Does the World Smile Together? A Network Analysis of Global Index Option Implied Volatilities

Abstract

We apply the directed acyclic graph and spillover index models and find significant evidence of both implied volatility contagion and spillover. First, the global implied volatility smiles exhibit strong regional clustering. The European and American options markets form a separate contemporary contagion cluster from the Asia-Pacific region. However, the 30-day-lag test shows that none of these markets are completely independent of the other two regions in the long run. Among all of them, the European index options markets demonstrate the strongest implied volatility smile contagion. Second, there exists obvious heterogeneity among different markets in terms of the implied volatility spillover, and extreme market conditions like crises seem to intensify the spillover effect. A broader category of factors, including the short-run underlying index return trend, at-the-money option implied volatility and interest rate term spread, are the key determinants of implied volatility spillovers.