Modelling the implied volatility surface based on Shanghai 50ETF options

•We develop a dynamic factor model to forecast IVS.•Dynamic change of IVS is assumed to mean-reverting and Markovian.•We use a state space model to capture the dynamics of IVS.•We set the latent factors to be the Ornstein-Uhlenbeck processes.•We obtain the optimal estimations of parameters using the Kalman filter algorithm.

We develop a dynamic factor model to forecast the implied volatility surface (IVS) of Shanghai Stock Exchange 50ETF options. Based on the assumption that dynamic change in IVS is mean-reverting and Markovian, we use a state space model to capture the dynamics of IVS, and set the latent factors to be the Ornstein-Uhlenbeck processes. We obtain the optimal estimations of parameters using the Kalman filter algorithm. Empirical results show that our model performs better than the traditional IVS model in terms of fitting ability and prediction performance.