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NISM Certifications · NISM-Series-X-A: Investment Adviser (Level 1) · Understanding Derivatives

Which of the following best describes the effect of a rise in implied volatility, other factors unchanged, on the premium of options?

A rise in volatility tends to increase the premiums of both call and put options. Greater expected price swings raise the probability of the option ending in the money, which increases time value for both, while the buyer's loss remains limited to the premium.

  1. APremiums of both calls and puts tend to increaseCorrect
  2. BPremiums of calls increase while puts decrease
  3. CPremiums of both calls and puts tend to decrease
  4. DPremiums are unaffected because only intrinsic value matters

Explanation

Higher volatility raises the chance of large price moves, increasing the time value of both calls and puts. Options have limited downside for buyers but open upside, so greater uncertainty is valued. Hence the call-up, put-down view is incorrect.

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