What drives the implied volatility of index options

Abstract

The objective of this article is to identify and evaluate the correlates of volatility in index options during a speculative boom period. We investigate whether the persistence of changes in the CBOE volatility index is associated with Treasury-bill yield and common stock market index, such as SP 500, during the period of tremendous stock market growth of the late 1990s. We examine if the positive information from the market index and the innovations in the predictive variables play any role in explaining the variability of index options. The implied volatility from our model shows that high volatility of index options is accompanying falling prices in the market index. Overall, the empirical findings suggest that there is more downside weakness than upside strength in the predictive power of the market index. © 2010 Macmillan Publishers Ltd.