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Implied volatility string dynamics

Author

Listed:
  • Fengler, Matthias R.
  • Härdle, Wolfgang
  • Mammen, Enno

Abstract

A primary goal in modelling the dynamics of implied volatility surfaces (IVS) aims at reducing complexity. For this purpose one fits the IVS each day and applies a principal component analysis using a functional norm. This approach, however, neglects the degenerated string structure of the implied volatility data and may result in a severe modelling bias. We propose a dynamic semiparametric factor model, which approximates the IVS in a finite dimensional function space. The key feature is that we only fit in the local neighborhood of the design points. Our approach is a combination of methods from functional principal component analysis and backfitting techniques for additive models. The model is found to have an approximate 10% better performance than the typical naïve trader models. The model can be a backbone in risk management serving for value at risk computations and scenario analysis.

Suggested Citation

  • Fengler, Matthias R. & Härdle, Wolfgang & Mammen, Enno, 2003. "Implied volatility string dynamics," SFB 373 Discussion Papers 2003,54, Humboldt University of Berlin, Interdisciplinary Research Project 373: Quantification and Simulation of Economic Processes.
    • Handle: RePEc:zbw:sfb373:200354
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Implied Volatility Surface; Smile; Generalized Additive Models; Backfitting; Functional Principal Component Analysis;
    All these keywords.

    JEL classification:

    • C14 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Semiparametric and Nonparametric Methods: General
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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