Implied Volatility

Final Report
2015/06/30

Group 1

1.
2.
3.
4.

Siti Maghfirotul Ulyah

Uurtsaikhbaatar
Jean-Raymond Fontin
Dyah Ayu Kusumaningtyas

M10318801
M10308802
M10318805
M10308801

VOLATILITY SMILE OVERVIEW

A. Why volatility smile same for calls and puts?
This section will show that the implied volatility of a European call option is the same as
that of a European put option when they have the same strike price and time to maturity. This
means that the volatility smile for European calls with a certain maturity is the same as that
for European puts with the same maturity.
If European call and put options when they have the same strike price and time to
maturity should satisfy following equation which called put-call parity.
where
p
c
T
K
q
r

= European put option price

= European call option price
= Maturity
= Strike price
= Dividend yield on underlying asset
= Risk free rate for maturity

A key feature of the put-call parity relationship is that it is based on a relatively simple
no-arbitrage argument. For a particular value of the volatility,
and
are the values of
European put and call options calculated using the Black-Scholes-Merton model. Suppose
further that
and
are the market values of these options. Because put-call parity
holds for the Black-Scholes-Merton model, we must have
In the absence of arbitrage opportunities, put-call parity also holds for the market prices, so
that
Subtracting these two equations, we get
This shows that the dollar pricing error when the Black-Scholes-Merton model is used to
price a European put option should be exactly the same as the dollar pricing error when it is
used to price a European call option with the same strike price and time to maturity.
B. Why is exchange rates not lognormally distributed?
Two of the conditions for an asset price to have a lognormal distribution are:
1. The volatility of the asset is constant.
2. The price of the asset changes smoothly with no jumps.
But in practice, neither of these conditions is satisfied for an exchange rate.
C. How does the shape of foreign currency options implied volatility?
As pointed in (B), the volatility of an exchange rate is far from constant, and exchange
rates frequently exhibit jumps. It turns out that the effect of both a non-constant volatility and

jumps is that extreme outcomes become more likely. The impact of jumps and non-constant
volatility depends on the option maturity. As the maturity of the option is increased, the
percentage impact of a non-constant volatility on prices becomes more pronounced, but its
percentage impact on implied volatility usually becomes less pronounced. The percentage
impact of jumps on both prices and the implied volatility becomes less pronounced as the
maturity of the option is increased. The result of all this is that the volatility smile becomes
less pronounced as option maturity increases.
In other words, for foreign currency options, the volatility smile is U-shaped. Both out-ofthe-money and in-the-money options have higher implied volatilities than at-the-money
options.
D. How does the shape of equity options (stock options) implied volatility?
The volatility smile for equity options has been studied by several people. Prior to 1987
there was no marked volatility smile. Since 1987 the volatility smile used by traders to price
equity options (both on individual stocks and on stock indices. This is sometimes referred to
as a volatility skew. The volatility decreases as the strike price increases. The volatility used
to price a low-strike-price option (a deep-out-of the-money put or a deep-in-the-money call)
is significantly higher than that used to price a high-strike-price option (a deep-in-the-money
put or a deep-out-of-the-money call).
We can say that for equity options, the volatility smile tends to be downward sloping.
This means that out-of-the-money puts and in-the-money calls tend to have high implied
volatilities whereas out-of-the-money calls and in-the-money puts tend to have low implied
volatilities.
One possible explanation for the smile in equity options concerns leverage. As a
company's equity declines in value, the company's leverage increases. This means that the
equity becomes more risky and its volatility increases. As a company's equity increases in
value, leverage decreases. The equity then becomes less risky and its volatility decreases.
This argument suggests that we can expect the volatility of a stock to be a decreasing function
of the stock price. Another explanation is crashopobia. People are worrying about market
crash. It will make the price in the left side become higher, because people tend to buy
insurance.
E. Alternative ways of characterizing the volatility smile
Another approach to defining the volatility smile is as the relationship between the
implied volatility and the delta of the option. This approach sometimes makes it possible to
apply volatility smiles to options other than European and American calls and puts. When the
approach is used, an at-the-money option is then defined as a call option with a delta of 0.5 or
a put option with a delta of -0.5. These are referred to as "50-delta options."
F. The volatility term structure and volatility surfaces
Traders allow the implied volatility to depend on time to maturity as well as strike price.
Implied volatility tends to be an increasing function of maturity when short-dated volatilities
are historically low. This is because there is then an expectation that volatilities will increase.

