have an account?【sign in】implied volatility surface construction methodologies and characteristics
creedauthorImplied volatility surfaces are essential tools for derivative traders and investors to make informed decisions and risk management. They provide insights into the expected future volatility of an asset class or individual security, and are crucial for value evaluation and trading strategy development. This article will discuss the different methodologies for constructing implied volatility surfaces and their characteristics, including historical volatility, forward volatility, and option-adjusted spread (OAS)-based surfaces.
Historical Volatility Surfaces
Historical volatility surfaces are based on the past volatility of an asset class or individual security. They can be calculated using different techniques, such as the Gaussian mixture model (GMM), local volume weighted average price (LVWAP), or the Heston model. The GMM and LVWAP methods use historical price data to estimate the underlying volatility, while the Heston model assumes a stochastic volatility process. Historical volatility surfaces can be useful for identifying trends and market sentiment, but they may not capture the true volatility of the underlying asset due to the limited sample size and potential time-varying volatility.
Forward Volatility Surfaces
Forward volatility surfaces are calculated using forward prices and futures contracts. They provide a forecast of the future volatility of an asset class or individual security. The forward volatility surface can be constructed using various methods, such as the Black-Scholes model, the Heston model, or the CIR model. The Black-Scholes model assumes a constant volatility process, while the Heston and CIR models consider stochastic volatility. Forward volatility surfaces are more accurate in capturing the future volatility of the underlying asset due to the use of forward prices, which are more likely to reflect the true volatility of the market. However, they may be less useful for identifying trends and market sentiment due to the reliance on forward prices.
Option-Adjusted Spread-Based Surfaces
Option-adjusted spread (OAS)-based surfaces are calculated using the difference between the market value of a security and its discounted future dividends, adjusted for the option price. They provide a measure of the riskiness of a security and are commonly used in valuing fixed income securities. OAS-based implied volatility surfaces can be constructed using various methods, such as the Black-Scholes model, the Heston model, or the CIR model. OAS-based surfaces can be useful for identifying potential market inefficiencies and valuation anomalies, but they may not capture the true volatility of the underlying asset due to the limited sample size and potential time-varying volatility.
Implied volatility surface construction methodologies and characteristics play a crucial role in derivative trading and investment decision-making. Historical volatility surfaces, forward volatility surfaces, and option-adjusted spread-based surfaces each have their advantages and limitations. Traders and investors should understand the characteristics of these surfaces and use them in conjunction with other tools and insights to make informed decisions and manage risk. As market conditions and investor needs evolve, it is essential to continuously explore and refine the construction and use of implied volatility surfaces to maximize their value in decision-making.