DEPARTMENT OF MANAGEMENT

AFDELING FOR VIRKSOMHEDSLEDELSE

Working Paper 1998 - 13

The Relationship Between Implied and Realized Volatility

in the Danish Option and Equity Markets

Charlotte Strunk Hansen

UNIVERSITY OF AARHUS C DENMARK

ISSN 1398-6228
 The Relationship Between Implied and
Realized Volatility in the Danish Option
and Equity Markets
Charlotte Strunk Hansen¤
School of Economics and Management
University of Aarhus, Bldg. 350
DK-8000 Aarhus C, DENMARK
e-mail: chansen@econ.au.dk

Current version: January 7, 1999

Abstract: In this paper we examine the information content of options on the Danish KFX share index.
These options are traded very infrequently and with a low volume. We consider the relationship between
the volatility implied in an option’s price and the subsequently realized volatility. Recently, Christensen
and Prabhala (1998) (CP) find that implied volatility in at-the-money one month OEX call options on the
S&P 100 index is an unbiased and efficient forecast of ex-post realized index volatility after the 1987 stock
market crash. In this paper we investigate whether the OEX market is special, and whether the infrequent
trading and low volume in the KFX case lead to bias and inefficiency in the implied volatility forecast.
We apply the procedure from CP to one month at-the-money KFX calls. We also extend the procedure
to similar puts, and we introduce an implied volatility measure that combines information from both call
and put prices. We find that implied volatility indeed contains information about realized index return
volatility. In fact, implied volatility remains significant even in the multiple regression where historical
volatility is included, it subsumes the information content of this, and the bias in the implied volatility
forecast is insignificant. The results suggest that the finding in the OEX market may be extended to the
much smaller KFX market.

Key words: Illiquid Markets, Implied Volatility, Index Options, Information, KFX Data, Market Effi-
ciency, Volatility Forecasting.
JEL Classification: G13, G14, C53.

¤
I thank Bent Jesper Christensen for helpful comments and suggestions. Document typeset in LATEX.

1
An option pricing model requires several input variables: Price of the underlying, exercise price,
time to maturity, interest rate, and expected volatility. Given an option pricing model, the implied
volatility idea is to insert observed or estimated parameter values, such that the option price can
be interpreted as a function of volatility alone. By forcing the model price to equal the actual
market price, one can solve for the expected volatility, or implied volatility.
Option prices are highly related to market expectations about the distribution of the underlying
asset’s future value. Under a rational expectations assumption, the market uses all the information
available to form its expectations about future volatility. Hence, the market option price reveals
the market’s true volatility estimate. Furthermore, if the market is efficient, the market’s estimate,
the implied volatility, is the best possible forecast given the currently available information. That
is, all information necessary to explain future realized volatility generated by all other explanatory
variables in the market information set should be subsumed in the implied volatility.
The hypothesis that implied volatility is a rational forecast of subsequently realized volatility
has been frequently tested in the literature. Several studies have cast doubt about the rationality
hypothesis in the context of the most active option market, namely, the market for OEX options
on the S&P 100 stock market index (see Day and Lewis (1992), Harvey and Whaley (1992),
and Canina and Figlewski (1993)). More recently, however, Christensen and Prabhala (1998)
(henceforth CP) find that implied volatility in at-the-money one-month OEX call options in fact
is an unbiased and efficient forecast of ex-post realized index volatility after the 1987 stock
market crash. The remaining forecast errors cannot be explained by simple ARCH or GARCH
specifications (see Fleming (1998) on the OEX case and Lin, Strong and Xu (1998) on the
S&P 500 index options).
In this paper we investigate whether the U.S. index option market is special, and whether
the infrequent trading and low volume lead to bias and inefficiency in the implied volatility
forecast in the KFX case. This paper focuses on the Danish market for share index options. The
market for the Danish KFX share index options is thin. Generally, there has not been a long
tradition of options trading in Denmark. KFX index options with 3, 6, and 9 months to expiration
were introduced in September 1990. One month index options were not introduced until August
1995. This causes a natural limitation on data available. The KFX index options are traded very
infrequently and the volume is low, compared to other markets for index options (for instance
the S&P 100 index options). It may be expected that if option prices are stale they do not reflect

2
the true prices, and in this case the volatility implied by the observed option prices do not reflect
the market expectations. The volatility implied in the KFX option’s price is widely conceived as
less informative compared to the historical index return volatility. In fact, the Danish newspaper
Børsen used to report the implied volatility, but stopped so as of February 9, 1998. The purpose
of this paper is to examine whether KFX option prices contain information about the subsequently
realized KFX index return volatility, in spite of the infrequent trading and low volume. To our
knowledge, there has not yet been any study of the information implied in the KFX option prices.
We examine the hypothesis that the volatility implied in a KFX option’s price is a better forecast
of future index return volatility than the historical return volatility. We apply the methods from CP
to KFX options. Following CP, we focus on a lower (monthly) sampling frequency than earlier
studies. This allows us to construct non-overlapping data on realized volatility and implied
volatility from at-the-money options with about 22 trading days to expiration. This sampling
procedure ensures that each option in our data set expires before the next option is sampled. In
spite of the fact that the market for KFX index options is not as liquid as for instance the market
for S&P 100 index options, we find strong indications that the option prices indeed contain
information about realized index return volatility. Thus, we are able to show that the results in
CP are not specific for the S&P 100 index, but do also apply for the Danish KFX share index.
As a natural extension of CP, who focused on at-the-money call options, we also include
at-the-money put options on the KFX index in our investigation, and show that similar results
appear. In addition, we let the historical return volatility include more days compared to the study
by CP, which may increase its explanatory power. We do not exclude days around maturity of
the option. We also find that volatility implied in put option prices contain information about the
subsequent realized index return volatility. Put implied volatility also subsumes the information
content in historical volatility.
Lastly, we give a procedure to construct a common implied volatility measure by combining
the call and put measures. This procedure should be particularly useful in less liquid option
markets. Our results show not only that this new implied volatility is an efficient estimate of
realized index return volatility, but also that it is significant even in the multiple regression where
historical volatility is included, and that the bias in the forecast is insignificant. This provides an
even better forecast of future index return volatility than either of the separate call or put implied
volatility.

