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FRM Part II · FRM Exam Part II · Volatility Smiles and Volatility Surfaces

A portfolio manager holds an equity index fund and buys out-of-the-money puts for protection. After a market crash in 1987, which change in market behavior is generally cited as the origin of the pronounced skew in equity index options?

After the 1987 crash, market participants began pricing in the possibility of large downward moves, increasing demand for out-of-the-money puts and raising their implied volatilities. This so-called crashophobia created the pronounced downward skew seen in equity index options ever since.

  1. ATraders began to price the possibility of crashes, raising demand for out-of-the-money puts and their implied volatilitiesCorrect
  2. BRegulators capped implied volatilities on put options
  3. CDealers began using Black-Scholes for the first time, lowering call prices
  4. DIndex volatility became constant across all strikes

Explanation

Before 1987 the equity smile was close to flat. Afterward, crashophobia and demand for portfolio insurance puts raised the implied volatility of low strikes. The other options do not describe a real market change.

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