Chapter 20

Volatility Smiles
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Graph

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What is a Volatility Smile?
• A plot of the implied volatility of an option with a
certain life as a function of its strike price [with
the same underlying asset and the expiration
date] is known as a volatility smile.
• The shape of the relationship looks like a
smiling mouth and hence the name volatility
smile.

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 Implied Volatility and Volatility Smile
• The implied volatility of a European call option
is the same as that of a European put option
when they have the same strike price and time
to maturity. Loading…
• This means the volatility smile for European
call options with a certain maturity is the same
as that for European put options with the same
maturity
• The same is at least approximately true for
American options
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• The shape of the volatility smile reveals that implied
volatility is relatively low for ATM options, and it rises
when the option is out of the money (OTM) or in the
money (ITM).

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Why the Volatility Smile is the Same for
European Calls and Put
• Since, implied volatility of a European call option is
the same as that of a European put option when
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they have the same strike price and time to maturity,
the volatility smiles for European call and put with a
certain maturity also the same.
• As such when talking about a volatility smile we do
not have to worry about whether the options are
calls or puts.

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Volatility Smile is the Same for European
Call and Put ……..
• Put-call parity provides a relationship between the prices
of European call and put options when they have the
same strike price and time to maturity
p + S0 = c +K e–rT
• With a dividend yield on the underlying asset at a rate of
q, the relationship is
p + S0e−qT = c +K e–rT
• Key feature of put-call parity relationship is that it is based on a
simple no-arbitrage argument
• Does not require any assumption about the probability distribution
of the asset price in the future, when it is lognormal and when it is
not lognormal. It is true for both.
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• Suppose that, for a particular value of the volatility, pBS
and cBS are the values of European put and call options
calculated using the Black–Scholes–Merton model.
• Suppose further that pmkt and cmkt are the market
values of these options.
• Because, put–call parity holds for the Black–Scholes–
Merton model, we must have
pBS + S0e−qT = cBS +K e–rT
• Put-call parity also holds for market prices (pmkt and
cmkt) in the absence of no-arbitrage, so that
pmkt + S0e−qT = cmkt +K e–rT
• Subtracting these two equations, we get
pmkt− pbs=cmkt− cbs
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• When pbs = pmkt, it must be true that cbs = cmkt
• This shows that the pricing error when the Black–
Scholes–Merton model is used to price a European put
option should be exactly the same as the pricing error
when it is used to price a European call option with the
same strike price and time to maturity.
• Suppose that the implied volatility of the put option is
22%. This means that pBS = pmkt when a volatility of
22% is used in the Black–Scholes–Merton model.
• It also follows that cBS = cmkt when this volatility is used.
The implied volatility of the call is, therefore, also 22%.

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• Thus, the implied volatility of a European call option is
always the same as the implied volatility of a European
put option when the two have the same strike price and
maturity date.
• This means that the volatility smile is also the same for
both calls and puts.
• It also means, that the volatility term structure (that is the
relationship between implied volatility and maturity for a
particular strike price) is the same for calls and puts.
• It also means that the volatility surface (i.e., the implied
volatility as a function of strike price and time to maturity)
is the same for European calls and European puts.

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Foreign Currency Options
• The volatility smile used by traders to price foreign
currency options has the general form as the Figure
below (Figure 20.1)

• It is generally U-shaped.

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• This pattern for the implied volatility of currency
options shows that IV is relatively low for at-the-
money options (ATM)
• IV becomes progressively higher as an option
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moves either into (deep) in-the-money (ITM) or
(deep)-out-of-the-money (OTM) options.
• The volatility smile shape depicted in Figure 20.1
corresponds to the implied distribution shown by
the solid line (red coloured) in Figure 20.2 below.

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Implied and Lognormal Distribution for
Foreign Currency Options.

Implie
d
Lognormal
Lognorma Implied
l
Heavier tail Heavier tail

K1 K2

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 Properties of Implied Distribution for
Foreign Currency Options
• The implied probability distribution for a foreign
currency option has heavier tails (both) than the
lognormal probability distribution (known as
kurtosis)
• It is also more peaked than the lognormal
distribution as assumed by the BSM model.

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Lognormal Distribution of an Asset Price
• For an asset price to have a lognormal
distribution as assumed by the BSM model, the
following two conditions are to be satisfied
• The volatility of the asset is constant
• The price of the asset changes smoothly with no
jumps.

• In practice, neither of these two conditions is

satisfied for an exchange rate.

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• Exchange rate changes are not lognormally
distributed because-
• It exhibits jumps rather than continuous changes
• Volatility of exchange rate is stochastic

• Both small and large movements in the exchange rate

are more likely to happen than with the lognormal
distribution.
• As such the volatility of an exchange rate is not
constant.
• Exchange rates frequently exhibit jumps.
• The jumps sometimes could be the responses to the
actions of central banks.
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Equity Options’ Volatility Pattern
• The volatility pattern for equity option is different
from the volatility pattern for currency option.
• The pattern is usually more of a “skew/smirk”
than a smile (half-smile, ). This is sometimes
referred to as a volatility skew/smirk
• Volatility pattern used by traders to price equity
options (both on individual stocks and on stock
indices) has the general form as shown in
Figure 20.3.

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The Volatility Smile for Equity
Options (Figure 20.3)
I
m
pl
ie
d
v
ol
at K/S
ili 1.0 0
ty

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• The volatility pattern for equity options tends to be
downward sloping.
• This indicates that out-of-the-money (OTM) puts and in-
the-money calls (ITM) have higher implied volatilities
while out-of-the-money (OTM) calls and in-the-money
puts (ITM) have lower implied volatilities (See the figure
below).

