On implied volatility for options-Some reasons to smile and more to correct

We analyze the properties of the implied volatility, the commonly used volatility estimator by direct option price inversion. It is found that the implied volatility is subject to a systematic bias in the presence of pricing errors, which makes it inconsistent to the underlying volatility. We propose an estimator of the underlying volatility by first estimating nonparametrically the option price function, followed by inverting the nonparametrically estimated price. It is shown that the approach removes the adverse impacts of the pricing errors and produces a consistent volatility estimator for a wide range of option price models. We demonstrate the effectiveness of the proposed approach by numerical simulation and empirical analysis on S&P 500 option data.