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Dynamic Factor Models for the Volatility Surface

Author

Listed:
  • Michel van der Wel

    (Erasmus University Rotterdam and CREATES)

  • Sait R. Ozturk

    (Erasmus University Rotterdam and the Tinbergen Institute)

  • Dick van Dijk

    (Erasmus University Rotterdam, the Tinbergen Institute and ERIM)

Abstract

The implied volatility surface is the collection of volatilities implied by option contracts for different strike prices and time-to-maturity. We study factor models to capture the dynamics of this three-dimensional implied volatility surface. Three model types are considered to examine desirable features for representing the surface and its dynamics: a general dynamic factor model, restricted factor models designed to capture the key features of the surface along the moneyness and maturity dimensions, and in-between spline-based methods. Key findings are that: (i) the restricted and spline-based models are both rejected against the general dynamic factor model, (ii) the factors driving the surface are highly persistent, (iii) for the restricted models option Delta is preferred over the more often used strike relative to spot price as measure for moneyness.

Suggested Citation

  • Michel van der Wel & Sait R. Ozturk & Dick van Dijk, 2015. "Dynamic Factor Models for the Volatility Surface," CREATES Research Papers 2015-13, Department of Economics and Business Economics, Aarhus University.
    • Handle: RePEc:aah:create:2015-13
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    File URL: https://repec.econ.au.dk/repec/creates/rp/15/rp15_13.pdf
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    References listed on IDEAS

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    More about this item

    Keywords

    Dynamic Factor Models; Implied Volatility Surface; Kalman filter; Max-imum likelihood;
    All these keywords.

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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