FRM Part II · FRM Exam Part II · Volatility Smiles and Volatility Surfaces
A risk analyst observes that implied volatilities for one-year options on an equity index fall steadily as the strike price rises from 80% to 120% of the current index level. Which description best fits this pattern?
Implied volatility falling as strike rises is a volatility smirk, or downward-sloping skew, which is the standard pattern for equity index options. Currency options usually show a symmetric smile, and Black-Scholes would imply a flat surface across strikes.
- AA volatility smirk (downward-sloping skew) typical of equity index optionsCorrect
- BA symmetric volatility smile typical of currency options
- CAn upward-sloping skew typical of commodity options
- DA flat volatility term structure consistent with Black-Scholes
Explanation
Implied volatility that declines as strike rises is the downward-sloping skew (smirk) seen in equity index options. A symmetric smile is typical of currencies. A flat surface would be implied by Black-Scholes, which is not what is observed.
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