Modeling of implied volatility surfaces of nifty index options

Abstract

The Implied Volatility Of An Option Contract Is The Value Of The Volatility Of The Underlying Instrument Which Equates The Theoretical Option Value From An Option Pricing Model (Typically, The Black-Scholes-Merton Model) To The Current Market Price Of The Option. The Concept Of Implied Volatility Has Gained In Importance Over Historical Volatility As A Forward-Looking Measure, Reflecting Expectations Of Volatility (Dumas Et Al., 1998). Several Studies Have Shown That The Volatilities Implied By Observed Market Prices Exhibit A Pattern Very Different From That Assumed By The Black- Scholes-Merton Model, Varying With Strike Price And Time To Expiration. This Variation Of Implied Volatilities Across Strike Price And Time To Expiration Is Referred To As The Volatility Surface. Empirically, Volatility Surfaces For Global Indices Have Been Characterized By The Volatility Skew. For A Given Expiration Date, Options Far Out-Of-The-Money Are Found To Have Higher Implied Volatility Than Those With An Exercise Price At-The-Money. For Short-Dated Expirations, The Cross-Section Of Implied Volatilities As A Function Of Strike Is Roughly V-Shaped, But Has A Rounded Vertex And Is Slightly Tilted. Generally, This V-Shape Softens And Becomes Flatter For Longer Dated Expirations, But The Vertex Itself May Rise Or Fall Depending On Whether The Term Structure Of At-The-Money Volatility Is Upward Or Downward Sloping. The Objective Of This Study Is To Model The Implied Volatility Surfaces Of Index Options On The National Stock Exchange (Nse), India. The Study Employs The Parametric Models Presented In Dumas Et Al. (1998); Pella Et Al. (1999), And Several Subsequent Studies To Model The Volatility Surfaces Across Moneyness And Time To Expiration. The Present Study Contributes To The Literature By Studying The Nature Of The Stationary Point Of The Implied Volatility Surface And By Separating The In-The-Money And Out-Of-The-Money Components Of The Implied Volatility Surface. The Results Of The Study Suggest That An Important Difference Between The Implied Volatility Surface Of Index Call And Put Options: The Implied Volatility Surface Of Index Call Options Was Found To Have A Minimum Point, While That Of Index Put Options Was Found To Have A Saddlepoint. The Results Of The Study Also Indicate The Presence Of A Volatility Smile Across Strike Prices, With A Minimum Point In The Range Of 2.3-9.0% In-The-Money For Index Call Options And Of 10.7-29.3% In-The-Money For Index Put Options; Further, There Was A Jump In Implied Volatility In The Transition From Out-Of-The-Moneyness To In-The-Moneyness, By 10.0% For Index Call Options And About 1.9% For Index Put Options.