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Volatility surfaces: theory, rules of thumb, and empirical evidence

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  • Toby Daglish
  • John Hull
  • Wulin Suo

Abstract

Implied volatilities are frequently used to quote the prices of options. The implied volatility of a European option on a particular asset as a function of strike price and time to maturity is known as the asset's volatility surface. Traders monitor movements in volatility surfaces closely. In this paper we develop a no-arbitrage condition for the evolution of a volatility surface. We examine a number of rules of thumb used by traders to manage the volatility surface and test whether they are consistent with the no-arbitrage condition and with data on the trading of options on the S&P 500 taken from the over-the-counter market. Finally we estimate the factors driving the volatility surface in a way that is consistent with the no-arbitrage condition.

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Bibliographic Info

Article provided by Taylor & Francis Journals in its journal Quantitative Finance.

Volume (Year): 7 (2007)
Issue (Month): 5 ()
Pages: 507-524

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Handle: RePEc:taf:quantf:v:7:y:2007:i:5:p:507-524

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Related research

Keywords: Implied volatility; Volatility surface; Dynamics; No-arbitrage; Empirical results;

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Cited by:
  1. Frédéric Abergel & Riadh Zaatour, 2012. "What drives option prices ?," Post-Print hal-00687675, HAL.
  2. Carey, Alexander, 2010. "Higher-order volatility: time series," MPRA Paper 21087, University Library of Munich, Germany.
  3. Fengler, Matthias R. & Härdle, Wolfgang & Mammen, Enno, 2003. "Implied volatility string dynamics," SFB 373 Discussion Papers 2003,54, Humboldt University of Berlin, Interdisciplinary Research Project 373: Quantification and Simulation of Economic Processes.
  4. Matthias Fengler & Wolfgang Härdle & Enno Mammen, 2005. "A Dynamic Semiparametric Factor Model for Implied Volatility String Dynamics," SFB 649 Discussion Papers SFB649DP2005-020, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
  5. Cristian Homescu, 2011. "Implied Volatility Surface: Construction Methodologies and Characteristics," Papers 1107.1834, arXiv.org.
  6. repec:hal:wpaper:hal-00687675 is not listed on IDEAS
  7. Wallmeier, Martin, 2012. "Smile in Motion: An Intraday Analysis of Asymmetric Implied Volatility," FSES Working Papers 427, Faculty of Economics and Social Sciences, University of Freiburg/Fribourg Switzerland.

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