The Local Volatility Surface: Unlocking the Information in Index Option Prices

Emanuel Derman, Iraj Kani and Joseph Z. Zou

Financial Analysts Journal, 1996, vol. 52, issue 4, 25-36

Abstract: The structure of listed index options prices, examined through the prism of the implied tree model, reveals the local volatility surface of the underlying index. In the same way as fixed-income investors analyze the yield curve in terms of forward rates, so index options investors should analyze the volatility smile in terms of local volatilities. This article explains the concept of local volatility and its use. It also presents three heuristic rules that relate local and implied volatilities. Local volatilities are used in markets with a pronounced smile to measure market sentiment, to compute the evolution of implied volatilities through time, to calculate the index exposure of standard index options, and to value and hedge exotic options. In markets with significant smiles, all of the results show large discrepancies from those of the standard Black–Scholes approach.

Date: 1996
References: Add references at CitEc
Citations: View citations in EconPapers (3)

Downloads: (external link)
http://hdl.handle.net/10.2469/faj.v52.n4.2008 (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:taf:ufajxx:v:52:y:1996:i:4:p:25-36

Ordering information: This journal article can be ordered from
http://www.tandfonline.com/pricing/journal/ufaj20

DOI: 10.2469/faj.v52.n4.2008

Access Statistics for this article

Financial Analysts Journal is currently edited by Maryann Dupes

More articles in Financial Analysts Journal from Taylor & Francis Journals
Bibliographic data for series maintained by Chris Longhurst ().