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

A portfolio manager says the equity skew steepened sharply after a market sell-off even though at-the-money implied volatility rose only slightly. Which explanation is most consistent with commonly cited reasons for the equity skew?

The steeper skew is best explained by greater demand for out-of-the-money puts as downside protection, together with the leverage effect, where falling stock prices increase firm leverage and hence volatility. Both push low-strike implied volatility up relative to at-the-money levels.

  1. AInvestors increased demand for out-of-the-money puts as portfolio protection, and leverage effects raise volatility when prices fallCorrect
  2. BDealers sold large volumes of out-of-the-money puts, depressing their prices
  3. CStock returns became more normally distributed, reducing tail risk
  4. DInterest rates fell, which mechanically raises implied volatility at high strikes

Explanation

Commonly cited explanations are crashophobia (demand for downside protection) and the leverage effect, where falling equity prices raise leverage and volatility. Selling puts would lower, not raise, low-strike implied volatility, and more normal returns would flatten the skew.

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