Volatility estimation for stock index options: A GARCH approach

The objective of this paper is to compare the mispricing of option valuation models when alternate techniques are applied to the volatility estimation. Akgiray (1989) shows that out-of-sample forecasts of return variances of stock indices based on a GARCH model are superior predictors of the actual ex-post variances in comparison to forecasts generated using standard rolling regression methods. A second objective of this study is to examine if Akgiray's results carry over to option valuation. Although we find that the implied volatility technique results in the least mispricing, within the class of forecasts using only historic returns data, the use of GARCH models will also significantly reduce model mispricing.