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

A risk analyst compares a stock's 30-day historical volatility of 18% with the implied volatility of its 30-day at-the-money options, which is 25%. Which statement best describes what the implied volatility represents?

Implied volatility is the volatility input that makes a pricing model such as Black-Scholes-Merton match the option's observed market price. It is forward-looking and market-derived, unlike historical or EWMA estimates, and it is not a guaranteed realized volatility.

  1. AThe volatility that, when input into an option pricing model, reproduces the observed market price of the optionCorrect
  2. BThe average of past daily returns scaled to an annual figure
  3. CThe volatility forecast produced by an EWMA model with lambda of 0.94
  4. DThe realized volatility that will definitely occur over the option's life

Explanation

Implied volatility is obtained by inverting an option pricing model such as Black-Scholes-Merton so that the model price equals the market price. It is forward-looking and reflects market expectations and risk premia, not a guaranteed outcome. Historical or EWMA measures use past returns only.

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