Portfolio of Volatility Smiles versus Volatility Surface: Implications for pricing and hedging options

Sol Kim

Journal of Futures Markets, 2021, vol. 41, issue 7, 1154-1176

Abstract: In this study, we compare the pricing and hedging performance of options‐pricing models using two parameter‐estimation methods to employ cross‐sectional options data with multiple maturities. In the Portfolio of Volatility Smiles method, each set of parameters that describe the individual volatility smile for each maturity is estimated separately. In the Volatility Surface method, a single‐parameter set that describes the entire volatility surface is estimated, regardless of the time‐to‐maturity. When pricing and hedging options with various times to maturity, the Portfolio of Volatility Smiles method generally outperforms the Volatility Surface method, irrespective of the option‐pricing model used, maturity, and moneyness. Considering the volatility smile individually at each maturity is more effective in pricing and hedging options than is considering the volatility surface simultaneously.

Date: 2021
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