The term structure of option-implied volatility and future realized volatility

We extract the short-, medium-, and long-term factors from the term structure of the option-implied volatility (OIV) of the S&P 500, the FTSE 100, and the Chinese 50 Exchange-Traded Funds (ETF), using an extension of the Nelson-Siegel (N-S) model and use estimated factors to predict future realized volatility (FRV) in the US, UK, and Chinese markets. Several interesting findings emerged from our study. First, we confirmed that the VIX is more informative than historical realized volatility (HRV) in predicting FRV. Second, we find that the volatility term structure contains some additional information compared with the VIX and HRV. Third, we verify that the three factors extracted from the N-S model are strongly cointegrated, related to volatilities. Moreover, based on the normalized error term of the cointegrated pairs, we construct straddles and delta-hedging option trading strategies. Without taking transaction costs into account, the straddle call trading strategy achieves a mean return of 37.59% monthly, and, at the same time, the exponential cumulative returns for the straddle call strategies are 4.2411 at a threshold of 1.1 in the S&P 500. As the threshold increases, the volume of transactions declines, leading to a fall in cumulative mean returns.