Leveraged ETF Options Implied Volatility Paradox: A Statistical Study
SFB 649 Discussion Paper 2016-004, Economic Risk, Berlin
42 Pages Posted: 27 Jun 2016 Last revised: 14 Nov 2016
Date Written: November 13, 2016
In this paper, we study the statistical properties of the moneyness scaling transformation by Leung and Sircar (2015). This transformation adjusts the moneyness coordinate of the implied volatility smile in an attempt to remove the discrepancy between the IV smiles for levered and unlevered ETF options. We construct bootstrap uniform confidence bands which indicate that there remains a possibility that the implied volatility smiles are still not the same, even after moneyness scaling has been performed. This presents possible arbitrage opportunities on the (L)ETF market which can be exploited by traders. An empirical data application shows that there are indeed such opportunities in the market which result in risk-free gains for the investor. A dynamic "trade-with-the-smile" strategy based on a dynamic semiparametric factor model is presented. This strategy utilizes the dynamic structure of implied volatility surface allowing out-of-sample forecasting and information on unleveraged ETF options to construct theoretical one-step-ahead implied volatility surfaces. Additionally, we propose a semi-analytic and a simulation-based estimation approach for incorporating stochastic volatility into the moneyness scaling method. This approach allows to infer the "expected integrated variance smile" from the data.
Keywords: exchange-traded funds, options, moneyness scaling, stochastic volatility, bootstrap, dynamic factor models
JEL Classification: C00, C14, C50, C58
Suggested Citation: Suggested Citation