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

  • Toby Daglish
  • John Hull
  • Wulin Suo

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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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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