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Errors in Implied Volatility Estimation

Published online by Cambridge University Press:  06 April 2009

Ludger Hentschel
Ludger Hentschel
Affiliation:
hentschel@simon.rochester.edu, University of Rochester, William E. Simon Graduate School of Business Administration, Rochester, NY 14627.
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Abstract

Estimating implied volatility by inverting the Black-Scholes formula is subject to considerable error when option characteristics are observed with plausible errors. Especially for options away from the money, large changes in volatility produce small changes in option prices. Conversely, small errors in option prices and other option characteristics produce large errors in implied volatilities. In the presence of small measurement errors, unobserved truncation of option prices that violate lower bounds for absence of arbitrage can also lead to systematic volatility smiles. The paper proposes feasible GLS estimators that reduce the noise and bias in implied volatility estimates.

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Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 38 , Issue 4 , December 2003 , pp. 779 - 810
Copyright
Copyright © School of Business Administration, University of Washington 2003

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