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FRM Part I · FRM Exam Part I · Measuring Return, Volatility, and Correlation

A model-free variance estimate in the VIX methodology is built from out-of-the-money options. Which description of how the VIX-style calculation weights options at different strikes is correct?

Out-of-the-money options are weighted by the strike spacing divided by the squared strike, 1/K². This gives lower-strike options more weight per dollar of option price, and uses a wide strip of strikes rather than only at-the-money options or equal weights.

  1. AEach option is weighted equally across all strikes
  2. BOptions are weighted by the inverse of the squared strike, so low-strike options receive proportionally more weight per unit of price than high-strike options, scaled by strike spacingCorrect
  3. COptions are weighted by the square of the strike, so high-strike options dominate
  4. DOnly at-the-money options are used, weighted by their vega

Explanation

The VIX formula sums out-of-the-money put and call prices multiplied by the strike interval and divided by K squared (discounted). The 1/K² weighting gives low-strike puts relatively more influence per dollar of price. Equal weighting, K² weighting and ATM-only are not the method.

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