Principal Component Analysis of Volatility Smiles and Skews
16 Pages Posted: 8 Dec 2000
Date Written: May 2001
This paper develops a model for volatility sensitivity to the underlying asset price. It has applications to option pricing and dynamic delta hedging under stochastic volatility. The model allows at-the-money volatility sensitivity to change continuously with S and this corresponds to a quadratic parameterization to the volatility surface. The extension to fixed strike volatility sensitivities is achieved using a principal component analysis on the deviation of fixed strike volatilities from at-the-money volatility.
Note: Formerly titled "Principal Component Analysis of Implied Volatility Smiles and Skews"
JEL Classification: C13, C22, C51, G19
Suggested Citation: Suggested Citation