ARE VOLATILITY EXPECTATIONS CHARACTERIZED BY REGIME SHIFTS? EVIDENCE FROM IMPLIED VOLATILITY INDICES

1. Introduction

The behavior of asset prices and their reaction to economic information was the
impetus behind the development of a rich literature on market efficiency. But, changes in
speculative prices do not only provide evidence on the validity of equilibrium models of
asset pricing and have implications for investment management and risk hedging. Market
volatility has also strong bearing for financial regulation, monetary policymaking and
international market integration as well, given the growing evidence of volatility spillovers
across markets and countries, particularly during financial crises. Forecasting market
volatility is however a difficult exercise in quantifying uncertainty, which further gains in
complexity when perceptions of periodic economic reports and theoretical relationships by
market participants are not consistent over time.

Arguably, anticipations of market volatility may shed light on how new
information interacts with investors’ beliefs to produce changes in asset prices. As such, ex
ante measures of volatility can be reflective of investors’ perception of market risk.
Traditionally, the time-series of historical returns allows for the modelling of market
volatility in order to capture important features such as shock persistence, volatility
clustering and leverage effects reflected by the asymmetric impact of news. The present
study focuses rather on ex ante measures of short-term market volatility implied by stock
index option prices. The empirical analysis is aimed at providing evidence on mean
reversion and regime shifts in implied volatility dynamics, and thus investors’ anticipations
of price fluctuations.

The importance of these empirical issues is evident for instance, in the explicit
reference to the implied functions from options markets in the Bank of England’s monetary
policy meetings. This growing interest from policymakers is consistent with evidence from
many recent studies such as Carr and Wu (2006), who suggest that the S&P 500 new implied

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