Model-free implied volatility: From surface to index, forthcoming

Abstract. We propose a new method for approximating the expected quadratic variation of an asset based on its option prices. The quadratic variation of an asset price is often regarded as a measure of its volatility, and its expected value under pricing measure can be understood as the market’s expectation of future volatility. We utilize the relation between the asset variance and the Black-Scholes implied volatility surface, and discuss the merits of this new model-free approach compared to the CBOE procedure underlying the VIX index. The interpolation scheme for the volatility surface we introduce is designed to be consistent with arbitrage bounds. We show numerically under the Heston stochastic volatility model that this approach significantly reduces the approximation errors, andwe further provide empirical evidence from the Nikkei 225 options that the new implied volatility index is more accurate in predicting future volatility. Key words: model-free implied volatility index; volatility forecasting; volatility surface; variance swaps JEL classification: C02 1