Skip to content

FRM Part I · FRM Exam Part I · Measuring and Monitoring Volatility

Across strike prices, options on an equity index show implied volatilities that are highest for low-strike out-of-the-money puts and decline as strike rises. A risk manager interprets this pattern relative to the Black-Scholes-Merton assumption of constant volatility. Which interpretation is most consistent with this volatility skew?

A skew with the highest implied volatility at low strikes indicates the market prices a fatter left tail than the lognormal distribution with constant volatility assumes. Investors pay more for downside protection, so large drops are assigned higher probability than Black-Scholes-Merton implies. It does not signal a breach of put-call parity.

  1. AThe market assigns a higher probability to large downward moves than a lognormal distribution with constant volatility impliesCorrect
  2. BThe market assigns a lower probability to large downward moves than a lognormal distribution implies
  3. CHistorical volatility must be higher for high-strike calls than for low-strike puts
  4. DThe skew shows that put-call parity has failed for European options on the index

Explanation

Higher implied volatility for low-strike puts means those options are priced richer than constant-volatility BSM would imply, signaling a fatter left tail than lognormal returns. This is consistent with crash fears and leverage effects. Put-call parity is unaffected, since it holds for the same strike and expiry regardless of the skew.

Did you get it right without looking?

One question tells you little. A timed set on Measuring and Monitoring Volatility shows your real accuracy, how long you take and where you lose marks.

Practise Measuring and Monitoring VolatilityFree diagnostic mock

More Measuring and Monitoring Volatility questions