Implied volatility is essentially an output from Black-Scholes model when it is matched with the existing option price. Implied volatility also implies that the differences of distribution used in Black-Scholes model (but that's not important in this question).
Here comes the questions:
- Since the model is relying on the same underlying asset, thus it must have the same underlying volatility. So, IF the model is right, i.e. all assumptions of the model are correct, it will return a flat volatility surface. No smile, no skew, no curvature implied by the volatility term structure? The Figure 1 will be plain flat like a flat paper.
- After going through some texts related to volatility surfaces and some article on advancement in option pricing, I have noticed that the authors are comparing the model's implied volatility surface to the implied volatility in the first figure in this thread, i.e. comparing the if the model fits the empirical implied volatility surface. My question is this: shouldn't the authors attempt to obtain a flat volatility surface such as describe in the first question, since it'll indicate that the model is consistent with the market prices? I am definitely missing something here :(
- Another confusion that might be cleared if I understand the first 2 questions (idk?) is the way of fitting an option pricing model. For example, to fit the Heston model, we normally extract the empirical prices from the market itself and use some algorithms to minimize the errors from the model to obtain the required parameters. From here we can compare the models by comparing the volatility surfaces that it had generated from the Heston model vs the empirical volatility surfaces generated from Black Scholes. Since Heston model is a stochastic volatility model, by definition of it, shouldn't the volatility can't be attained from its model. A similar question is from Confusion with volatility smiles implied by different models . I don't understand one of the answer that says:
In the context of option pricing, "implied volatility" always refers to the equivalent diffusion coefficient in the geometric Brownian motion (GBM) dynamics that is necessary to match an observed European plain vanilla price for a given strike and maturity.
You choose some pricing model such as the ones mentioned in your question. You fix the model's parameters. Under the given model dynamics and parameters you value European plain vanilla option prices for all strikes of the maturity of interest. Finally, you then treat these model prices as the observed inputs to your implied volatility computation. I.e. you compute the equivalent GBM volatility such that the previously computed model prices are matched.
Here's a page from "The volatility surface, A Practitioner's Guide by Jim Gatheral" to illustrate my 2nd question
Can someone please clear my confusions on these several questions. I will be much appreciated in any effort or attempt to clear my confusion on this topic :(