CFA Level I · CFA Level I Exam · Pricing and Valuation of Options
An analyst observes that the market price of a European call option is higher than the price produced by an option pricing model using the analyst's historical volatility estimate. All other inputs are identical. The implied volatility of the call is most likely:
Implied volatility is most likely higher than the historical volatility. Option prices rise with volatility, so when the market price exceeds the model price built on historical volatility, a higher volatility input is needed for the model to reproduce the observed market price.
- Aequal to the historical volatility
- Blower than the historical volatility
- Chigher than the historical volatilityCorrect
Explanation
Option value increases with volatility. A market price above the model price means the model needs a higher volatility input to match the market price. Implied volatility is therefore higher than the historical estimate.
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