On Extracting Information Implied in Options
Journal
Computational Statistics
ISSN
0943-4062
ISSN-Digital
1613-9658
Type
journal article
Date Issued
2007-12-01
Author(s)
Abstract
Options are financial instruments with a payoff depending on future states of the underlying asset. Therefore option markets contain information about expectations of the market participants about market conditions, e.g. current uncertainty on the market and corresponding risk. A standard measure of risk calculated from plain vanilla options is the implied volatility (IV). IV can be understood as an estimate of the volatility of returns in future period. Another concept based on the option markets is the state-price density (SPD) that is a density of the future states of the underlying asset. From raw data we can recover the IV function by nonparametric smoothing methods. Smoothed IV estimated by standard techniques may lead to a non-positive SPD which violates no arbitrage criteria. In this paper, we combine the IV smoothing with SPD estimation in order to correct these problems. We propose to use the local polynomial smoothing technique. The elegance of this approach is that it yields all quantities needed to calculate the corresponding SPD. Our approach operates only on the IVs-a major improvement comparing to the earlier multi-step approaches moving through the Black-Scholes formula from the prices to IVs and vice-versa.
Language
English
Keywords
Implied volatility
Nonparametric regression
HSG Classification
contribution to scientific community
Refereed
Yes
Publisher
Physica-Verl.
Publisher place
Heidelberg
Volume
22
Number
4
Start page
543
End page
553
Pages
11
Subject(s)
Eprints ID
86937