Macroeconomic Conditions, Volatility Components, and Term Structure of Implied Volatility: An Empirical Investigation

Abstract

Using a Nelson-Siegel approach this article conducts an empirical study of the volatility components directly extracted from the observed implied volatility term structure. We show that (1) the long term volatility component can be explained by macroeconomic and financial variables; (2) a bivariate volatility-component option valuation model is sufficient for pricing options with different maturities; (3) the out-of-sample performance of the Nelson-Siegel model is better than Heston stochastic volatility model, GARCH (1,1) and ad hoc term structure models. The results provide empirical support for the emerging literature of component volatility models.