3
 The paper is organized as follows. Section 1 describes the data and sampling procedure.
Furthermore, we calculate the implied and realized volatility series. Section 2 contains the
empirical results. In this section we essentially replicate the study of CP on Danish data. Our
study differs from CP in that we incluse more information in historical volatility and include
implied volatilities from puts. Furthermore, we construct a new implied volatility measure from
implied call and put volatility, which in fact gives an even less biased estimator of realized index
return volatility. Section 3 concludes.

1 Options on the KFX Share Index

The KFX share index includes the twenty most liquid shares traded at the Copenhagen Stock
Exchange. It is used as the underlying instrument for futures and options. The index is calculated
every minute during opening hours. Options on the KFX share index are the so called KFX index
options. They are listed on the Copenhagen Stock Exchange and issued and guaranteed by the
FUTOP Clearing Center A/S, a subsidiary of the Stock Exchange.
Options on the KFX index were originally introduced on September 21, 1990, but only with 3,
6, and 9 months to expiry. On August 21, 1995, the Danish FUTOP Clearing Center additionally
introduced options on the KFX index with maturities of 1 and 2 months. Furthermore, the Danish
FUTOP Clearing Center changed the maturities of options opened after 21 August 1995, such
that the KFX options now expire the third Friday every month. Previously, expiration was the
first trading day in the quarterly cycle: March, June, September, and December. The change in
maturity dates means that the FUTOP Clearing Center’s instruments mature at the same time as
options on foreign indexes, for instance the German DAX or the S&P 100 index. Consequently,
trading based on spreads between for instance Denmark and Germany is simplified.
In practice, a contract is a right to buy or sell 1,000 times the KFX share index at a specified
strike price. The KFX options are European style, and in-the-money options are automatically
exercised on the third Friday of the month or, if this is not a trading day, the preceding day.
On expiration, the settlement is in cash rather than in delivery. On the first trading day after
expiration options with new expiration dates are opened.

4
1.1 SAMPLING PROCEDURE

The sampling procedure follows CP. The KFX options expire on the third Friday of every month,
or if this is not a business day, on the business day before. In order to avoid overlapping data
and possibly extreme prices and thereby extreme volatilities around maturity, we move to the
following Wednesday and record the closing price of the call and put KFX option closest to
being at-the-money.
We now compute implied call and put volatilities, as well as realized index return volatilities
(sample standard deviations) over the life of the option. The CP procedure thus produces a
multivariate time series where for each month we have implied volatility and the associated
realized volatility that the implied presumably is a forecast of. Note that volatilities pertain to
non-overlapping time intervals.
KFX options are thinly traded, so we cannot solely apply the sampling procedure proposed by
CP. In some months no options with one month to maturity are traded on Wednesday following
the third Friday. In such months, we apply the following sampling procedure:

1. record the closing price of the option closest to being at-the-money the previous day (i.e.
Tuesday following the third Friday).

2. If no options are traded on Tuesday, move two days forward and record the closing price
of the option closest to being at-the-money on that day (i.e. Thursday following the third
Friday in the expiration month).

3. If no options are traded on Thursday either, move three days back and record the closing
price of the option closest to being at-the-money that day (i.e. Monday following the third
Friday in the expiration month).

4. If no options are traded on Monday, move four days forward and record the closing price
of the option closest being at-the-money that day (i.e. the Friday following the third Friday
in the expiration month).

5. Lastly, if this is not possible, we continue moving one trading day forward and record the
closing price of the option closet being at-the-money that day, in order to avoid overlapping
in our data set.

5
This procedure preserves the non-overlapping feature of the data which makes it possible to avoid
the problem of serially correlated forecast errors. The resulting data set for at-the-money KFX
call options with one month to expiration consists of 33 observations, covering the period from
September 1995 to April 1998. Seven of these observations are not recorded at a Wednesday.1
Regarding the put options, ten observations are not sampled on Wednesday following the third
Friday of the month. In January 1998 the options are so thinly traded that it is not even possible
to find a price of a one month put option and avoid overlapping data. Therefore, the monthly
time series for puts simply includes a missing value for January 1998. The data on the option
prices are sampled from The Copenhagen-Stock-Exchange (1995–1998).

1.2 IMPLIED VOLATILITY

We have now sampled two monthly time-series of option prices and one consisting of the closing
level of the underlying KFX index. Let ct denote the price of the KFX call option closest to
being at-the-money in month t and let St denote the closing index level recorded simultaneously
with the option prices in month t. We use one month CIBOR as proxy for the risk free interest
rate rt whose maturity most closely matches the option life.2 We apply the Black and Scholes
(1973) option pricing formula. The volatility parameter implied in the call and put option price
can be found by solving (1) and (2) numerically.
1
Two of these observations, January and February 1998, are recorded more than a week away from the Wednesday
following the third Friday.
2
CIBOR is Copenhagen Inter Bank Offer rate, sampled from Datastream.

