Volatility Surfaces: Theory, Rules of Thumb and Empirical Evidence
Posted: 12 Dec 2009
Date Written: December 10, 2009
Abstract
Implied volatilities are frequently used to quote the prices of options. The implied volatility of a European option on a particular asset as a function of strike price and time to maturity is known as the asset's volatility surface. Traders monitor movements in volatility surfaces closely. In this paper we develop a no-arbitrage condition for the evolution of a volatility surface. We examine a number of rules of thumb used by traders to manage the volatility surface and test whether they are consistent with the no-arbitrage condition and with data on the trading of options on the S&P 500 taken from the over-the-counter market. Finally we estimate the factors driving the volatility surface in a way that is consistent with the no-arbitrage condition.
Keywords: Volatilies, Option Pricing, Strike price, No-arbitrage condition
JEL Classification: C01, D12, G11, G12
Suggested Citation: Suggested Citation