Volatility
Market Volatility
• Volatility is change in return from market price movements over time
• Volatility is measured as the standard deviation of the continuously
compounded rate of return in 1 year
• The standard deviation of the return in time Dt is
• Volatility varies across market trading times (higher at market
opening and lower at market close)
• Volatility hence is measured in trading days and not based on
calendar days when options are valued
Determinants of Option Premium
• Striking price
• Time until expiration
• Stock price
• Volatility
• Dividends
• Risk-free interest rate
Determinants of Option Premium
• Strike Price
• The lower (higher) the striking price, the more the call (put) option is worth
• Call (put) option lets the holder buy (sell) at a predetermined striking price
• Time to Expiry
• The longer the time until expiration, the more the option is worth
• The option premium increases for more distant expirations for puts and calls
• Stock Price
• The higher (lower) the stock price, the more a call (put) option is worth
• Call (put) option holder benefits from a rise (fall) in the stock price
Determinants of Option Premium
• Risk Free Interest Rate
• Higher the risk-free interest rate, higher the option premium.
• Higher discount rate implies that the premium must rise for the put/call
parity equation to hold
• Volatility
• Greater the price volatility, the more the option is worth
• Implied volatility cannot be directly observed and must be estimated
• Volatility is a determent of time value
• Dividends
• Dividend payment will result in a lesser option premium
• Listed options do not adjust for dividends and stock price falls on ex-
dividend date
Black-Scholes Model
• Valuation equation has two parts
• One gives a (pseudo-probability) weighted expected stock price (an inflow)
• One gives the time-value of money adjusted expected payment at exercise (an outflow)
Cash Inflow Cash Outflow
• The value of a call option is the difference between the expected benefit from acquiring
the stock outright and paying the exercise price on expiration day
• Two different option premiums are not comparable
• Options have different degrees of moneyness (strike price difference)
• A more distant expiration implies more time value
• The levels of the stock prices are different
Implied Volatility
• Volatility from a past series of prices is historical volatility
• Implied volatility gives an estimate of what the market perceives
about likely volatility in the future
• Relation between the standard deviation of returns (over the past)
and the current implied volatility
• Current level of implied volatility contains both an ex-post component
based on actual past volatility and an ex-ante component based on
the market’s forecast of future variance
• Volatility that equates the Black-Scholes price to the market price
Implied Volatility
• Instead of solving for the call premium, assume the market-
determined call premium is correct
• Solve for the volatility that makes the equation hold good
• Sigma (implied volatility) cannot be isolated in the BSOPM
• Solve for sigma using trial and error
• For at-the-money call, the correct value of implied volatility is:
Reference: Options, Futures and Other Derivatives: John C.Hull, Pearson, 2022.
Option Volatility (Moneyness)
Implied volatilities of Call and Put Options
• When Put-call parity p +S0e-qT = c +K e–r T holds for the Black-Scholes
model,
pBS +S0e-qT = cBS +K e–r T
it also holds for the market prices
pmkt +S0e-qT = cmkt +K e–r T
subtracting these two equations,
pBS － pmkt = cBS － cmkt
• It shows that the implied volatility of a European call option is always
the same as the implied volatility of European put option when both
have the same strike price and maturity date
Implied Volatility: Example
• Value of the Australian dollar: USD 0.74(S )
0
• Risk-free interest rate in America (per annum):2%
• Risk-free interest rate in Australia (per annum):8%
• Market price of European call option on the AUD with a maturity of 1 year
and a strike price of USD 0.70 is 0.0909. Implied volatility of the call is 35%