6
 p
ct = St N(dct ) ¡ ert ¿1;t Kt N(dct ¡ ¾c;t ¿2;t ) (1)

St 2
ln( K ) + rt ¿2;t + ¾c;t ¿1;t
dct = t
p
¾c;t ¿1;t

p
pt = Kt e¡rt ¿1;t N(¡dpt ¡ ¾p;t ¿2;t ) ¡ St N(¡dpt ) (2)

St 2
ln( K ) + rt ¿2;t + ¾p;t ¿1;t
dpt = t
p
¾p;t ¿1;t

We let ¾c;t denote the volatility implied by the call option which matures in month t, and let ¾p;t
denote the volatility implied by the put option which matures in month t. Interest rate payments
are based on calendar days, while volatility is a trading day related phenomenon. Therefore,
we use two measures of time to maturity, ¿1;t and ¿2;t . The first is the number of trading days
until maturity divided by the number of trading days in a year, and the second is the number of
calendar days until maturity divided by the number of calendar days in a year.3
In some months option prices do not obey the arbitrage boundaries.4 These arbitrage bound-
aries prevents the volatility parameter from being negative. Based on this, we eliminate two
observations in the call data set and nine observations in the put data set. The resulting data
set consists of 31 volatility observations for calls and 23 for puts. It is worth mentioning, that
it is never the case that both call and put prices fail to meet the arbitrage condition in the same
month. This means that in every month there is at least one implied volatility observation.
To use all the months in our data set, we construct a new implied volatility measure ¾i;t , given
by

r
1 2 1 2
¾i;t = ¾c;t + ¾p;t (3)
2 2

when both volatilities are available. In months where we do not have an observation for the
implied put volatility (either because there were no traded put options, or because the price does
3
As convention we use 252 trading days per year as in Hull (1993).
4
The boundaries for call option prices are (S ¡ Ke¡r¿1 )+ · c · S and for put options (Ke¡r¿1 ¡ S)+ · p · S.

7
not meet the arbitrage conditions), we let ¾i;t equal the implied call volatility, and vice versa.
The resulting data on this implied volatility measure consequently consists of 33 observations.

1.3 REALIZED AND HISTORICAL VOLATILITY

In this study, we want to examine the relationship between volatility implied by an option price
and subsequently realized index return volatility. We therefore need to construct a time series
of realized volatility. Each realized volatility is calculated as the standard deviation of the daily
index returns during the remaining life of the option, the period covered by the implied volatility.
First we calculate the daily index returns:5
Sk
Rk = ln( ) (4)
Sk¡1
where Sk denotes the closing index level on day k. Let Rt denote the sample mean of the index
returns in month t. The annualized realized standard deviation of the index return for month t is
then given by:

v
u Tt
u 252 X
¾h;t =t (Rt;k ¡ Rt )2 (5)
Tt ¡ 1 k=1

where k runs from the Thursday following the third Friday in month t to the third Friday in month
t + 1. In case the recording day is not a Wednesday, k runs from the day after the recording day.
Following this procedure, we obtain a time series of non-overlapping data of the realized index
return volatility. Here, Tt denotes the number of trading days to maturity for options with expiry
in month t + 1. Note that while the implied volatilities ¾c;t and ¾p;t are known at the beginning of
period t, the realized volatility ¾h;t is not known until the end of period t (the expiration day of
the option). However, at time t we have knowledge of the fluctuation of the share index returns
so far. We will denote the volatility of the previous month’s index returns, without cutting of
days of around maturity, ¾H;t¡1 . We call this volatility measure historical volatility.

v
u 0
Tt¡1
u 252 X
¾H;t¡1 =t 0 (Rt¡1;k ¡ Rt¡1 )2 (6)
Tt¡1 ¡ 1 k=1
5
Following Campbell, Lo and MacKinlay (1997) p. 362 we use continuously compounded returns (log returns).
The sample variance of these returns is the maximum likelihood estimator of ¾2 in the geometric Brownian motion.

8
 0
where Tt¡1 denotes the total number of trading days from the option is opened till it expires.
Hence, we include more information in our historical volatility compared to CP who simply used
¾h;t¡1 instead of ¾H;t¡1 for historical volatility, essentially losing volatility information from the
period Friday-Tuesday, just before measuring the next implied volatility.

1.4 DESCRIPTIVE STATISTICS

Let us first take a look at the data. In Table I, we have reported descriptive statistics for the time
series: Volatility implied by call and put options on the KFX index, ¾c;t and ¾p;t, the realized and
historical volatility, ¾h;t and ¾H;t, and finally the constructed implied volatility measure ¾i;t (3).
The first part contains descriptive statistics for the logarithm of the volatilities (ln(¾)), second
part for the variances (¾ 2 ), and the last part contains summary statistics for the raw volatilities (¾).
We first notice that the means of both realized volatilities (¾h and ¾H ) lie significantly below
both implied call and implied put volatility. This is also found in previous studies Christensen
and Prabhala (1998) and Lin et al. (1998). Furthermore, we see that on average implied call
volatility is larger than implied put volatility. If the option had been American style, we might
have expected the opposite inequality, since the early exercise premium embedded in American
option prices may have a larger value for put options. However, KFX index options are European
style, so there is no embedded early exercise premium. In our sampling period, KFX call options
tend to be traded slightly more frequent than put options. A possible excess demand for calls may
increase call option prices relative to put option prices. Since there is a one to one correspondence
between an option’s price and its volatility,6 this implies that on average the call volatilities will
be larger. Within our sampling period September 1995 to August 1998 the KFX index has
increased from index 102 to 237. The value of a call option will increase if the market expect
the price of the underlying to increase. Investors will therefore be willing to pay a higher price
if they expect the underlying asset to increase.
It is also seen that the implied volatilities are less volatile than realized volatility. This makes
sense if the implied volatilities are conditional expectations of the subsequent realized volatilities.
Considering the skewness and kurtosis we immediately see that the logarithms of the volatilities
6
Vega, the partial derivative of the option price with respect to the volatility parameter is positive.

