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

In the foreign currency option market, volatility smiles are often quoted as a function of delta rather than strike. What is the main practical advantage of this approach?

Quoting the smile by delta keeps moneyness roughly constant as spot moves, so quotes such as 25-delta volatility can be compared across dates and market levels. It does not make the smile symmetric, remove model dependence, or eliminate interest rate effects.

  1. AIt guarantees the smile is perfectly symmetric
  2. BIt removes the need for a pricing model
  3. CIt allows the smile to be compared across time and spot levels, since a given delta corresponds to a similar degree of moneyness as the exchange rate movesCorrect
  4. DIt eliminates the effect of interest rate differentials on pricing

Explanation

Quoting by delta keeps the option's relative moneyness roughly stable as spot moves, so the smile for, say, 25-delta options is comparable over time. It does not guarantee symmetry or remove the need for a model, since implied volatility itself comes from a model.

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