On the Role of Risk Premia in Volatility Forecasting

I explain why at-the-money implied volatility is a biased and inefficient forecast of future realized volatility using the insights from the empirical option-pricing literature. First, I explain how the risk premia, which manifest themselves through disparity between objective and risk-neutral probability measures, lead to the disparity between realized and implied volatilities. Second, I show that this disparity is a function of the latent spot volatility, which I estimate using the historical volatility and high–low range. An empirical exercise that is based on at-the-money implied volatility series of foreign currencies and stock market indexes, is supportive of my risk premia-based explanation of the bias.