Semiparametric modeling of implied volatility. (Q2571098)

This book brings together recent advances in the theory of implied volatility and refined semiparametric estimation strategies and dimension reduction methods for functional surfaces. The theory of implied and local volatility is presented. The smile-consistent modeling approaches are discussed in detail. Estimation techniques are also treated. This book is for readers with a preknowledge of stochastic processes and interest in financial derivatives, as for example plain vanilla or exotic options. The book has six chapters. After the introduction, chapter 2 treats the implied volatility surface. Smile consistent volatility models follow in chapter 3, and smoothing techniques in chapter 4. After dimension-reduced modeling (chapter 5) the book ends with a conclusion and outlook in chapter 6. After Chapter 1 (Introduction), Chapter 2 (The Implied Volatility Surface) gives an introduction into the Black-Scholes model. Next, the concepts of implied volatility (IV) and implied volatility surface (IVS) are introduced. Potential directions of relaxing are discussed. The chapter concludes by giving an account of the potential reasons for the existence of non-constant smile functions. Chapter 3 (Smile Consistent Volatility Models) is devoted to local volatility. It discusses several methods to extract local volatility, especially implied tree techniques. Implied trees are parametric approximations to the local volatility functions. It ends by the class of stochastic IV models. Chapter 4 (Smoothing Techniques) treats smoothing techniques of the IVS. After introducing the Nadaraya-Watson estimator as the simplest nonparametric estimator for the IVS, the local polynominal estimation being decisive when it comes to the estimator of IVS is introduced. The least squares kernel estimator smoothes the IVS in the space of option prices. Chapter 5 (Dimension-Reduced Modeling) treats the dimension reduction in IVS modeling. It is divided in two parts. The first part focusses on linear transformations of the IVS. In principal components analysis the high dimensional variables are projected into a lower dimensional space such that as little information as possible is lost. Stability tests across different annual samples are derived and applied. The resulting factors are modeled via standard GARCH time series techniques. The second part treats nonlinear transformations via functional principal components techniques. A semiparametric factor model for the IVS is proposed. It provides a number of advantages compared with other methods, because surface estimation and dimension reduction can be achieved in one step, and the local neighborhood of the design points of the surface is estimated only. So, model biases are avoided. The techniques deliver a small set of functions and factor loadings that span the propagation of the IVS through space and time. Another time series analysis of these factors based on vector autoregressive models is described. Chapter 6 (Conclusion and Outlook) concludes and gives directions of further research.