Implied Volatility Surfaces of Options and their Relationship to Market Expectations of Large Events

Abstract

Financial markets are largely driven by big events such as elections, political announcements, and economic data releases. Market expectations of these specific events can have large effects on implied volatility surfaces of option contracts, specifically in the FX, treasury, or equity markets, which can lead to discrepancies surrounding pricing of these options as well problems with risk management. Past literature on the impact of large events on financial markets has proposed models of the impact of these big events on the implied volatility curves of options contracts using Black-Scholes as an underlying dynamic and have predicted elements of concavity in the implied volatility surfaces. In this paper, I test these predictions on market data surrounding large events that had significant implications for the FX or equity markets, specifically looking at Brexit in 2016 and its implications for the GBPUSD spot rate and at the US election in 2020 and its implications for the SP500 price. My analysis shows that the implied volatility surfaces for GBPUSD options tend to exhibit largely negative levels of skew prior to events that could potentially have large impacts on the GBPUSD rate, such as the Brexit vote in 2016 and the vote regarding Scottish Independence from the UK in 2014. In comparison to measures of average implied volatility, the skew levels tend to move more dramatically ahead of certain events, potentially being a better indicator to market participants of possible future moves in the GBPUSD spot rate. Looking at implied volatility and implied variance surfaces for option contacts on futures for the SP500, the skew levels exhibited a cyclical pattern, increasing as the date to expiration of the option contracts decreased. This made it hard to isolate negative spikes in the skew levels and attribute them to specific events. Looking at skew levels prior to the election in 2020, skew was more negative than previous times as a a result of the ongoing Covid-19 pandemic, but there were no largely negative levels of skew that could be attributed to the election. Unlike the skew measures for GBPUSD option contracts, there was no argument for an added benefit in looking at the skew levels of the implied variance surfaces of SP500 futures options contracts as compared to looking at summary measures of volatility, such as the CBOE VIX and the average implied volatility.