Dynamic Factor Models for the Volatility Surface

Michel van der Wel (vanderwel@ese.eur.nl), Sait Ozturk and Dick van Dijk

CREATES Research Papers from Department of Economics and Business Economics, Aarhus University

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.

Keywords: Dynamic Factor Models; Implied Volatility Surface; Kalman filter; Max-imum likelihood (search for similar items in EconPapers)
JEL-codes: C32 C58 G13 (search for similar items in EconPapers)
Pages: 44
Date: 2015-01-30
New Economics Papers: this item is included in nep-ets
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