THE NELSON-SIEGEL MODEL OF THE TERM STRUCTURE OF OPTION IMPLIED VOLATILITY AND VOLATILITY COMPONENTS

We develop the Nelson-Siegel model in the context of option-implied volatility term structure and study the time series of volatility components. Three components, corresponding to the level, slope, and curvature of the volatility term structure, can be interpreted as the long-, medium-, and short-term volatilities. The long-term component is persistent and driven by macroeconomic variables, the medium-term by market default risk, and the short-term by financial market conditions. The three-factor Nelson-Siegel model has superior performance in forecasting the volatility term structure, with better out-of-sample forecasts than the popular deterministic implied volatility function and a restricted two-factor model, providing support to the literature of component volatility models. (C) 2014 Wiley Periodicals, Inc.