You Don't Have to Bother Newton for Implied Volatility
28 Pages Posted: 20 Dec 2006
Date Written: November, 2006
The Black-Scholes formula is often used in the backward direction to invert the implied volatility, usually with some solver method. Solver methods, being aesthetically unappealing, are also slower than closed-form approximations. However, closed-form approximations in previous works lack accuracy, often providing option pricing errors well exceeding the bid-ask spreads. We develop a new closed-form method based on the rational approximation. By exploiting the homogeneity in the Black-Scholes formula, we are able to show explicitly our domain of approximation and investigate thoroughly the accuracy of our method. The rational approximation is much faster than typical solver methods and very accurate for both at-the-money and away-from-the-money options. Its accuracy can be further improved by one or two steps of Newton-Raphson iterations.
Keywords: Implied volatility, Black-Scholes formula, rational approximation
JEL Classification: C63, G12, G13
Suggested Citation: Suggested Citation