9
conform much better to normality than the raw volatilities or the variances. In the following, we
concentrate on the logarithms of the volatilities.
Even though they are not reported, we have also examined the time series properties of the
volatility series. Based on the sample we have found that a stationary AR(1) is the best descrip-
tion of each of our the time series. Thus, our time series do not seem to be unusual compared
to other volatility time series (see for example Christensen and Prabhala (1998) and Harvey and
Whaley (1991)).

1.5 MEASUREMENT ERRORS

We must be aware that the data may be affected by measurement errors. There are several
sources of measurement errors in implied volatility. First of all, data are sampled by hand from
Copenhagen Stock Exchange Monthly Reports. Even though extreme keypunching errors have
been removed, there may still be errors to some extent. Other measurement errors may stem
from limitations of the Black-Scholes option pricing formula. The pricing formula does not take
dividend payments into account. However, index dividends are relatively small and are paid
relatively uniformly over time and may therefore not have a first order effect. Furthermore, the
Black-Scholes option pricing formula assumes that the price of the underlying index evolves
according to a lognormal diffusion process. Even if the theoretical option pricing formula is
correct, market micro structure effects may cause additional measurement errors. KFX options
are not traded very frequently. Furthermore, it is unlikely that all twenty underlying asset prices
reflect trades which are simultaneous with the option trade. Lastly, we have not taken other
market imperfections such as transaction costs, taxation, etc. into account. Measurement errors
are controlled for in the empirical analysis below.

2 Empirical Results

In this section, we examine the relationship between realized return volatility and volatility implied
by the option price.
We start out by estimating a log-linear relationship between the volatility implied in one month

10
at-the-money call options on the KFX share index and subsequent realized volatility. We have
chosen a log-linear relation since the logarithms of volatilities conform best to normality, but also
because it enables us to compare our results to those obtained in previous literature. CP use a
log-linear relationship and conclude that volatility implied one month in at-the-money OEX call
options is an almost unbiased and efficient estimator of realized volatility.
We estimate the simple regression (7), where we only include an intercept and implied call
volatility. The results are reported in Table II.

ln(¾h;t ) = ®0 + ®c ln(¾c;t) + ²t (7)

Within this regression we are able to examine several hypotheses. Firstly, a significant slope
coefficient on log-implied volatility indicates that implied call volatility contains some information
about realized volatility. Secondly, we say that log-implied volatility is an unbiased estimator of
7
log-realized volatility, if the slope coefficient is insignificantly different from unity.
The first the three regressions in Table II are estimated using OLS. From the first regression it
is seen that logarithm of implied volatility does contain information about the logarithm of realized
volatility. Already this is a strong result which might not have been anticipated, given that the
KFX index option market is highly illiquid and the options often assumed to be incorrectly priced.
The result shows that even in this market, option prices carry information about the stochastic
process governing the underlying asset. However, we cannot conclude that the logarithm of
implied volatility is an unbiased estimator of realized volatility. The coefficient is 0:38 and is
significantly different from zero, but also significantly less than unity. It is therefore interesting
to examine whether we by including an additional explanatory variable can predict log-realized
volatility with higher explanatory power. This is the motivation for the next two regressions.
Log-realized volatility for the previous month ln(¾h;t¡1 ) does not enter significantly into the
regression. We also run the regression where we replace past log-realized volatility with the
sample standard deviation of the log index returns, where we use all observations from the day
the option is opened til expiration, namely historical volatility ln(¾H;t¡1) from (6).
7
Since we have used a log-transformation, the intercept may be expected to be negative (see CP), so it is not
appropriate to include a zero condition on the intercept in the definition of unbiasedness.

11
 ln(¾h;t ) = ®0 + ®c ln(¾c;t ) + ®H ln(¾H;t¡1) + ²t (8)

When we use more information about past realized volatility it enters with a slightly higher
coefficient and t-statistic, but it remains insignificant, which indicates that it does not contain
information beyond that in implied call volatility. Again, this is a strong result in that even in
the illiquid KFX index option market, implied volatility is efficient: It is sufficiently precise that
it subsumes the information content of historical volatility. This is an argument in favor of the
validity of option pricing theory, even in the context of this thin market.
In the following regressions we will only use ¾H;t¡1 historical volatility instead of the simple
lagged realized volatility from (5) used by CP. There is no reason why we should leave out
information about the returns on the days around opening of the option which we use to back
out implied volatility.
As previously mentioned, our data may be measured with errors. Consequently, the results may
be affected by errors in variables. Errors in variables induces a bias in both slope coefficients.
The slope on implied volatility is biased downwards towards zero. Under the null (slope of
historical volatility equal to zero), the bias in the slope of implied volatility is even greater when
historical volatility is included in the regression than when it is left out. Further, assuming
that the slope coefficient on implied volatility and the correlation between implied and historical
volatility are positive, which is supported by our empirical investigations, the slope associated
with historical volatility is biased upwards. Even under the efficiency null, the probability limit
of the OLS estimate ®
^H is positive (see CP).
Consistent estimation in presence of the possible errors in variables problem may be achieved
using an instrumental variable method. Thus, instruments for implied volatility are called for.
We test down to the most parsimonious model using OLS. The result is reported in the last line
of Table II. Even though historical volatility appears only barely significant, adjusted R2 declines
dramatically when it is left out of the regression. The significance would probably improve if
we had more observations. We therefore use the regression

ln(¾c;t ) = ¯0 + ¯c ln(¾c;t¡1 ) + ¯H ln(¾H;t¡1 ) + ect (9)

We then take the fitted values of ln(¾c;t¡1 ) from this regression and run the following regression

