Volatility Surfaces: Theory, Rules of Thumb and Empirical Evidence

Posted: 12 Dec 2009

See all articles by Wulin Suo

Wulin Suo

Queen's University - Smith School of Business

John C. Hull

University of Toronto - Rotman School of Management

Toby C. Daglish

Victoria University of Wellington - Te Herenga Waka - School of Economics & Finance

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

Suo, Wulin and Hull, John C. and Daglish, Toby C., Volatility Surfaces: Theory, Rules of Thumb and Empirical Evidence (December 10, 2009). Available at SSRN: https://ssrn.com/abstract=1521882

Wulin Suo

Queen's University - Smith School of Business ( email )

Smith School of Business - Queen's University
143 Union Street
Kingston, Ontario K7L 3N6
Canada

John C. Hull

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada
(416) 978-8615 (Phone)
416-971-3048 (Fax)

Toby C. Daglish (Contact Author)

Victoria University of Wellington - Te Herenga Waka - School of Economics & Finance ( email )

P.O. Box 600
Wellington 6140
New Zealand

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