Towards a volatility index for the Italian stock market

The aim of this paper is to analyse and empirically test how to unlock volatility information from option prices. The information content of three option based forecasts of volatility: Black-Scholes implied volatility, model-free implied volatility and corridor implied volatility is addressed, with the ultimate plan of proposing a new volatility index for the Italian stock market. As for model-free implied volatility, two different extrapolation techniques are implemented. As for corridor implied volatility, five different corridors are compared. Our results, which point to a better performance of corridor implied volatilities with respect to both Black-Scholes implied volatility and model-free implied volatility, are in favour of narrow corridors. The volatility index proposed is obtained with an overall 50% cut of the risk neutral distribution. The properties of the volatility index are explored by analysing both the contemporaneous relationship between implied volatility changes and market returns and the usefulness of the proposed index in forecasting future market returns.