12
 dc;t ) + ®H ln(¾H;t¡1) + eh
ln(¾h;t ) = ®0 + ®c ln(¾ (10)
t

The fourth and fifth lines of Table II report the resulting instrumental variable estimates. In
a Hausman test, we cannot reject the presence of errors in variables in the OLS regressions.
Historical volatility is still insignificant, and when it is dropped from the regression, the slope
coefficient ®
^c = 0:56 on implied volatility is now stronger than in the OLS regression and not
significantly different from unity. We cannot reject that volatility implied by call options on the
KFX index is an unbiased estimator of subsequently realized index return volatility. This is a
strong result, given the relatively low activity level on the Danish option market.
Theoretically, it should be possible to obtain information from the put prices about realized
return volatility. An interesting question is whether this can be empirically supported. If so, how
well does the put implied volatility explain future realized return volatility, compared to implied
call volatility? The first two regressions in Table III are similar to those in Table II, but we have
replaced call implied volatility by put implied volatility. Similar results emerge for puts and calls
from the OLS regressions. Implied put volatility does contain information about subsequently
realized return volatility, and it also subsumes the information in historical volatility. The slope
coefficient is slightly larger than that on implied call volatility.
Several hypotheses can be tested within specification (11), where we include both implied
volatilities as explanatory variables, as an extension beyond CP.

ln(¾h;t ) = ®0 + ®c ln(¾c;t) + ®p ln(¾p;t ) + ®H ln(¾H;t¡1) + ²t (11)

Apart from the efficiency hypothesis (®

^H = 0), we may investigate the issue of which of the two
implied volatilities is most informative about future realized volatility. Together, the two implied
volatilities subsume the information content in historical volatility (third regression in Table III).
The slope coefficients on both implied volatilities have higher t-values than that on historical
volatility, but they remain insignificantly, even after dropping historical volatility (fourth line of
Table III). Of course the results may be affected by multicollinearity, which makes it difficult
to judge which implied volatility is the best forecast of realized volatility. Furthermore, only 23
observations are used when implied put volatility is included as a regressor.

13
 In fact, we are interested in a precise forecast of realized return volatility. Instead of including
both implied volatilities separately, and trying to pick the best of the two, we now try to regress
realized volatility on the implied volatility measure we have introduced in (3).

ln(¾h;t ) = ®0 + ®i ln(¾i;t ) + ®H ln(¾H;t¡1 ) + ²t (12)

Not surprisingly ln(¾i;t ) has similar features to both implied volatilities, but it has the advantage
that it can be computed in all time periods (see section 1.2). Judged by the OLS estimates in
the fifth and sixth line of Table III, implied volatility is an efficient but slightly biased estimator
of realized volatility. The slope coefficient is now higher (0:52) compared to the regressions
where we only include one implied volatility, and it has a higher t-value (3:53). Notably, implied
volatility now enters the regression significantly (t-statistic of 2.1) even when historical volatility
is included. This was not true for the separate call and put implied volatility measures.
We also estimate the regression using an instrumental variable method. The last line of Table III
contains the instrumentation, and the second last line the results of regressing realized volatility
on fitted (instrumented) implied volatility. The slope coefficient is even larger than the OLS
estimate at 0.61. This indicates the presence of an errors in variable problem, which can also not
be rejected in a Hausman test. Furthermore, this slope estimate is larger than those for implied
call or put volatility estimated using the instrumental variable method,8 and it is not significantly
different from unity. The new implied volatility measure indeed appears to be an efficient forecast
of realized return volatility and the evidence against unbiasedness is insignificant.9
Finally, we have checked the robustness of the results, running similar regressions on the
variances and the raw volatility series instead of the log-transformed volatilities. The conclusions
remain. We cannot reject that implied volatility (from calls, puts, or both) contains information
about future realized return volatility. Implied volatility in fact subsumes the information content
in historical return volatility. This is a particularly strong result given the thin trading on the
Danish option market.

8
The instrumental variable results for put implied volatility are not reported.
1
9
It is worth noting that if we define ¾i;t as the average of implied volatilities 2 ¾c;t + 21 ¾p;t instead of taking
average of the implied variances, it does not alter the conclusions.

14
3 Conclusion

We have in this paper studied whether volatility implied by the Danish KFX index call and put
option prices predict future realized index return volatility. To our knowledge this question has
not been examined previously.
We find that historical return volatility does not add any information beyond that in implied
volatility. This is so even though we have included more information in the historical volatility
measure than the simple lagged realized volatility. Hence, we cannot reject the hypothesis that
the volatility implied by one month at-the-money call or put KFX option prices is an efficient
albeit slightly biased estimator of realized return volatility. This result provides support for the
use of option pricing theory even for KFX options and might not have been anticipated, given
the relative illiquidity of the Danish market. The analysis shows that the KFX option market
perhaps surprisingly shares some efficiency features with the largest option market, that for OEX
options on the S&P 100 index.
Due to infrequent trading of the KFX options, in some months either put option prices or call
prices do not meet the arbitrage boundaries. We therefore introduce a common implied volatility
which includes information from both call and put prices, in such a way that we do not get any
missing observations. We find that this implied volatility measure is an even better forecast of
future realized return volatility than either of the separate call and put implied volatilities: It is
efficient, significant even in the multiple regression where historical volatility is also included,
the bias is insignificant, and there is no problem with missing observations. We have therefore
at the same time constructed a method for forecasting realized return volatility in a market char-
acterized by infrequent option trading.

15
References

Black, F. and Scholes, M. (1973), ‘The pricing of options and corporate liabilities’, Journal of
Political Economy 81, 637–654.

Campbell, J. Y., Lo, A. W. and MacKinlay, A. C. (1997), The Econometrics of Financial Markets,
1 edn, Princeton University, Press New Jersey.

Canina, L. and Figlewski, S. (1993), ‘The informational content of implied volatility’, Review of
Financial Studies 6, 659–681.

Christensen, B. J. and Prabhala, N. R. (1998), ‘The relation between implied and realized volatil-
ity’, Journal of Financial Economics 50, 125–150.

