Part II

The Volatility Surface

FX derivatives trading desks maintain volatility surfaces in all tradable currency pairs in order to determine the implied volatility for vanilla options with any expiry date and strike. It is therefore important that traders understand details about how volatility surfaces are constructed since it is a vital part of all FX derivatives valuation.

Fundamentally, a volatility surface is constructed along two axes: maturity and strike. The ATM curve forms the backbone of the volatility surface along different expiry dates and the volatility smile defines the implied volatility for strikes away from the ATM strike. Volatility surface construction is usually split into these two separate considerations.