Impact of Net Buying Pressure on Changes in Implied Volatility: Before and After the Onset of the Subprime Crisis

Abstract

In the Black–Scholes (BS) framework and valuation model, asset returns follow a lognormal diffusion and volatility is a constant parameter. In such a world, implied volatility is equal to the true volatility and is the same for options of all strikes. But, as everyone knows, the volatility “smile” in the real world stands as a serious contradiction to pure Black–Scholes. What causes the smile, and why does it change shape periodically? One set of possible answers to these important questions comes from modifying the BS assumptions, for example, by allowing stochastic volatility or non-lognormal fat-tailed return distributions. Another potential explanation is that the smile, and especially its dynamics, reflects imbalances in option demand and supply within the market population. A serious market shock can provide valuable insight into this question by revealing how implied volatilities respond to market events in times of stress. In this article, Shiu, Pan, Lin, and Wu explore the demand imbalance explanation as it applies to the TAIEX index of Taiwan stocks before and during the financial crisis of 2008. They find strong evidence that demand pressure does affect the implied volatility surface, but unlike in the U.S., the nature of the influence is more concentrated in calls than in puts.