Copenhagen-Stock-Exchange (1995–1998), Monthly Report, Vol. 279–311, Copenhagen Stock

Exchange A/S.

Day, T. E. and Lewis, C. M. (1992), ‘Stock market volatility and the information content of stock
index options’, Journal of Financial Economics 52, 3–30.

Fleming, J. (1998), ‘The quality of market forecasts implied by s&p 100 index option prices’,
Journal of Empirical Finance 5, 317–345.

Harvey, C. and Whaley, R. (1991), ‘S&p 100 index option volatility’, Journal of Finance
46, 1551–1561.

Harvey, C. and Whaley, R. (1992), ‘Market volatility prediction and the efficiency of the s&p
100 index option market’, Journal of Financial Economics 31, 43–73.

Hull, J. C. (1993), Options, Futures, and other Derivative Securities, 2 edn, University of Toronto,
Prentice Hall.

Lin, Y., Strong, N. and Xu, G. (1998), ‘The encompassing performance of s&p 500 implied
volatility forecasts’, The University of Manchester, England, WP .

16
 TABLE I
Statistic ln(¾c;t ) ln(¾p;t) ln(¾h;t ) ln(¾H;t ) ln(¾i;t)
Mean -1.965 -2.070 -2.155 -2.136 -1.987
Variance 0.203 0.248 0.180 0.156 0.187
Skewness -0.281 -0.118 0.327 0.312 -0.434
Kurtosis -0.550 -0.782 0.769 0.071 -0.309
2 2 2 2 2
Statistic ¾c;t ¾p;t ¾h;t ¾H;t ¾i;t
Mean 0.028 0.025 0.020 0.019 0.026
Variance*100 0.053 0.061 0.048 0.035 0.042
Skewness 1.214 2.338 2.817 2.504 1.397
Kurtosis 0.572 7.243 8.329 6.773 1.665
Statistic ¾c;t ¾p;t ¾h;t ¾H;t ¾i;t
Mean 0.154 0.141 0.127 0.128 0.149
Variance*100 0.435 0.478 0.366 0.301 0.365
Skewness 0.568 0.970 1.749 1.459 0.543
Kurtosis -0.423 1.403 3.655 2.596 0.018

The first part of the table contains descriptive statistics for time series of the logarithm of volatility
implied in call and put options on the KFX share index ln(¾c;t ) and ln(¾c;t ), respectively, and the
logarithm of the realized KFX index return volatility ln(¾ q h;t ) and logarithm of historical index
return volatility ln(¾H;t¡1 ). We define ln(¾i;t ) = ln( 12 ¾c;t 2
+ 12 ¾p;t
2
) if observations on both
ln(¾c;t ) and ln(¾c;t ) are available. If one of these observations is missing, we set ln(¾c;t) equal to
the other. The second and third part of the table contain summary statistics of the corresponding
variances and volatilities. Statistics are based on monthly observations for each time series in the
period from September 1995 to August 1998.

17
 TABLE II
Dependent Intercept ln(¾c;t) ln(¾h;t¡1 ) ln(¾H;t¡1) ln(¾c;t¡1 ) Adj. R2
ln(¾h;t ) -1.370a 0.383b 16.6%
(-4.69) (2.64)
ln(¾h;t ) -1.191b 0.301 0.148 9.4%
(-2.60) (1.55) (0.65)
a
ln(¾h;t ) -1.128 0.245 0.234 14.3%
(-2.87) (1.29) (1.10)
ln(¾h;t ) -1.00 0.395 0.153 9.7%
(-1.89) (0.90) (0.46)
ln(¾h;t ) -1.020 0.555b 7.0%
(-1.90) (2.00)
ln(¾c;t ) -0.291 0.393 0.407 34.7%
(-0.68) (1.96) (2.52)
a b
p ¡ value < 0:01; p ¡ value 2 [0:01; 0:05]

The first part of the table contains the OLS estimates. The second part contains estimates from
similar regressions using 2SLS. The first stage instrument equation is in the last part of the table.
Data consist of monthly non-overlapping observations for the period from September 1995 to
August 1998. Numbers in parentheses denote asymptotic t-statistics.

18
 TABLE III
Dependent Intercept ln(¾c;t) ln(¾p;t ) ln(¾H;t¡1 ) ln(¾i;t ) Adj. R2
ln(¾h;t ) -1.318a 0.416b 17.1%
(-3.50) (2.35)
ln(¾h;t ) -0.486 0.321 0.468 24.0%
(-0.80) (1.79) (1.70)
ln(¾h;t ) -0.750 0.229 0.207 0.240 11.2%
(-1.15) (0.94) (1.04) (0.77)
ln(¾h;t ) -1.094b 0.309 0.220 13.2%
(-2.33) (1.42) (1.12)
ln(¾h;t ) -1.116a 0.524a 26.3%
(-3.70) (3.53)
ln(¾h;t ) -0.883b 0.203 0.418b 23.9%
(-2.15) (0.89) (2.10)
ln(¾h;t ) -0.955 0.606b 23.8%
(-2.00) (2.52)
Dependent Intercept ln(¾i;t¡1) ln(¾H;t¡1 ) Adj. R2
ln(¾i;t ) -0.186 0.301 0.542a 39.8%
(-0.49) (1.94) (3.06)
a
p ¡ value < 0:01; b p ¡ value 2 [0:01; 0:05]

The first part of the table contains the OLS estimates. The second part contains 2SLS esti-
q The first stage instrument equation is in the last part of the table. We define ln(¾i;t ) =
mates.
ln( 12 ¾c;t
2
+ 12 ¾p;t
2
) if observations on both ln(¾c;t ) and ln(¾c;t) are available. If one of these ob-
servations is missing, we set ln(¾c;t) equal to the other. Data consist of monthly non-overlapping
observations for the period from September 1995 to August 1998. Numbers in parentheses denote
asymptotic t-statistics.

