Using interpolated implied volatility for analysing exogenous market changes

Abstract

This paper focuses on market changes due to exogenous effects. The standard implied volatility is shown to be insufficient for a proper detection and analysis of this type of risk. This is mainly because such changes are usually dominated by endogenous effects coming from a specific trading mechanism or natural market dynamics. A methodologically unique approach based on artificial options that always have a constant time to maturity is proposed and explicitly defined. The key principle is to use interpolated volatilities, which can effectively eliminate instabilities due to the natural market dynamics while the changes caused by the exogenous causes are preserved. Formal statistical tests for distinguishing significant effects are proposed under different theoretical and practical scenarios. Statistical theory, computational and algorithmic details, and comprehensive empirical comparisons together with a real data illustration are all presented.