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

Which explanation for the equity volatility skew is most consistent with the leverage effect?

The leverage effect says that when equity value falls, financial leverage rises, so equity becomes riskier and more volatile. Volatility therefore rises as prices fall, producing higher implied volatility for low strikes and the downward-sloping equity skew.

  1. AWhen a firm's equity value falls, its debt-to-equity ratio rises, making equity more volatileCorrect
  2. BWhen equity prices rise, firms issue more debt, lowering equity volatility
  3. CEquity returns are negatively skewed because dividends reduce prices on ex-dates
  4. DIndex options are in lower demand than single-stock options

Explanation

A fall in equity value raises leverage, so equity volatility increases as prices drop. This produces a negative relationship between price and volatility, which generates a downward-sloping skew. Option B describes the wrong direction of the effect and is not the leverage argument.

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