Determinants Of Implied Volatility Movements In Individual Equity Options

Abstract

In this study, I introduce a parsimonious model that explains implied volatility time series for individual stock options. The current state of risk management for individual equity options still seems to lack the presence of pertinent exogenous variables. This study suggests a few easily observable variables that can be used to explain the changes in implied volatilities of stock options. These variables can be used in the risk models in order to more accurately manage option positions for individual stocks. The first chapter provides a motivation for the VIX as the primary explanatory variable for changes in implied volatility. It also examines the role of fundamental variables. The second chapter shows that the VIX as a good explanatory variable for explaining changes in implied volatility. It also examines the return of the underlying asset as an explanatory variable. Various techniques are used to determine the efficacy of the variables such as Fama-Macbeth cross-sectional regressions, Principal Component analysis, and individual regressions for each company in the sample. The final chapter examines risk premia in straddle returns and provides a practical application of volatility hedging.