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

  • Chalamandaris, Georgios
  • Rompolis, Leonidas S.

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.

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Article provided by Elsevier in its journal Journal of Banking & Finance.

Volume (Year): 36 (2012)
Issue (Month): 4 ()
Pages: 1028-1044

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Handle: RePEc:eee:jbfina:v:36:y:2012:i:4:p:1028-1044
Contact details of provider: Web page: http://www.elsevier.com/locate/jbf

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