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

A trader finds that the implied volatility surface for a stock shows a much higher implied volatility for a 90-day option at one strike than the smooth surface fitted from neighbouring strikes and maturities would suggest. Which is the most appropriate first step before treating this as a mispricing opportunity?

The trader should first verify that the quote is current and tradable and check no-arbitrage conditions such as butterfly and calendar spreads. Outliers often come from stale prices or wide spreads, so confirming data quality is needed before concluding there is a genuine mispricing.

  1. ACheck that the quote is not stale or wide, and that it satisfies no-arbitrage conditions such as butterfly and calendar spread restrictionsCorrect
  2. BImmediately sell the option and buy the neighbouring options in equal notional
  3. CReplace the quote with the average implied volatility of all strikes
  4. DAssume the Black-Scholes model is correct and the quote is wrong

Explanation

An apparent outlier may reflect stale prices, wide bid-ask spreads, or illiquidity rather than true mispricing. Verifying data quality and testing no-arbitrage constraints comes first. Trading immediately ignores transaction costs and data error risk.

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