The forecasting accuracy of implied volatility from ECX carbon options

- We study implied volatility of carbon options traded on European Climate Exchange.
- Option implied volatility is highly informative about the future variance of returns.
- It is also directionally accurate in predicting future volatility changes.
- However, implied volatility of carbon options is a biased predictor of the future volatility.

This study analyzes the forecasting accuracy of the implied volatility of options on futures contracts for the delivery of CO2 emission allowances (carbon options) traded on the European Climate Exchange. We demonstrate that option implied volatility is highly informative about the variance of returns realized over the remaining life of the options. It is also directionally accurate in predicting future volatility changes. However, we also find that implied volatility of carbon options is biased, especially for periods of time which do not coincide with the remaining life of the option. This suggests that the market has yet to fully mature.