July 1999
Joshua Rosenberg
ABSTRACT
Dumas, Fleming, Whaley (DFW, 1998) find that option models based on deterministic volatility functions (DVF) perform
poorly because the estimated volatility function is unstable over time. DFW provide evidence that the DVF changes
significantly on a weekly basis.
This paper proposes a new class of dynamic implied volatility function models (DIVF). This class of models separates
a time-invariant implied volatility function from the stochastic state variables that drive changes in the individual
implied volatilities. The dynamics of the state variables are modeled explicitly. This framework facilitates consistent
pricing and hedging with time-variation in the implied volatility function (IVF).
Subject: Investments/Derivatives, Investments/Volatility of Asset Prices, Investments/Econometrics
Rosenberg: (212) 998-0311 jrosenb0@stern.nyu.edu
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