.07 0.05 0.04 0.02 0.05 199
index call options DITM Average 0.02 0.03 0.03 0.03 0.02 0.02 0.03 43
(years 2008-2011) Sub-total Average 0.14 0.14 0.21 0.19 0.13 0.04 0.17 5,252

analysis. Despite of fact that the principal concept of ATM IV and IVX is same,
performance of IVX is worst. The reason could be its standardized determination
process which involves near month (short term) liquid contracts and next month
(medium term) illiquid contracts for inferring IV (visit www.nseindia.com for details).
As, EWMA is just an advance replication of HV, therefore suffers from common
weakness, replicates past into future, but thats not the case (Figure 4), therefore prices
options poorly.
The above results strongly suggest that in both windows, IV model is the only
model which yields values closer to the market prices, compared to others. But, so far
the quintessence of this research drive concerned, though IV dominate the rests in all
the categories of moneyness-maturity, but it is not able to replicate the market prices
completely.

6. Managerial implication of research

The final outcome of this research which ended successfully in exploring a dominant
model, guided successfully through the most volatile period of Indian economy can be
used to safe guard investors faith and to figure a design which could compete on the
canvass of option pricing. As, such financial hardships (similar to 2006-2011) always
remains a burning question for all experts on the subject, thinkers and concept makers
trying to model a skilled an apt matrix which could survive successfully and keep the
investment protected if not multiplying the returns. In line, the dominant model of this
paper can be used by options traders and portfolio managers to safeguard their
investments from large downside fluctuations and for measuring & managing the
directional trade.
 7. Conclusion Volatility models
Several approaches have been suggested in the paper to model the volatility dynamics in option pricing
of asset time series. Each of these approaches in turn, is used to testify the forecasting
effectiveness of option pricing model BS. Out of the six models tested and critically
examined here, we procure only a single model, IV, which best caters to the
requirements of option traders and as a result we concluded that only IV supports
the multifarious moneyness-maturity dimension of option pricing of Nifty index 373
options. Our analysis also confirms, that the standard VIX is not a reliable tool for
determining the base price of Nifty index options (via BS). As the IV landmarks during
the most dynamic phase of Indian capital market, which is a touchstone to justify the
quality of any model, we can deduced that IV could continue to perform in hardships of
Downloaded by Management and Science University At 07:30 06 February 2017 (PT)

financial contraction at par, working smoothly and effectively. Though, IV is found to

be a reliable tool for pricing of Nifty index options, but its computational complexity
restricts its real time uses. Further efforts are required to find a simple method of
finding the assets volatility, which would not only replicate the real volatility, but also
when incorporated in models such as BS, shall improve the pricing and hedging
performance of those models notably across moneyness-maturity.

References
Alberg, D., Shalit, D. and Yosef, R. (2008), Estimating stock market volatility using asymmetric
GARCH models, Applied Financial Economics, Vol. 18 No. 15, pp. 1201-1208.
Baillie, R.T. and DeGennaro, R.P. (1990), Stock return and volatility, Journal of Financial and
Quantitative Analysis, Vol. 25 No. 2, pp. 203-214.
Beckers, S. (1981), Standard deviations implied in option prices as predictors of future stock
price variability, Journal of Banking and Finance, Vol. 5 No. 3, pp. 363-381.
Bekaert, G. and Wu, G. (2000), Asymmetric volatility and risk in equity markets, Review of
Financial Studies, Vol. 13 No. 1, pp. 1-42.
Black, F. and Scholes, M. (1973), The pricing of options and corporate liabilities, Journal of
Political Economy, Vol. 81 No. 3, pp. 637-659.
Blair, B., Poon, S.H. and Taylor, S.J. (2001), Forecasting S&P 100 volatility: the incremental
information content of implied volatilities and high frequency index returns, Journal of
Econometrics, Vol. 105 No. 1, pp. 5-26.
Bollerslev, T. (1986), Generalized autoregressive conditional heteroskedasticity, Journal of
Econometrics, Vol. 31 No. 3, pp. 307-327.
Brandt, M.W. and Jones, C.S. (2006), Volatility forecasting with range-based EGARCH models,
Journal of Business and Economic Statistics, Vol. 24 No. 4, pp. 470-486.
Canina, L. and Figlewski, S. (1993), The informational content of implied volatility, Review of
Financial Studies, Vol. 6 No. 3, pp. 659-681.
Chiarella, C., Craddock, M. and El-Hassan, N. (2000), The calibration of stock option pricing
models using inverse problem methodology, Research Paper Series No. 39, Quantitative
Finance Research Centre, School of finance and economics, University of Technology,
Sydney.
Christensen, B.J. and Prabhala, N.R. (1998), The relation between implied and realized volatility,
Journal of Financial Economics, Vol. 50 No. 2, pp. 125-150.
Christoffersen, P. and Jacobs, K. (2004), The importance of the loss function in option pricing,
Journal of Financial Econometrics, Vol. 72 No. 2, pp. 291-318.
Cumby, R., Figlewski, S. and Hasbrouck, J. (1993), Forecasting volatilities and correlations with
EGARCH models, Journal of Derivatives, Vol. 1 No. 2, pp. 51-63.
 JAMR Day, T.E. and Craig, M.L. (1992), Stock market volatility and the information content of stock
index options, Journal of Econometrics, Vol. 52 Nos 1-2, pp. 267-287.
10,3
Dumas, B., Fleming, J. and Whaley, R.E. (1998), Implied volatility functions: empirical tests,
Journal of Finance, Vol. 53 No. 6, pp. 2059-2107.
Ederington, L.H. and Guan, W. (2002), Is implied volatility an informationally efficient and
effective predictor of future volatility, Journal of Risk, Vol. 4 No. 3, pp. 29-46.
374 Edey, M. and Elliot, G. (1992), Some evidence on option prices as predictors of volatility, Oxford
Bulletin of Economics & Statistics, Vol. 54 No. 4, pp. 567-578.
Engle, R.F. (1982), Autoregressive conditional heteroscedasticity with estimates of the variance
of UK inflation, Econometrica, Vol. 50 No. 4, pp. 987-1008.
Engle, R.F. and Ng, V.K. (1993), Measuring and testing the impact of news on volatility, Journal
Downloaded by Management and Science University At 07:30 06 February 2017 (PT)

