erc/metu
INTERNATIONAL CONFERENCE IN ECONOMICS  IV
September 13-16, 2000, Ankara

Modeling and Forecasting the Term Structure of Stock Market Volatility: Evidence from Turkey

Ercan Balaban (Deniz Yatırım A.Ş.)

Abstract

This is a first effort to model and forecast the term structure of volatility in the Turkish stock market. We employ the daily observations of the Istanbul Securities Exchange Composite Index (ISECI) for the period January 1988 to May 2000. First, we test whether the term structure of volatility of the ISECI returns is consistent with the square root of time model. We construct 16 different non-overlapping holding periods from one day to one year. The in-sample results show that the volatility grows faster than the theoretical model assumes regardless of the length of holding period. We empirically estimate the growth rate of volatility through time for a chosen sample. The estimated coefficient fits better to the term structure of volatility. We also use the empirical model for the out-of-sample forecasting of the term structure. The performance of the theoretical and empirical models is first evaluated using the conventional symmetric error statistics such as the mean error, the mean absolute error, the mean squared error, and the mean absolute percenatge error. However, the underprediction or overprediction of volatility has different implications for asset pricing, in particular, for option pricing. Hence we also employ such asymmetric error statistics as mean mixed errors to penalize underprediction and overprediction more heavily. The results show that the empirical model is always superior to forecast the out-of-sample term structure of volatility regardless of holding period. We also find that the empirical model produces better results if underprediction of volatility is undesired. In addition, the empirical model is an unbiased forecaster. We discuss the implications of our empirical findings for asset and option pricing, hedging decisions and portfolio management.

Economic Research Center
Middle East Technical University
06531 Ankara Turkey
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e-mail: metuerc@metu.edu.tr