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

A risk analyst observes that implied volatilities for equity index options decline steadily as the strike price rises from well below to well above the current index level. Which description best fits this pattern in the equity index market?

The pattern is a volatility skew, or smirk, where implied volatility is highest for low strikes and falls as strike rises. This is the usual shape for equity index options, reflecting strong demand for downside protection and fear of crashes.

  1. AA volatility skew (or smirk), with higher implied volatility for low strikesCorrect
  2. BA symmetric smile with equal implied volatility for both deep in-the-money and out-of-the-money calls
  3. CA reverse skew with higher implied volatility for high strikes
  4. DA flat surface consistent with Black-Scholes-Merton assumptions

Explanation

Equity index options typically show implied volatility that decreases as strike increases, a downward-sloping skew or smirk. Low-strike puts are priced with higher implied volatility. A reverse skew is typical of some commodity or currency situations, not equity indices.

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