Stochastic volatility index (SVI) modeling provides a surface that defines implied volatility across various strike prices and expiration dates. This surface is generated using a parametric model, allowing for a smooth representation of volatility and facilitating the pricing and hedging of complex derivatives. For instance, given a set of observed option prices, the SVI model can be calibrated to determine the parameters that best fit the market data, allowing for the extraction of implied volatilities at any strike and maturity.
Accurate modeling of the volatility surface is crucial for risk management and option pricing. Traditional methods often struggle to capture the complexities of market dynamics, leading to mispricing and potential losses. The parametric nature of this approach offers a robust and efficient solution, contributing to more accurate valuations and improved hedging strategies. Initially developed in the early 2010s, it has rapidly gained popularity in financial markets due to its effectiveness and flexibility.