A random walk down the options market

Under the efficient market hypothesis, option‐implied forward variance forms a martingale and changes in forward variance follow a random walk. In this study, we extract forward variance from option prices following a model‐free approach and empirically test the random walk hypothesis. Although results from standard orthogonality tests support the martingale restriction, further results from autoregressive regressions seem to reject the martingale restriction as daily changes in forward variance are found to exhibit negative autocorrelation. However, this anomalous pattern of negative correlation is fully explained by illiquidity effects. Overall, the findings support the random walk hypothesis and informational efficiency of the options market. © 2011 Wiley Periodicals, Inc. Jrl Fut Mark 32:505–535, 2012