The Predictive Ability of Implied Volatility: the Evidence From the European Stock Market

In the Master’s thesis, the information content of implied volatility against future returns in Europe and against future volatility is analyzed. To achieve this goal, the following hypotheses are set: 1. Stock market returns are negatively related to the implied volatility properties in Europe; 2. The implied volatility is a superior proxy of future market volatility in Europe compared to other volatility models; 3. If implied volatility is a proxy of future volatility, implied volatility can be considered as the investors’ “fear gauge”. It is revealed that the changes in implied volatility are negatively related to the future returns on the 22-day holding period. Also, the weaker negative relationship persists for put-call ratio, whereas implied volatility skewness has an almost negligible negative relationship with future returns. Furthermore, we find that the implied volatility outperforms four popular models including GARCH(1,1), EGARCH(1,1), GJR-GARCH(1,1), HAR-RV, HAR-RV-J at 1-day forecasting period and explains almost 60% of future volatility. The maximal predictive power is achieved if the implied volatility is used in cooperation with HAR models. Finally, we find that the implied volatility may serve as the investors’ “fear gauge”: there is a strong relationship with negative returns and investors’ sentiment variables.