19
 AFDELING FOR VIRKSOMHEDSLEDELSE
DEPARTMENT OF MANAGEMENT
UNIVERSITY OF AARHUS
Tel. (+45) 89 42 15 53

AFV-SKRIFTER

Working Papers - Research Notes

(1989-1 – 1995-4: Ifv-Skrifter ISSN 0905-2836)

1989-1 Peder Smed Christensen: »Strategy, Opportunity Identification, and Entrepre-

neurship - A Study of the Entrepreneurial Opportunity Identification Process«.
(Doctoral Dissertation).
1989-2 Jørn Flohr Nielsen: »Informationsteknologi og borgerkontakt i danske kommu-
nalforvaltninger«, Bidrag til 4. Nordiske Konference i Serviceledelse, Oslo,
April.
1989-3 Bendt Rørsted: »Decentralisering og målstyring - resultatcentre i et pengeinstitut
?«, Bidrag til Festskrift til Laurits Ringgård. (Reprint)
1989-4 Bendt Rørsted: »Kvalitet i de handelsmæssige/økonomiske uddannelser«,
Bidrag til Undervisningsministeriets handelsudvalg.
1989-5 Peder Smed Christensen, Ole Øhlenschlæger Madsen & Rein Peterson: »Oppor-
tunity Identification: The Contribution of Entrepreneurship to Strategic Man-
agement«. Paper presented at the 9th Annual Strategic Management Society
Conference »Strategies for Innovation«, San Francisco, October.
1989-6 Johannes Raaballe: »Realinvestering, finansiel skattearbitrage samt dividende«,
I.
1989-7 Johannes Raaballe: »Realinvestering og leasing«, II.
1989-8 Johannes Raaballe: Egen- og fremmedkapital samt ligevægt«, III.

1990-1 Hans Peter Myrup: ȯkonomisk styring af fjernvarmeproduktionens omfang

ved forenet produktion af varme og affaldsforbrænding«.
1990-2 Johannes Raaballe: »Beskatningsformer, realinvesteringer og rente«, IV.
1990-3 Peder Smed Christensen og Rein Peterson: »Opportunity Identification: Map-
ping the Sources of New Venture Ideas«.
1990-4 Bendt Rørsted: »Balance Lost ? - An Appraisal of Activity Based Costing«.
1990-5 Johannes Raaballe and Klaus Bjerre Toft: »Taxation in Bond Markets Charact-
erized by No Arbitrage Equilibrium«, V.
1990-6 Hans Peter Myrup: »Nogle enkle matematiske modeller til brug ved driftsøkono-
misk analyse«.
1990-7 Johannes Raaballe: »Gældseftergivelse burde være skattepligtig, salg af skat-
temæssige underskud bør ske uhindret«.

1991-1 Jørn Flohr Nielsen: »Administrative job under ændring, - ny teknologi hos kom-
munalt ansatte«.
1991-2 Bendt Rørsted: »Activity-Based Confusion ? - ABC-status primo 1991. English
version: Activity-Based Costing 1987-1991 - Activity-Based Confusion ?
1991-3 Kent T. Nielsen: »Industrielle netværk«. Licentiatafhandling.
1991-4 Peder Smed Christensen, Ole Øhlenschlæger Madsen og Rein Peterson:
»Identification of Business Opportunities«.
1991-5 Peder Smed Christensen: »Strategic Group and Country Culture Influences on
Strategic Issue Interpretation«.
1991-6 Ole Øhlenschlæger Madsen og Peder Smed Christensen: »Virksomhedens for-
nyelsesproces«. Genoptryk fra Ledelse- & Erhvervsøkonomi, 4/91 55. årgang,
oktober 1991.

1992-1 Jørn Flohr Nielsen: »En trængt leders tidsanvendelse - tidsregistreringer og ud-
skiftninger af socialchefer«.
1992-2 Bendt Rørsted: »The Liberation of Management Accounting«.
1992-3 Mogens Dilling-Hansen, Kristian Rask Petersen og Valdemar Smith: »Mobili-
tetsanalyse for fyringstruede ansatte på en større lokaltdominerende arbejds-
plads«.
1992-4 Johs. Raaballe: »On Black, Blue and Orange Bonds« - A Tax Arbitrage Model
with Asymmetric Taxation.
1992-5 Johs. Raaballe: »Kursgevinstbeskatning af obligationer efter realisationsprin-
cippet«.
1992-6 Per Nikolaj D. Bukh: »Technical Efficiency and Returns to Scale in the Danish
Banking Sector: An Application of a Nonparametric Estimation Method«.

1993-1 Jens Holmgren: »Teknologiske forandringer belyst i organisationskulturens

skær«. Licentiatafhandling.
1993-2 Jørn Flohr Nielsen and Niels Jørgen Relsted: »The New Agenda for User Par-
ticipation - Reconsidering the Old Scandinavian Prescription«.
1993-3 Bendt Rørsted: »Strategies in a Euro-Brand Market«.
1993-4 Bendt Rørsted: »Management Accounting on its own«. (se 1995-5)
1993-5 Jens Hørlück: »The Pragmatics of EDI«.
1993-6 Martin Lippert-Rasmussen: »Core Capabilities and Boundaries of the Firm«.
1993-7 Mogens Dilling-Hansen, Kristian Rask Petersen og Valdemar Smith: »Testing
the Catch-Up Hypothesis on Danish Regional Data«.
1993-8 Johs. Raaballe: »Om sorte og blå fordringer (II). Private investorers arbitrage-
muligheder, hvem køber og udsteder fordringerne«.
1993-9 Johs. Raaballe: »Multi-period Asset Pricing and Tax Arbitrage when Capital
Gains are Taxed on an Accrual Basis«.

