(1) Athens Derivatives Exchange Research and Development Group, Greece;(2) Financial Options Research Centre, Chrisanthemon 76, N. Iraklio, 14121 Athens, Greece;(3) Warwick Business School, University of Warwick, Coventry, CV4 7AL, UK
Abstract:
This empirical study is motivated by the literature on “smile-consistent” arbitrage pricing with stochastic volatility. We
investigate the number and shape of shocks that move implied volatility smiles and surfaces by applying Principal Components
Analysis. Two components are identified under a variety of criteria. Subsequently, we develop a “Procrustes” type rotation
in order to interpret the retained components. The results have implications for both option pricing and hedging and for the
economics of option pricing.
This revised version was published online in June 2006 with corrections to the Cover Date.