Abstract
This empirical study is motivated by the literature on “smile-consistent” arbitrage pricing with stochastic volatility. We investigate the number and shape of shocks that move the implied volatility surface by applying Principal Components Analysis. Our methodology differs from the one followed by Skiadopoulos, Hodges and Clewlow (1998) who looked at the dynamics of implied volatility smiles for a given expiry bucket. We examine the dynamics of implied volatility surfaces under two different metrics: the strike metric and the moneyness metric. We find similar results for both metrics. Using a variety of criteria, we conclude that two shocks explain the movements of the volatility surface. The first shock is interpreted as a shift, while the second one has a Z-shape. The results have implications for both option pricing and hedging and for the economics of option pricing.
We would like to thank participants at the 1998 FORC Conference and at the 1999 Decision Science Institute Conference. We would also like to thank Russell Grimwood, Jens Jackwerth, Wojtek Krzanowski, Joao Pedro Nunes, Juan Carlos Mejia Perez and Chris Strickland for helpful discussions and comments. Part of this paper was written while the first author benefited from the Human Capital & Mobility Programme of the European Commission. Financial support from the Corporate Members of FORC is also gratefully acknowledged. Any remaining errors are our responsibility alone.
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Skiadopoulos, G., Hodges, S., Clewlow, L. (2000). The Dynamics of Implied Volatility Surfaces. In: Zanakis, S.H., Doukidis, G., Zopounidis, C. (eds) Decision Making: Recent Developments and Worldwide Applications. Applied Optimization, vol 45. Springer, Boston, MA. https://doi.org/10.1007/978-1-4757-4919-9_14
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DOI: https://doi.org/10.1007/978-1-4757-4919-9_14
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