1994-1 Martin Lippert-Rasmussen: »On reputation effects and transaction costs«.

1994-2 Per Nikolaj D. Bukh: »Efficiency Loss in the Danish Banking Sector: A Data
Envelopment Approach«.
1994-3 Lars Bonderup Bjørn: »Koordinationstiltag: Erfaringer fra 6 østjyske logistikaf-
delinger«.
1994-4 J.V. Lundberg-Petersen: »Erfaringerne med zero-base systemet i private virk-
somheder«.
1994-5 J.V. Lundberg-Petersen: »Budgetudarbejdelse og budgetkontrollering hos PLS
Consult A/S.«
1994-6 Arne Geel Andersen: »Værdiansættelse af anlægsaktiver i årsregnskabet - en
teoretisk analyse«.
1994-7 Jørn Flohr Nielsen & Jens Genefke: »Tracing the Barriers and Possibilities of
Co-operation«.
1994-8 Niels Warrer: »Budgetary Doubts«.
1994-9 Niels Peter Mols: »Transaktionsomkostningsteori og andelsorganisering«.
1994-10 Lars Bonderup Bjørn: »Organisatorisk grænsedragning ved danske virksomhe-
ders etablering i Japan«.
1994-11 Jørn Flohr Nielsen: »Servicevirksomhedens grænse«.
1994-12 Bendt Rørsted: »Budgettets rolle i en serieproducerende sæsonvirksomhed«.
1994-13 Jens Holmgren: »Bidrager transaktionsomkostningsteorien til større forståelse af
intraorganisatoriske forhold?«
1994-14 Johannes Raaballe and Jesper Helmuth Larsen: »Bond Pricing with Differential
and Asymmetric Taxation».

1995-1 Per Nikolaj D. Bukh og Boel E. L. Christensen: »Subteknologier i pengeinstitut-

sektoren: En dataindhyldningsanalyse«.
1995-2 Jens Genefke og Jens Holmgren: »Service-Management i Contingency-Belys-
ning: En ledelsesorienteret klassifikation af produktionssitu-ationer«.
1995-3 Hans-Joachim Zilcken: »The Privatised Enterprise in Russia: From Centralised
Allocation of Supplies to Search for Market Development«.
1995-4 Jens Hørlück: »Efter EDI: Elektroniske hierarkier, elektroniske markeder,
eller?«
1995-5 Bendt Rørsted: »Det interne regnskabsvæsens driftsøkonomiske grundlag«.
1995-6 Niels Peter Mols: »The Exercise of Power and Satisfaction in a Buyer-Seller
Relationship«.
1995-7 Anders Grosen and Peter Løchte Jørgensen: »The Valuation of Inte-rest Rate
Guarantees: An Application of American Option Pricing Theory«.
1995-8 Per Nikolaj D. Bukh: »Produktivitet og efficiens i pengeinstitutsektoren -
Overvejelser ved valg af input og output i forbindelse med DEA-analyser«.
1995-9 Johannes Raaballe og Peter Lyhne Hansen: »Manglende Baissemuligheder på
Københavns Fondsbørs«.
1995-10 Niels Warrer: »Budget Format«.

1996-1 Niels Peter Mols: »Plural Forms of Governance«.

1996-2 Lars Bjørn and Jørn Flohr Nielsen: »Organizational or Cultural Interfaces of
Foreign Subsidiaries?«.
1996-3 Niels Peter Mols: »A Note on the Institutional Environment in
Williamson's Transaction Cost Theory«.
1996-4 Peter Løchte Jørgensen and Johannes Raaballe: »Numeraire Invariance,
Change of Measure, and Pricing by Arbitrage in Continuous Time Financial
Models«.
1996-5 Mogens Dilling-Hansen and Valdemar Smith: »Estimating Inter-Regional
Migration Using a Hiring Function Approach«.
1996-6 Brian Almann Hansen: »Price Search in the Retail Grocery Market«.

1997-1 Niels Peter Mols: »Danish Farmers’ Vertical and Horizontal Interfirm Rela-
tionships«.
1997-2 Per Nikolaj D. Bukh: »Activity Based Costing«.
1997-3 Per Nikolaj D. Bukh: »Kunderentabilitetsanalyser«.
1997-4 Jens Genefke og Per Nikolaj D. Bukh: »On hikers, tigers, trust and opportu-
nism«.
1997-5 Per Nikolaj D. Bukh og Jens Genefke: »Om at hælde gammel teori ud«.
1997-6 Niels Peter Mols: »Teoretiske tilgange til duale distributionskanaler«.
1997-7 Bendt Rørsted: »From Product to Core Competence - Marketing Theory 1933-
1993«.
1997-8 Per Nikolaj D. Bukh: »Den balancerede rapportering«.
1997-9 Niels Peter Mols, Per Nikolaj D. Bukh og Per Blenker: »European Customers’
Choice of Domestic Cash Management Banks«
1997-10 Per Nikolaj D. Bukh, Niels Peter Mols og Per Blenker: »Choosing a Cash
Management Bank: customer criteria and bank strategies«
1997-11 Niels Peter Mols: »Dual Channels of Distribution«
1997-12 Per Blenker: »Strategibegrebet: – belyst ved industrielle underleverandør-
aftager relationer«
1997-13 Asbjørn T. Hansen og Peter Løchte Jørgensen: »Analytical Valuation of
American-style Asian Options«
1997-14 Johannes Raaballe: »Egenkapitalproblemer ved generationsskifte i landbruget«
1997-15 J.V. Lundberg-Petersen: »Resultatbudgettets skematiske form«
1997-16 Jørn Flohr Nielsen og Viggo Høst: »The Path to Service Quality at <Bureaucra-
tic Encounters: The Impact of Private and Public Initiatives«

ISSN 1395-8143