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Understanding the Implied Volatility Surface for Options on a Diversified Index

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Abstract

This paper describes a two-factor model for a diversifed index that attempts to explain both the leverage effect and the implied volatility skews that are characteristic of index options. Our formulation is based on an analysis of the growth optimal portfolio and a corresponding random market activity time where the discounted growth optimal portfolio is expressed as a time transformed squared Bessel process of dimension four. It turns out that for this index model an equivalent risk neutral martingale measure does not exist because the corresponding Radon-Nikodym derivative process is a strict local martingale. However, a consistent pricing and hedging framework is established by using the benchmark approach. The proposed model,which includes a random initial condition for market activity, generates implied volatility surfaces for European call and put options that are typically observed in real markets. The paper also examines the price differences of binary options for the proposed model and their Black-Scholes counterparts.

Suggested Citation

  • David Heath & Eckhard Platen, 2004. "Understanding the Implied Volatility Surface for Options on a Diversified Index," Research Paper Series 128, Quantitative Finance Research Centre, University of Technology, Sydney.
    • Handle: RePEc:uts:rpaper:128
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    1. Wolfgang Breymann & Leah Kelly & Eckhard Platen, 2005. "Intraday Empirical Analysis and Modeling of Diversified World Stock Indices," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 12(1), pages 1-28, March.
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    6. David Heath & Simon Hurst & Eckhard Platen, 1999. "Modelling the Stochastic Dynamics of Volatility for Equity Indices," Research Paper Series 7, Quantitative Finance Research Centre, University of Technology, Sydney.
    7. Leah Kelly, 2004. "Inference and Intraday Analysis of Diversified World Stock Indices," PhD Thesis, Finance Discipline Group, UTS Business School, University of Technology, Sydney, number 1-2004, January-A.
    8. Rama Cont & Jose da Fonseca, 2002. "Dynamics of implied volatility surfaces," Quantitative Finance, Taylor & Francis Journals, vol. 2(1), pages 45-60.
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    10. David Heath & Eckhard Platen, 2006. "Local volatility function models under a benchmark approach," Quantitative Finance, Taylor & Francis Journals, vol. 6(3), pages 197-206.
    11. Peter Carr & Liuren Wu, 2003. "The Finite Moment Log Stable Process and Option Pricing," Journal of Finance, American Finance Association, vol. 58(2), pages 753-777, April.
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    13. Das, Sanjiv Ranjan & Sundaram, Rangarajan K., 1999. "Of Smiles and Smirks: A Term Structure Perspective," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 34(2), pages 211-239, June.
    14. Eric Renault & Nizar Touzi, 1996. "Option Hedging And Implied Volatilities In A Stochastic Volatility Model1," Mathematical Finance, Wiley Blackwell, vol. 6(3), pages 279-302, July.
    15. Eckhard Platen, 2004. "Modeling The Volatility And Expected Value Of A Diversified World Index," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 7(04), pages 511-529.
    16. Platen, Eckhard, 2000. "A minimal financial market model," SFB 373 Discussion Papers 2000,91, Humboldt University of Berlin, Interdisciplinary Research Project 373: Quantification and Simulation of Economic Processes.
    17. Alan L. Lewis, 2000. "Option Valuation under Stochastic Volatility," Option Valuation under Stochastic Volatility, Finance Press, number ovsv, December.
    18. Joshua Rosenberg, 1999. "Implied Volatility Functions: A Reprise," New York University, Leonard N. Stern School Finance Department Working Paper Seires 99-027, New York University, Leonard N. Stern School of Business-.
    19. Long, John Jr., 1990. "The numeraire portfolio," Journal of Financial Economics, Elsevier, vol. 26(1), pages 29-69, July.
    20. Eckhard Platen, 2001. "Arbitrage in Continuous Complete Markets," Research Paper Series 72, Quantitative Finance Research Centre, University of Technology, Sydney.
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    Cited by:

    1. Eckhard Platen, 2006. "A Benchmark Approach To Finance," Mathematical Finance, Wiley Blackwell, vol. 16(1), pages 131-151, January.
    2. David Heath & Eckhard Platen, 2005. "Currency Derivatives Under A Minimal Market Model With Random Scaling," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 8(08), pages 1157-1177.
    3. Shane Miller, 2007. "Pricing of Contingent Claims Under the Real-World Measure," PhD Thesis, Finance Discipline Group, UTS Business School, University of Technology, Sydney, number 2-2007, January-A.
    4. Hardy Hulley, 2009. "Strict Local Martingales in Continuous Financial Market Models," PhD Thesis, Finance Discipline Group, UTS Business School, University of Technology, Sydney, number 19, July-Dece.
    5. Shane Miller & Eckhard Platen, 2004. "A Two-Factor Model for Low Interest Rate Regimes," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 11(1), pages 107-133, March.
    6. Amine Bouden, 2008. "The Behavior Of The Implied Volatility Surface: Evidence From Crude Oil Futures Options," World Scientific Book Chapters, in: Mondher Bellalah & Jean-Luc Prigent & Jean-Michel Sahut & Georges Pariente & Olivier Levyne & Michel (ed.), Risk Management And Value Valuation and Asset Pricing, chapter 8, pages 151-175, World Scientific Publishing Co. Pte. Ltd..
    7. Hardy Hulley, 2009. "Strict Local Martingales in Continuous Financial Market Models," PhD Thesis, Finance Discipline Group, UTS Business School, University of Technology, Sydney, number 2-2009, January-A.

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    More about this item

    Keywords

    index derivatives; minimal market model; random scaling; growth optimal portfolio; fair pricing; binary options;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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