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FRM Part I · FRM Exam Part I · Measuring and Monitoring Volatility

Which statement about implied volatility versus historical volatility is correct?

Implied volatility is the volatility value that equates a model option price to the observed market price, so it reflects the market's expectation of future volatility. Historical volatility is calculated from past returns and is backward-looking. Neither is systematically always higher or lower than the other.

  1. AImplied volatility is backed out of observed option prices using a pricing model and reflects market expectations of future volatilityCorrect
  2. BImplied volatility is computed directly from past daily returns using the sample standard deviation
  3. CHistorical volatility is derived from option prices and is forward-looking
  4. DImplied volatility is always lower than historical volatility because of risk neutrality

Explanation

Implied volatility is the volatility input that makes a model price (e.g., Black-Scholes-Merton) equal the market option price, so it is forward-looking. Historical volatility is computed from past returns. The claim that implied is always lower is false; it often exceeds realized volatility.

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