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The dynamics of implied volatilities: A common principal components approach

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  • Fengler, Matthias R.
  • Härdle, Wolfgang K.
  • Villa, Christophe

Abstract

It is common practice to identify the number and sources of shocks that move implied volatilities across space and time by applying Principal Components Analysis (PCA) to pooled covariance matrices of changes in implied volatilities. This approach, however, is likely to result in a loss of information, since the surface structure of implied volatilities in the maturities and moneyness dimension is neglected. In this paper we propose to estimate the implied volatility surface at each point in time nonparametrically and to analyze the implied volatility surface slice by slice with a common principal components analysis (CPCA). As opposed to traditional PCA, the basic assumption of CPCA is that the space spanned by the eigenvectors is identical across groups, whereas variances associated with the components are allowed to vary. This allows us to study a p variate random vector of k groups, say the volatility smile at p different grid points of moneyness for k maturities, simultaneously. Our evidence suggests that surface dynamics can indeed be traced back to a common eigenstructure between covariance matrices of the surface slices, which allow for the usual shift, slope, and twist interpretation of shocks to implied volatilities. This insight is a suitable starting point for VaR Monte Carlo Simulations of delta-gamma neutral, vega sensitive option portfolios.

Suggested Citation

  • Fengler, Matthias R. & Härdle, Wolfgang K. & Villa, Christophe, 2001. "The dynamics of implied volatilities: A common principal components approach," SFB 373 Discussion Papers 2001,38, Humboldt University of Berlin, Interdisciplinary Research Project 373: Quantification and Simulation of Economic Processes.
  • Handle: RePEc:zbw:sfb373:200138
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    References listed on IDEAS

    as
    1. 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.
    2. Rama Cont & Jose da Fonseca, 2002. "Dynamics of implied volatility surfaces," Quantitative Finance, Taylor & Francis Journals, vol. 2(1), pages 45-60.
    3. Farshid Jamshidian & Yu Zhu, 1996. "Scenario Simulation: Theory and methodology (*)," Finance and Stochastics, Springer, vol. 1(1), pages 43-67.
    4. Bernard Dumas & Jeff Fleming & Robert E. Whaley, 1998. "Implied Volatility Functions: Empirical Tests," Journal of Finance, American Finance Association, vol. 53(6), pages 2059-2106, December.
    5. Fengler, Matthias R. & Wang, Qihua, 2003. "Fitting the Smile Revisited: A Least Squares Kernel Estimator for the Implied Volatility Surface," SFB 373 Discussion Papers 2003,25, Humboldt University of Berlin, Interdisciplinary Research Project 373: Quantification and Simulation of Economic Processes.
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    More about this item

    Keywords

    Common Principal Component Analysis; Implied Volatility Surface; Principal Component Analysis; Smile;

    JEL classification:

    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • C49 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - Other
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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