Volatile Puzzlement

As a result of my latest article on VIX Derivatives I have received some feedback from top players. I am certainly glad to see that leading pros take an interest in my humble musings (after all, they are my target audience). I continue to be a bit puzzled though by the fact that some practitioners continue to religiously believe that implied volatility (and thus the VIX) is a pretty good mirror into expected future real volatility. I mean, I can understand why academics (always in search of mechanistical relationships that can be econometricized) would be eager to defend such link, but real-world pros?

What I would ask those defenders of implied vol as expected vol is, how do you know? How do you know that the market is even thinking about future real vol at all when pricing options? Have you asked all traders around the world? Taken to the extreme, who is to guarantee that traders develop any view on volatility when pricing options? Yes, if you plot the VIX with some measure of real volatility it looks as if the graphs move somewhat in sync, but the gaps are anyway still quite sizable (that is, even if we assume that the market is forecasting, it appears to be a lousy forecaster). But of course such graphical representations could be the result of coincidence, luck, or external forces.

On the other side of the debate we have the strong evidence provided by the vol smile, which clearly tells us that implied vol is not expected real vol. Why? Because you can´t have twenty different consensual average forecasts for vol. Either vol for an underlying asset is consensually expected to be 20% or 30% or 40%, but it can´t be consensually expected to be 20% and 30% and 40%. Obviously, other factors are at play when determining implied vol. A vol forecast might (just might) be one of them, but certainly not the only one.

I know that I have already spoken about all this in the past, but my latest e-conversations with top players has re-awakened my impulse to defend implied vol's non-forecasting identity.

Of course, as I have humbly admitted to my readers, I could be wrong (perhaps suffering from "armchairism"), but my argument feels quite right.

ptriana@profesor.ie.edu