of Finance, Vol. 48 No. 5, pp. 1749-1778.

Engle, R.F. and Patton, A.J. (2001), What good is a volatility model?, Quantitative Finance,
Vol. 1 No. 2, pp. 237-245.
Feinstein, S.P. (1989), The Black-Scholes formula is nearly linear in sigma for at-the-money
options; therefore implied volatilities from at-the-money options are virtually unbiased,
Working Paper No. 88-9, Federal Reserve Bank, Atlanta, GA.
Fengler, M.R. (2012), Option data and modeling BSM implied volatility, in Duan, J.-C., Hardle,
W.K., Gentle, J.E. (Eds), Handbooks of Computational Finance, Springer, Berlin,
pp. 117-142.
Fleming, J. (1998), The quality of market volatility forecasts implied by S&P 100 index option
prices, Journal of Empirical Finance, Vol. 5 No. 4, pp. 317-345.
French, K., Schwert, G. and Stambaugh, R.F. (1987), Expected stock returns and volatility,
Journal of Financial Economic, Vol. 19 No. 1, pp. 3-29.
Glosten, L.R., Jagannathan, R. and Runkle, D.E. (1993), On the relation between the expected
value and the volatility of the nominal excess return on stocks, Journal of Finance, Vol. 48
No. 5, pp. 1779-1801.
Harrison, B. and Moore, W. (2012), Forecasting stock market volatility in central and eastern
European countries, Journal of Forecasting, Vol. 31 No. 6, pp. 490-503.
Heston, S. (1993), A closed-form solution for options with stochastic volatility, with applications
to bond and currency options, Review of Financial Studies, Vol. 6 No. 2, pp. 327-343.
Heston, S. and Nandi, S. (2000), A closed-form GARCH option valuation model, Review of
Financial Studies, Vol. 13 No. 3, pp. 585-625.
Hull, J. and White, A. (1987), The pricing of options on assets with stochastic volatilities,
Journal of Finance, Vol. 42 No. 2, pp. 281-300.
Li, H. and Hong, Y. (2011), Financial volatility forecasting with range-based autoregressive
volatility model, Finance Research Letters, Vol. 8 No. 2, pp. 69-76.
McKenzie, M.D. and Mitchell, H. (2002), Generalised asymmetric power ARCH modeling of
exchange rate volatility, Applied Financial Economics, Vol. 12 No. 8, pp. 555-564.
McKenzie, M.D. and Mitchell, H. (2004), GARCH model selection criteria, Quantitative Finance,
Vol. 3 No. 4, pp. 262-284.
Mayhew, S. (1995), Implied volatility, Financial Analyst Journal, Vol. 51 No. 4, pp. 8-20.
Mixon, S. (2009), Option markets and implied volatility: past versus present, Journal of
Financial Economics, Vol. 94 No. 3, pp. 171-191.
Nelson, D.B. (1991), Conditional heteroskedasticity in asset pricing: a new approach,
Econometrica, Vol. 59 No. 2, pp. 347-370.
Pagan, A.G. (1996), The econometrics of financial markets, Journal of Empirical Finance, Vol. 3
No. 1, pp. 15-102.
 Pagan, A.G. and Schwert, G.W. (1990), Alternative models for conditional stock volatility, Volatility models
Journal of Econometrics, Vol. 45 Nos 1-2, pp. 267-290.
in option pricing
Poon, S.H. and Granger, C.W.J. (2003), Forecasting volatility in financial markets: a review,
Journal of Economic Literature, Vol. 41 No. 2, pp. 478-539.
Rouah, F.D. and Vainberg, G. (2007), Option Pricing Models and Volatility Using Excel VBA,
John Wiley & Sons, New Jersey, NJ.
Schwert, G.W. (1989), Why does stock volatility change over time?, Journal of Finance, Vol. 44 375
No. 5, pp. 1115-1153.
Taylor, S.J. (1986), Modeling Financial Time Series, John Wiley & Sons, New York, NY.

Corresponding author
Downloaded by Management and Science University At 07:30 06 February 2017 (PT)

Dr Vipul Kumar Singh can be contacted at: vksingh@imtnag.ac.in

To purchase reprints of this article please e-mail: reprints@emeraldinsight.com

Or visit our web site for further details: www.emeraldinsight.com/reprints
 This article has been cited by:

1. Vipul Kumar Singh National Institute of Industrial Engineering (NITIE), Mumbai, India . 2015. Pricing
competitiveness of jump-diffusion option pricing models: evidence from recent financial upheavals. Studies
in Economics and Finance 32:3, 357-378. [Abstract] [Full Text] [PDF]
Downloaded by Management and Science University At 07:30 06 February 2017 (PT)