• European put option with a strike price of USD 0.7 and maturity of 1 year
will be:
p +0.740e-0.02x1 = 0.0909 +0.70e-0.08x 1
p=USD 0.0936 , implied volatility is 35%
Exchange Rate Call / Put Option
USD / EUR (1 Day)
6.40%
6.30%
Implied Volatility
6.20%
6.10%
6.00%
5.90%
1.154 1.155 1.156 1.157 1.158 1.159 1.16 1.161
Strike Price
Volatility Smiles
• Volatility smiles are in contradiction
to the BSOPM, which assumes
constant volatility across all strike Implied
prices volatility
• A plot of implied volatility against
striking prices often looks like a smile
• It is the relationship between
implied volatility and strike price for
options with similar maturity Strike price
Variation in Standard Deviation
Standard Deviation Standard Log normal • Percentage of
days when
(Expected) returns daily
Returns exchange
rate moves
> 1 standard deviation 25.04 31.7 are greater
> 2 standard deviation 5.27 4.55 than one,
two,… ,six
> 3 standard deviation 1.35 0.27 standard
> 4 standard deviation 0.30 0.01 deviations
(Standard
> 5 standard deviation 0.08 0.00 deviation of
daily change)
> 6 standard deviation 0.03 0.00
Log Normal Return Assumptions
• Conditions for an asset
price to have a
lognormal distribution:
σ(USD/AUD)
• Volatility of the
Lognormal
asset is constant
• Price of the asset
changes smoothly
with no jump
K1 K2 S(USD/AUD)
Implied Vs. Lognormal
Implied Implied
volatility
σ(USD/AUD)
Lognormal
Strike
K1 K2 s(USD/AUD)
Shift in Price (Sudden Jumps)
• Equity price variations may be
True Distribution
based on favorable or unfavorable
Log
information on the stock. normal
• Probability distribution of the stock
price might consist of the
expectation from favorable
information and unfavorable Stock price
information.
• Lognormal distribution might
exhibit this scenario as a mix of
both probabilities.
Implied Volatility
0
0.1
0.3
0.4
0.5
0.2
15150
15350
15550
15750
15950
16150
16350
16550
16750
16950
17150
17350
Nifty Index Volatility Smile
ATM 18447
17550
Strike Price
17750
17950
18150
18350
18550
ATM
18750
18950
19150
19350
19550
19750
Binomial Model Pricing
• Assume the risk-free rate
is 12% per annum. 58
• Options valued with
binomial model
parameters u=1.16,
d=0.85, t=0.05, and 50
p=0.4821
42
Binomial Model (Equity Stock)
Implied Volatility
80
70
Implied Volatility
60
50
40
30
20
10
0
44 46 48 50 52 54 56
Strike Price
Market Implications
• Traders use a volatility term structure when pricing options besides “smile”
• Volatility used to price an at-the-money option depends on the maturity of
the option
• Volatility surfaces combine volatility smiles with the volatility term
structure to measure the volatilities appropriate for pricing an option with
any strike price and any maturity
• Shape of the volatility smile depends on the option maturity .
• Smile tends to become less pronounced as the option maturity increases
• Volatility smile in equity options is caused by leverage
• Crash phobia leads to volatility smile
Variations
Volatility Smile
• Plot implied volatility against 16
K/S0 (volatility smile is more
stable) 15
Standard Deviation
• Plot implied volatility against 14
K/F0(Traders usually define an 13
option as at-the-money when K 12
equals the forward price, F0, 11
not when it equals the spot
price S0) 10
0.9 0.95 1 1.05 1.1
• Plot implied volatility against K/S0
delta of the option (volatility
smile to be applied to non- 1 month 3 month 6 month 2 year 5 year
standard options)
Option Greeks & Volatility Smile
• Volatility smile complicates the calculation of option Greek
• Relationship between the implied volatility and K/S for an option with
a time to maturity remains the same (Assumption)
• Delta of a call:
• Where cBS is the Black-Scholes price of the option expressed as a function of the
asset price S and the implied volatility σimp
• Volatility is a decreasing function of K/S . Implied volatility increases
as the asset price increases Delta is higher than that given
by the Black-Scholes
assumptions
EUR /USD Options (1 day to Expiry)
Source: https://in.investing.com
EUR /USD Options (1 Month to Expiry)
Source: https://in.investing.com
