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

Short-dated at-the-money implied volatility for an equity index is 30% while long-dated at-the-money implied volatility is 20%. Current realized volatility is unusually high following a market shock. Which interpretation is most consistent with standard practice?

A downward-sloping term structure after a shock reflects mean reversion: current volatility is high relative to its long-run level, so the market expects it to fall, making long-dated implied volatility lower than short-dated implied volatility.

  1. AThe term structure is downward sloping because volatility is expected to revert toward its long-run meanCorrect
  2. BThe term structure is downward sloping because long-dated options are mispriced and should be bought
  3. CThe downward slope implies the Black-Scholes model assumes volatility rises over time
  4. DThe pattern indicates that long-dated options have higher strikes than short-dated options

Explanation

When current volatility is above its long-run level, implied volatility tends to decline with maturity because of mean reversion. It does not imply mispricing, and Black-Scholes assumes constant volatility, not rising volatility.

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