Abstract

Previous studies have tested the expectations hypothesis of the term structure of implied volatility using fixed-interval time-series of at-the-money options. We show, using a stochastic volatility option pricing model, that even the implied volatilities of at-the-money options are not necessarily unbiased and that the fixed-interval time-series can produce misleading results. We then suggest an alternative approach and test the expectations hypothesis using S&P 500 stock index options. Our results do not support the expectations hypothesis: long-term volatilities rise relative to short-term volatilities but the increases are not matched as predicted by the expectations hypothesis. In addition, an increase in the current long-term volatility relative to the current short-term volatility is followed by a subsequent decline.

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