Volatility Smirk

[rahul.goyl]

Hi david,

Could you please help with this one on Volatility Smirk.

Equity options tend to exhibit volatility smirk where low strike price options have a higher implied volatility than high strike price options. An explanation that has not been used for the smirk pattern is

a) Heteroskedasticity in the underlying
b) A higher proportion of debt in the capital structure as equity prices fall.
c) Less firm leverage as equity prices rises.
d) The threat of another market crash

Thanks
Rahul

 

[David Harper CFA FRM]

Hi Rahul,

Please see http://forum.bionicturtle.com/viewthread/1673/

... so the correct, following Hull is (d) because of "crashophia"
... and (b) because, says Hull, "as leverage increases ... equity becomes riskier and volatility increases"

(I have an issue with his view that this is consistent with the volatility smirk. Specifically, the smirk shows higher volatility for ITM call options -- i.e., lower strike prices -- which would *appear* to correspond to lower leverage companies...I have not been able to resolve ... but i don't think it matters as Hull's reasons are clearly 1. crashophobia and 2. higher leverage)

David

 

[rahul.goyl]

Hi David,
The answer for the above is A, the question asked about
An explanation that has not been used for the smirk pattern. I think that is the catch in the question, so accordingly Heteroskedasticity is probable option.
Rest all 3 option are correct & have been observed in market, I checked this with fellow student.


Regards,
Rahul

 

[David Harper CFA FRM]

Hi Rahul,

Oh ... I mis-read the question and missed the "not" ... I was saying that Hull does give (d) and (b)...Yes, I agree, the other 3 have been offerred as explains (even though b and c are in conflict, both have been offerred as explains for the smirk)

David