In this paper, we introduce perceived volatility, an exponential and dynamically-weighted combination of past returns on the S&P 500. We find that it is closely correlated with implied volatility, showing that the VIX may just be a (smart) reflection of the past instead of a real forward-looking measure, as generally claimed.
Just like implied volatility, perceived volatility has some predicting power of future volatility (27% standard estimation error), but the model is unstable and limited to short forecasting horizons (38-trading day is the optimal forecasting horizon, very close to the VIX promise).
This matters because volatility — be it historical or implied — is widely used to calibrate risk-taking in the financial services industry, from volatility-targeting strategies, to collateral requirements estimation, to prudential regulation. As such, it is a potential endogenous source of man-made unknown unknowns.
Just like implied volatility, perceived volatility has some predicting power of future volatility (27% standard estimation error), but the model is unstable and limited to short forecasting horizons (38-trading day is the optimal forecasting horizon, very close to the VIX promise).
This matters because volatility — be it historical or implied — is widely used to calibrate risk-taking in the financial services industry, from volatility-targeting strategies, to collateral requirements estimation, to prudential regulation. As such, it is a potential endogenous source of man-made unknown unknowns.