Principal Component Analysis of Volatility Smiles and Skews

16 Pages Posted: 8 Dec 2000

See all articles by Carol Alexander

Carol Alexander

University of Sussex Business School

Date Written: May 2001

Abstract

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

Alexander, Carol, Principal Component Analysis of Volatility Smiles and Skews (May 2001). EFMA 2001 Lugano Meetings; University of Reading Working Paper in Finance 2000-10. Available at SSRN: https://ssrn.com/abstract=248128 or http://dx.doi.org/10.2139/ssrn.248128

Carol Alexander (Contact Author)

University of Sussex Business School ( email )

Falmer, Brighton BN1 9SL
United Kingdom

HOME PAGE: http://www.carolalexander.org

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