On implied volatility for options—Some reasons to smile and more to correct

Song Chen and Zheng Xu

Journal of Econometrics, 2014, vol. 179, issue 1, 1-15

Abstract: We analyze the properties of the implied volatility, the commonly used volatility estimator by direct option price inversion. It is found that the implied volatility is subject to a systematic bias in the presence of pricing errors, which makes it inconsistent to the underlying volatility. We propose an estimator of the underlying volatility by first estimating nonparametrically the option price function, followed by inverting the nonparametrically estimated price. It is shown that the approach removes the adverse impacts of the pricing errors and produces a consistent volatility estimator for a wide range of option price models. We demonstrate the effectiveness of the proposed approach by numerical simulation and empirical analysis on S&P 500 option data.

Keywords: Bias correction; Implied volatility; Kernel estimator; Pricing errors (search for similar items in EconPapers)
JEL-codes: C50 C58 (search for similar items in EconPapers)
Date: 2014
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (7)

Downloads: (external link)
http://www.sciencedirect.com/science/article/pii/S0304407613002200
Full text for ScienceDirect subscribers only

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:eee:econom:v:179:y:2014:i:1:p:1-15

DOI: 10.1016/j.jeconom.2013.10.007

Access Statistics for this article

Journal of Econometrics is currently edited by T. Amemiya, A. R. Gallant, J. F. Geweke, C. Hsiao and P. M. Robinson

More articles in Journal of Econometrics from Elsevier
Bibliographic data for series maintained by Catherine Liu ().