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Stochastic Models of Implied Volatility Surfaces |
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| Authors: | Rama Cont Jose da Fonseca & Valdo Durrleman |
| Institution: | Centre de Mathematiques Appliquees, Ecole Polytechnique, France,;Ecole Superieure d'Ingenierie Leonard de Vinci, Paris La Defense, France,;Department of Operations Research and Financial Engineering, Princeton University, USA |
| Abstract: | We propose a market–based approach to the modelling of implied volatility, in which the implied volatility surface is directly used as the state variable to describe the joint evolution of market prices of options and their underlying asset. We model the evolution of an implied volatility surface by representing it as a randomly fluctuating surface driven by a finite number of orthogonal random factors. Our approach is based on a Karhunen–Loeve decomposition of the daily variations of implied volatilities obtained from market data on SP500 and DAX options. We illustrate how this approach extends and improves the accuracy of the well–known 'sticky moneyness' rule used by option traders for updating implied volatilities. Our approach gives a justification for the use of 'Vegas' for measuring volatility risk and provides a decomposition of volatility risk as a sum of independent contributions from empirically identifiable factors. (J.E.L.: G130, C14, C31). |
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