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Exploring the role of the realized return distribution in the formation of the implied volatility smile

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  • Chalamandaris, Georgios
  • Rompolis, Leonidas S.

Abstract

This article explores the role of the realized return distribution in the formation of the observed implied volatility smile using the framework of an adaptive expectations model. According to this framework investors update their expectations of future events, through which options are priced, by incorporating information from the underlying asset traded in the spot market. Our study is conducted at the level of cumulants which provide a complete description of investors expectations and can be considered as largely non-parametric with a minimal set of assumptions for the stochastic process that drives asset returns. The empirical results, based on the S&P 500 index, support the significance of the realized distribution in the formation of the implied volatility smile.

Suggested Citation

  • Chalamandaris, Georgios & Rompolis, Leonidas S., 2012. "Exploring the role of the realized return distribution in the formation of the implied volatility smile," Journal of Banking & Finance, Elsevier, vol. 36(4), pages 1028-1044.
  • Handle: RePEc:eee:jbfina:v:36:y:2012:i:4:p:1028-1044
    DOI: 10.1016/j.jbankfin.2011.10.016
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    Cited by:

    1. Jarno Talponen, 2018. "Matching distributions: Recovery of implied physical densities from option prices," Papers 1803.03996, arXiv.org.
    2. repec:mod:depeco:0015 is not listed on IDEAS
    3. silvia Muzzioli & Alessio Ruggieri, 2013. "Option Implied Trees and Implied Moments," Department of Economics (DEMB) 0015, University of Modena and Reggio Emilia, Department of Economics "Marco Biagi".
    4. Bernales, Alejandro & Guidolin, Massimo, 2014. "Can we forecast the implied volatility surface dynamics of equity options? Predictability and economic value tests," Journal of Banking & Finance, Elsevier, vol. 46(C), pages 326-342.
    5. Liu, Yi-Fang & Zhang, Wei & Xu, Hai-Chuan, 2014. "Collective behavior and options volatility smile: An agent-based explanation," Economic Modelling, Elsevier, vol. 39(C), pages 232-239.

    More about this item

    Keywords

    Filtered Historical Simulation; Risk-neutral cumulants; Realized cumulants; Adaptive expectations;

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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