Measuring implied volatility surface risk using principal components analysis (Q4518941)

By the Black-Scholes formula [see \textit{F. Black} and \textit{M. Scholes}, J. Polit. Econ. 81, 637-659 (1973)] practitioners still have a useful tool in pricing options. Given the underlying stock level, the strike price and the remaining time to expiration, the BS-formula gives a one-to-one correspondence between option price and volatility which can be inverted numerically, resulting in the (so-called) implied volatility \(\widehat\sigma\). It is, however, empirically well-known that this implied volatility is not at all constant, but has a ``smile effect'' pattern as it varies in a \(U\)-shape form across different maturities and strike prices. In this paper the authors provide the following contributions: ``The first one is to apply a Principal Components Analysis (PCA) on the implied volatility surface in order to address the issue of determining the number and the nature of the factors that cause the smile to move across time. This is particularly important in smile-consistent derivative pricing. The second point is to use the results in managing the risk of volatility through Value-at-Risk methodology''. Some smile-consistent pricing models, including local, implicit and stochastic local volatility models, are discussed in more detail. For the entire collection see [Zbl 0943.00038].