A Dynamic Copula Approach to Recovering the Index Implied Volatility Skew

Equity index implied volatility functions are known to be excessively skewed in comparison with implied volatility at the single stock level. We study this stylized fact for the case of a major German stock index, the DAX, by recovering index implied volatility from simulating the 30-dimensional return system of all DAX constituents. Option prices are computed after risk neutralization of the multivariate process which is estimated under the physical probability measure. The multivariate models belong to the class of copula asymmetric dynamic conditional correlation models. We show that moderate tail dependence coupled with asymmetric correlation response to negative news is essential to explain the index implied volatility skew. Standard dynamic correlation models with zero tail dependence fail to generate a sufficiently steep implied volatility skew. Copyright The Author 2012. Published by Oxford University Press. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.