Session-7

Volatility Smile
 What is a Volatility Smile?
• It is the relationship between implied
volatility and strike price for options with a
certain maturity
• The volatility smile for European call
options should be exactly the same as that
for European put options
• The same is at least approximately true for
American options

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Q: What is implied volatility?
• Implied volatility represents the expected volatility of a
stock over the life of the option. As expectations
change, option premiums react appropriately. Implied
volatility is directly influenced by the supply and
demand of the underlying options and by the
market's expectation of the share price's direction.
Q: What is historical volatility?
✓ Historical volatility is the annualized standard
deviation of past stock price movements. It measures
the daily price changes in the stock over the past year.

• Implied volatility represents the current market price

for volatility, or the fair value of volatility based on the
market's expectation for movement over a defined
period of time. Realized volatility, on the other hand, is
the actual movement that occurs in a given underlying
over a defined past period.
Source: Bloomberg
Estimation of Realized and Implied
Volatility

Let n be the number of trading days before the expiration of an option, Si be the index
level, and Ri be the log-return on the ith day during the remaining life of the option. Then,
realized volatility is defined as follows:
 Why the Volatility Smile is the
Same for European Calls and Put
• Put-call parity p + S0e−qT = c +K e–rT holds for market
prices (pmkt and cmkt) and for Black-Scholes-Merton prices
(pbs and cbs)
• As a result, pmkt− pbs=cmkt− cbs
• Under no arbitrage condition
• When pbs = pmkt, it must be true that cbs = cmkt
• It follows that the implied volatility calculated from a
European call option should be the same as that
calculated from a European put option when both have
the same strike price and maturity

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Example
The market price of a European call is $3.00 and
its price given by Black-Scholes-Merton model
with a volatility of 30% is $3.50. The price given
by this Black-Scholes-Merton model for a
European put option with the same strike price
and time to maturity is $1.00. What should the
market price of the put option be?.
Solution:
Example
A European call option on a certain stock has a
strike price of $30, a time to maturity of one year,
and an implied volatility of 30%. A European put
option on the same stock has a strike price of $30, a
time to maturity of one year, and an implied
volatility of 33%. What is the arbitrage opportunity
open to a trader? Does the arbitrage work only
when the lognormal assumption underlying Black–
Scholes–Merton holds? Explain carefully the
reasons for your answer.
Solution
• Put–call parity implies that European put and
call options have the same implied volatility. If a
call option has an implied volatility of 30% and a
put option has an implied volatility of 33%, the
call is priced too low relative to the put. The
correct trading strategy is to buy the call, sell the
put and short the stock.
• This does not depend on the lognormal
assumption underlying Black–Scholes–Merton.
Put–call parity is true for any set of assumptions.
Example:
Suppose that the result of a major lawsuit affecting a
company is due to be announced tomorrow. The
company’s stock price is currently $60. If the ruling is
favorable to the company, the stock price is expected to
jump to $75. If it is unfavorable, the stock is expected to
jump to $50. What is the risk-neutral probability of a
favorable ruling? Assume that the volatility of the
company’s stock will be 25% for six months after the
ruling if the ruling is favorable and 40% if it is
unfavorable. Calculate the relationship between implied
volatility and strike price for six-month European options
on the company today. The company does not pay
dividends. Assume that the six-month risk-free rate is 6%.
Consider call options with strike prices of $30, $40, $50,
$60, $70, and $80.
The Volatility Smile for Foreign
Currency Options

1. The implied volatility is relatively low for at-the-money options

2. It becomes progressively higher as an option moves either into the money or out
of the money 12
The Volatility Smile for Equity Options
A more common skew pattern is the reverse skew or volatility smirk. The
reverse skew pattern typically appears for longer term equity options and
index options.

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Continue…
• In the reverse skew pattern, the IV for options at the lower
strikes are higher than the IV at higher strikes. The reverse
skew pattern suggests that in-the-money calls and out-of-
the-money puts are more expensive compared to out-of-
the-money calls and in-the-money puts.
• The popular explanation for the manifestation of the
reverse volatility skew is that investors are generally
worried about market crashes and buy puts for protection.
One piece of evidence supporting this argument is the fact
that the reverse skew did not show up for equity options
until after the Crash of 1987.
• Another possible explanation is that in-the-money calls
have become popular alternatives to outright stock
purchases as they offer leverage and hence increased ROI.
This leads to greater demands for in-the-money calls and
therefore increased IV at the lower strikes.
Forward Skew
In the forward skew pattern, the IV for options at the lower
strikes are lower than the IV at higher strikes. This suggests
that out-of-the-money calls and in-the-money puts are in
greater demand compared to in-the-money calls and out-of-
the-money puts.

The forward skew

pattern is common for
options in the
commodities market.
When supply is tight,
businesses would rather
pay more to secure
supply than to risk
supply disruption.
Q: A foreign currency is valued at $200.71. The
foreign currency has a European call option
market price of $13.55 and a strike price of
$225. In the US, the risk-free interest rate is 4%
per annum and 7% per annum in the foreign
country. Determine the price of a European put
option with a 1-year maturity for the foreign
currency.
A.$14.68
B.$13.55
C.$42.59
D.$15.48
Ways of Characterizing the Volatility
Smiles

• Plot implied volatility against K S0

• Plot implied volatility against K F0
– Note: traders frequently define an option as at-the-money when
K equals the forward price, F0, not when it equals the spot price
S0
• Plot implied volatility against delta of the option
– Note: traders sometimes define at-the money as a call with a
delta of 0.5 or a put with a delta of −0.5. These are referred to as
“50-delta options”

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 Volatility Surface
• The implied volatility as a function of the
strike price and time to maturity is known
as a volatility surface

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Example of a Volatility Surface

K/S0
0.90 0.95 1.00 1.05 1.10

1 mnth 14.2 13.0 12.0 13.1 14.5

3 mnth 14.0 13.0 12.0 13.1 14.2

6 mnth 14.1 13.3 12.5 13.4 14.3

1 year 14.7 14.0 13.5 14.0 14.8

2 year 15.0 14.4 14.0 14.5 15.1

5 year 14.8 14.6 14.4 14.7 15.0

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Long Straddle
Strategy Suggestions
Options Greeks of a Long Straddle
Short Straddle
Continue….
Disclaimer: The content given in the slides have been collected from Corporate Finance by Ross,
Westerfield, Jaffe, Jordan and Kakani (11Ed.) McGrawHill Education, Financial Management: Theory and
Practice by Brigham et al., Cengage Publication., and Risk Management and Financial Institutions by
J.C.Hull (4th Ed.) Wiley and various websites such as clear tax, money control, economic times, zerodha,
Flyers.in etc. This is pure prepared for the classroom discussions at BITS Pilani.