Volatility Smile

Definition

The Volatility Smile is a financial term that refers to a pattern seen in options markets where options with lower and higher strike prices tend to have higher implied volatility than those at-the-money. It is graphically depicted as a curve that turns upwards at each end, resembling a smile. The phrase was coined to describe the comparison between the implied volatilities and the discrepancy observed in the predictions of the Black-Scholes option pricing model.

Phonetic

The phonetic pronunciation of “Volatility Smile” is:/vɒləˈtɪlɪti smʌɪl/

Key Takeaways

1. Nature of the Volatility Smile: The volatility smile is a phenomenon observed in financial markets where implied volatility for options on a particular asset displays a pattern forming a curve that is similar to a smile. This pattern is typically seen when the implied volatilities are plotted against strike prices.

2. Implications of the Volatility Smile: The existence of a volatility smile suggests that the market is pricing in different risks for different strike prices, which is a departure from the basic assumption of the Black-Scholes-Merton option pricing model that implies volatility should be constant across different strike prices.

3. Significance of the Volatility Smile: The volatility smile is especially significant in the options markets because it can indicate investor sentiment. Higher implied volatilities at lower and higher strike prices could mean that investors are anticipating a larger price move in the underlying asset, signaling a more uncertain or volatile market.

Importance

The Volatility Smile is a crucial concept in finance that plays a significant role in options pricing, portfolio management and risk assessment. It is a pattern that arises when plotting the implied volatilities of options across various strike prices, showing a curve or “smile” effect. This pattern contradicts the assumption about the constant volatility of options under the Black-Scholes model. The Volatility Smile is important as it indicates the market’s expectation of a security’s future volatility and the extent of unpredictability observed. This understanding helps traders and financial professionals to adjust their investment strategies, effectively price options, and manage risk, thus fostering efficient financial planning and decision-making.

Explanation

Volatility smile is a key tool used extensively in different areas of finance, particularly in options pricing, hedging, and risk management. Its main purpose is to reflect the variations in expected volatility across options with different strike prices. By presenting these volatilities graphically, the resultant curve forms a smirk or ‘smile’ , hence, the term ‘volatility smile’. The pattern helps traders and risk managers to understand the market’s behavior and expectations of the underlying asset’s price, and allows them to adapt their strategies accordingly.In the realm of finance, the volatility smile is commonly used to uncover potential pricing inefficiencies in the market. It plays a significant role in pricing financial derivatives such as options, where the implied volatility — a measure of how much the markets expect the asset’s price to move — is mapped against various strike prices. The resulting ‘smile’ helps traders to price options more accurately and also drive profitable arbitrage opportunities. Therefore, understanding and knowing how to interpret the volatility smile is of critical importance to options traders and other financial market participants.

Examples

1. Crash of 1987: One of the most famous examples of the volatility smile can be found in the aftermath of the 1987 market crash. Prior to the crash, options markets typically displayed a volatility skew. However, after the crash, this pattern became more of a smile, with the implied volatilities of both OTM (out of the money) puts and calls increasing sharply. This reflected the market’s new assessment that extreme price movements were more likely than they had previously believed.2. The 2008 Financial Crisis: During the 2008 financial crisis, many stocks experienced higher price volatility than usual due to uncertain economic conditions. This led to a volatility smile effect in options markets where options with lower and higher strike prices had higher implied volatility than options with around the money strike prices. This was because traders began to price-in the increasing likelihood of extreme market movements.3. Currency Options: In the foreign exchange markets, currency options often display a correct volatility smile. Currencies of smaller economies often have asymmetric volatility smiles because of their susceptibility to economic and political uncertainties. For example, the Russian Ruble during geopolitical turbulence or the British Pound during Brexit, both showed volatility smile patterns. This implied that the markets saw an increased likelihood of big currency movements, either upward or downward, instead of the currencies merely remaining stable.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Implied volatility
• Option pricing model
• Moneyness
• Black-Scholes Model
• Skewness

Sources for More Information

• Investopedia: https://www.investopedia.com/terms/v/volatilitysmile.asp
• The Balance: https://www.thebalance.com/volatility-smile-4773032
• Corporate Finance Institute: https://www.corporatefinanceinstitute.com/resources/knowledge/trading-investing/volatility-smile/
• Quantdare: https://quantdare.com/volatility-smile-volatility-skew/