| My dissertation addresses implied volatility dynamics, both in the time series and in the cross-section. It has long been understood that there is a negative relation between equity returns and the volatility of these returns, and in the first chapter I show that this relationship also holds between equity index returns and implied volatilities from the options markets.; It is also well-known that the cross-section of Black Scholes implied volatilities over strike prices is typically downward-sloping: the volatility "smile". In the second chapter, I propose and test a behavioral model for this phenomenon, and demonstrate that the smile can be explained by investors who are loss averse, and exhibit systematic subjective probability distortions. All of these biases are consistent with experimental evidence from the psychology and decision sciences literature.; The third chapter compares option valuation models based on regime-switching, GARCH, and jump-diffusion processes to a standard smile model, in which Black and Scholes implied volatilities are allowed to vary across strike prices. The other models provide significant improvement over a fixed smile model in fitting GBP and JPY option prices both in-sample and out-of-sample. A time-varying smile model, however, provides hedging performance that is comparable to the other models for the GBP options, suggesting that standard option valuation techniques may provide a reasonable basis for trading and hedging strategies. |
