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A dynamic copula approach to recovering the index implied volatility skew

Matthias Fengler (), Helmut Herwartz () and Christian Werner ()

No 1132, University of St. Gallen Department of Economics working paper series 2010 from Department of Economics, University of St. Gallen

Abstract: Equity index implied volatility functions are known to be excessively skewed in comparison with implied volatility at the single stock level. We study this stylized fact for the case of a major German stock index, the DAX, by recovering index implied volatility from simulating the 30 dimensional return system of all DAX constituents. Option prices are computed after risk neutralization of the multivariate process which is estimated under the physical probability measure. The multivariate models belong to the class of copula asymmetric dynamic conditional correlation models. We show that moderate tail-dependence coupled with asymmetric correlation response to negative news is essential to explain the index implied volatility skew. Standard dynamic correlation models with zero tail-dependence fail to generate a sufficiently steep implied volatility skew.

Keywords: Copula Dynamic Conditional Correlation; Basket Options; Multivariate GARCH Models; Change of Measure; Esscher Transform (search for similar items in EconPapers)
JEL-codes: C32 C15 G13 G14 (search for similar items in EconPapers)
Pages: 57 pages
Date: 2010-12, Revised 2011-11
New Economics Papers: this item is included in nep-ecm and nep-ore
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Journal Article: A Dynamic Copula Approach to Recovering the Index Implied Volatility Skew (2012) Downloads
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