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Saturday, March 30th 2019

Implied Volatility Term Structure and Interpolated IVs

Three ways to calculate constant maturity interpolated implied volatility.

Summary

ORATS offers three methods to calculate constant maturity interpolated implied volatility: simple interpolation, ex-earnings interpolation, and term structure IVs. Simple interpolation is useful for comparing relationships between constant implied volatility, ex-earnings interpolation is good for observing normalized IV readings, and term structure IVs can be used to model where other IVs line up theoretically.

Here at ORATS we have three ways to look at the implied volatility (IV) term structure and constant maturity interpolated IVs.

 

 

  • Simple interpolation: We take the expiration directly before and directly after the constant maturity day reading. For example, if we were looking at the 30-day implied volatility, we might use a 26 day and a 33 day expiration and weight the 13 day slightly more because it is 3 days away from 10 and the 6 is 4 away. In our data API this reading column header is: iv10d.
  • Ex-earnings interpolation: We take the earnings effect out of the implied volatility (see below). For example, if we were looking at the 30-day implied volatility, we might use a 26 day and a 33 day expiration and weight the 33 day slightly more because it is 3 days away from target of 30 and the 26 is 4 away. Moreover, if the earnings announcement is in 28 days, the portion of the IV attributable to earnings will be removed from the IV of the 33 day expiration (the 26 day expiration would not have an earnings effect). In our data API this reading column header is: exErnIv30d.
  • Term structure IVs: Whereas the two examples above use just two expirations to calculate a constant maturity IV, this method uses all expirations and minimizes the difference in a formulaic rational term structure from the term structure made using just two constant maturities, a 30 calendar day IV and a 2 year IV. An implied earnings effect is also simultaneously solved for to develop this term structure. In our data API this reading column header is: orIvXern20d (called this for 20 business days or 30 calendar days), orIvXernInf (called this as it relates to an infinite or asymtote), and impliedEe (implied earnings effect).

Each of these has important applications. Simple interpolation is great for comparing relationships between the 10, 20, 30, 60, 90, 180 and 365 day constant implied volatility. Ex-earnings interpolations are great for observing normalized IV readings. Term structure IVs can be used to model where the other IVs line up theoretically vs a target expiration IV and see if there is any edge.

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