Do Swedes Smile? On Implied Volatility Functions

An examination of implied volatilities for Swedish equity options shows a rather U-shaped smile pattern when the volatilities are averaged within groups according to their moneyness. The detected volatility smile makes the use of at-the-money implied volatilities for valuation of inor out-of-the-money options questionable. The at-the-money implied volatilities work well for valuing at-the-money options, but the smile pattern might make them inappropriate for other options. This paper investigates whether some kind of deterministic volatility function could lead to more accurate model values than the at-the-money implied volatilities, which are used as a benchmark. Different specifications of volatility functions are fitted over a six months estimation period. These functions are then used during a one-month evaluation period to value options as a test of the out-of-sample fit. Although the benchmark model performs best for the at-the-money options, other models are much better for deep inand to some extent out-of-the money options. However, no single model works very well for options of all moneyness levels.