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Implied and Lognormal Distribution
for Equity Options (Figure 20.4)

Implied

Lognormal
Lognormal Implied

Heavier left Less heavy right tail

tail than lognormal

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• The volatility smile for equity options corresponds to the
implied probability distribution given by the solid line in
Figure 20.4
• The half-smile volatility pattern suggests the existence of
a left-skewed implied probability distribution of equity
price changes.
• This implies that traders believe the probability of large
down movements in price is greater than large up
movements in price, as compared with a lognormal
distribution.

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Properties of Implied Distribution for
Equity Options
• The left tail is heavier than the lognormal
distribution

• The right tail is less heavy than the lognormal

distribution

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 Reasons for the shape of the Volatility
Smile in Equity Options
• There is a negative correlation between equity prices and
volatility
• As prices move down (up), volatilities tend to move up
(down).
• There are several possible reasons for this.
• Two of the main reasons (that explain the shape of the
volatility smile for equity options) are:
• Capital structure leverage
• Volatility feedback effect

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 • Capital Structure Leverage
• An increase in a company’s equity price results in a decrease of
company’s leverage, which means the company’s equity
becomes less risky. This lowers the volatility.

• The opposite happens if the company’s equity price decreases.

• Thus, it is expected that the volatility of equity is a

decreasing function of the stock price

• Volatility feedback effect.

• As volatility increases (decreases) because of external factors,
investors require a higher (lower) return and as a result the stock
price declines (increases)

• A further explanation is crash-o-phobia.

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 Other Volatility Smiles
• What is the volatility smile if
• True (implied) distribution has a less heavy left tail
and heavier right tail than those of the lognormal
distribution?
• True (implied) distribution has both a less heavy left
tail and a less heavy right tail than those of the
lognormal distribution?

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Volatility Term Structure (VTS)
• In addition to a volatility smile, traders also use a volatility
term structure when pricing option.
• Traders allow the implied volatility to depend on time to
maturity
• VTS is a curve depicting the differing implied volatilities
of options with the same strike price but different
maturities of the options.
• By looking at the term structure of IV, traders are able to
come up with a better expectation of whether an option
expiring at a certain time will rise or fall in the future.

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• A rising term structure means that the IV of long
term options is higher than that of short term
options.
• In these circumstances, trader would expect
short term IV to rise.
• Conversely, a falling term structure means that
the IV of long term options is lower than that of
short term options.
• In these circumstances, trader/investor would
expect short term IV to fall.

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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
• Volatility surfaces combine volatility smiles with
the volatility term structure to tabulate the
volatilities appropriate for pricing an option with
any strike price and any maturity.
• An example of a volatility surface that might be
used for foreign currency options is given in
Table 20.2 below.
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Example of a Volatility Surface
(Table 20.2, page 438)
K/S0
0.90 0.95 1.00 1.05 1.10

1 month 14.2 13.0 12.0 13.1 14.5

3 month 14.0 13.0 12.0 13.1 14.2

6 month 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

One dimension of Table 20.2 is K/S0; the other is time to maturity. The main
body of the table shows implied volatilities calculated from the BSM model.
The IV for these options are calculated directly from their market prices.
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• When a new option has to be valued, financial
engineers look up the appropriate volatility in the
table.
• For example, when valuing a 9-month option with a
K/S0 ratio of 1.05, a financial engineer would
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interpolate (linear) between 13.4 and 14.0 in Table
20.2 to obtain a volatility of 13.7% which would be
used in BSM formula.
• When valuing a 1.5-year option with a K/S0 ratio of
0.925, a two-dimensional (bilinear) interpolation
would be used to give an implied volatility of
14.525% and so on.
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Volatility Smiles When a Single Large Jump
is Expected/Anticipated
• An unusual volatility smile might arise in equity
markets
• Suppose that a stock price is currently $50 and an
important news announcement due in a few days is
expected either to increase the stock price by $8 or
to reduce it by $8. (This announcement could
concern the outcome of a takeover attempt or the
verdict in an important lawsuit or any other forms)

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• The probability distribution of the stock price in,
say, 1 month might then consist of a mixture of
two lognormal distributions, the first
corresponding to favorable news and the second
to unfavorable news (assuming that favourable
news and unfavourable news are equally likely).

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True distribution

Lognormal
distribution

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• The true probability distribution is bimodal (certainly not
lognormal).
• An extreme case where there are only two possible
future stock prices the distribution is binomial.
• In this case options can be valued using binomial model
(Chapter 13).
Figure 20.6 Change in stock price in 1 month

$58

So =
$50 $42

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•

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Table 20.3 Implied volatilities in situation where
true distribution is binomial (valuing a range of
different options
Strike price $
between strike
Call price $
price $42
Put price $
or $58)
Implied
volatility (%)
42 8.42 0 0
44 7.37 0.93 58.8
46 6.31 1.86 66.6
48 5.26 2.78 69.5
50 4.21 3.71 69.2
52 3.16 4.64 66.1
54 2.10 5.57 60.0
56 1.05 6.50 49.0
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• When a single large jump in stock price is
anticipated, then the volatility smile shape will
look like the opposite of that observed for
currency options (Table 20.3 & Figure 20.7)
• In this case, at the money implied volatilities
are higher than in-the-money or out-of-the-
money options (so that the smile is actually a
‘frown’)

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Figure 20.7 Shape of volatility smile when there is a
large single jump in stock price (Refer to Table 20.3)

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