Stochastic Models of Implied Volatility Surfaces

Rama Cont, José Da Fonseca and Valdo Durrleman

Economic Notes, 2002, vol. 31, issue 2, 361-377

Abstract: type="main" xml:lang="en">

We propose a market–based approach to the modelling of implied volatility, in which the implied volatility surface is directly used as the state variable to describe the joint evolution of market prices of options and their underlying asset. We model the evolution of an implied volatility surface by representing it as a randomly fluctuating surface driven by a finite number of orthogonal random factors. Our approach is based on a Karhunen–Loeve decomposition of the daily variations of implied volatilities obtained from market data on SP500 and DAX options.

We illustrate how this approach extends and improves the accuracy of the well–known ‘sticky moneyness’ rule used by option traders for updating implied volatilities. Our approach gives a justification for the use of ‘Vegas’ for measuring volatility risk and provides a decomposition of volatility risk as a sum of independent contributions from empirically identifiable factors.

(J.E.L.: G130, C14, C31).

Date: 2002
References: Add references at CitEc
Citations: View citations in EconPapers (17)

Downloads: (external link)
http://hdl.handle.net/10.1111/1468-0300.00090 (text/html)
Access to full text is restricted to subscribers.

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:bla:ecnote:v:31:y:2002:i:2:p:361-377

Ordering information: This journal article can be ordered from
http://www.blackwell ... bs.asp?ref=0391-5026

Access Statistics for this article

More articles in Economic Notes from Banca Monte dei Paschi di Siena SpA
Bibliographic data for series maintained by Wiley Content Delivery ().