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

A risk manager observes that equity index implied volatility falls steadily as strike rises from 80% to 120% of spot. Which description of this smile and its likely interpretation is most accurate?

This is an equity-style volatility skew: implied volatility declines with strike because the market-implied distribution has a heavier left tail and thinner right tail than lognormal, making low-strike options relatively expensive.

  1. AA symmetric smile typical of currency options, reflecting equal fat tails on both sides
  2. BA volatility skew with a heavier left tail than lognormal, so low-strike options are priced with higher implied volatilityCorrect
  3. CA flat term structure showing the Black-Scholes assumptions hold
  4. DA reverse skew where high-strike calls carry the highest implied volatility, as for commodities

Explanation

Implied vol decreasing in strike is the equity skew: the implied distribution has a heavier left tail and thinner right tail than lognormal, so low-strike puts are expensive. Symmetric smiles are typical of currencies, and reversed skews of some commodities.

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