Similarly, volatility tends to be a decreasing function of maturity when short-dated volatilities

are historically high. This is because there is then an expectation that volatilities will decrease.
Volatility surfaces combine volatility smiles with the volatility term structure to tabulate the
volatilities appropriate for pricing an option with any strike price and any maturity.
The implied volatility of an option then depends on its life. When volatility smiles and
volatility term structures are combined, they produce a volatility surface. This defines implied
volatility as a function of both the strike price and the time to maturity.
G. Greek letters
The volatility smile complicates the calculation of Greek letters. Assume that the
relationship between the implied volatility and K/S for an option with a certain time to
maturity remains the same. As the price of the underlying asset changes, the implied volatility
of the option changes to reflect the option's "moneyness" The formulas for Greek letters are
no longer correct.
H. When a single large jump is anticipated
When a single large jump is anticipated in the market probability of distribution would be
changed. Suppose that a stock price is currently $50 and an important news announcement
due in a few days is expected either to increase the stock price by $8 or to reduce it by $8.
The probability distribution of the stock price in, say, 1 month might then consist of a mixture
of two lognormal distributions, the first corresponding to favorable news, the second to
unfavorable news. The true probability distribution is bimodal (certainly not lognormal). One
easy way to investigate the general effect of a bimodal stock price distribution is to consider
the extreme case where the distribution is binomial.

Stock Returns, Implied Volatility Innovations, and the Asymmetric Volatility

Phenomenon
I. Introduction
The relation between stock returns and innovations in expected volatility is a fundamental
issue in financial markets. The expected return on a stock is found to be related to covariance
between its return and the return on a market portfolio (Black, Jensen and Scholes-1972),
factors extracted from a multivariate time series of returns (Roll and Ross-1980),
Macroeconomic variables, such as industrial production and changes in interest rates (Chen,
Roll and Ross (1986) and aggregate consumption (Breeden, Gibbons and Litzenberger-1986).
That have examined the intertemporal relation between risk and expected returns.
Asymmetric volatility is a well-documented empirical regularity in this area. The
asymmetric volatility phenomenon (AVP) refers to the stylized fact that negative return
shocks tend to imply higher future volatility than do positive returns shocks of the same
magnitude. The AVP has also been described as a negative correlation between stock returns
and innovations in expected volatility. The AVP literature has debated whether the AVP may
be more attributable to firm-level effects such as leverage (a negative return shock causes
increased volatility) or systematic market-wide influences such as volatility feedback (an
increase in expected market-level volatility causes a negative return.
This paper distinguished between innovations in systematic and idiosyncratic volatility.
Systematic volatility shock may result from macro events such as an interest rate shock or
international financial crisis, while idiosyncratic volatility shocks may originate from firmspecific events such as product introductions and patents.
II. Data and Variable Construction
A. Data
The data in this paper are the data of 50 individual stocks with options traded on the
CBOE. Those are daily dividend-adjusted returns (CRSP) from January 4, 1988 to December
31, 1995. They choose 50 firms that have the highest total option trading volume over the
period 1988-1995. They also use other different stock indices below:
S&P 100 (primary)
Value-weighted NYSE/AME/NASDAQ stock index from CRSP (market-level stock
return)
For the index IV, they use VIX. That is, the index representing IV of an at-the-money
option on the S&P 100 index with 22 trading days (30 calendar days). It is constructed by
taking a weighted average of the IVs for eight options, including a call and a put at the two
strike prices closest to the money and the nearest two expirations. For each firm, they
construct daily standardized IVs using eight individual stock options, where their weighting
method follows the CBOEs procedure for calculating VIX over their sample period. Below
is the table of sample description:

Table 1. Sample Description

Based on table above, we can see that the author distinguish between the largest and
smallest quintile of firms in order to show how their result vary with firms size, and the
related variations in volatility, IV variability, and option trading volume. The above table
shows that,
the median size of the largest 10 firms is about 20 times that of the smallest firms.
the return standard deviation , the IV level, and the daily variability in IV are all larger
for the smaller firms compared to the larger firms.
The median option trading volume for the largest 10 firms is about 7 times larger than
that for the smallest 10 firms.
B. Implied Idiosyncratic Volatility
The author decompose a stocks total implied volatility into a systematic market-level
component and an idiosyncratic components. The following procedure is explained below:
Define market-model regression for each firms

After estimating

, calculate an estimate of a firms implied idiosyncratic variance

where
= stock return of firm i ;
= firms i market beta ;
= the estimate of the firm is idiosyncratic varance at time t ;
= firm is standardized implied variance ;
= the standardized implied variance of the S&P 100.
Convert the implied idiosyncratic return variance to a standard deviation then calculate
the daily change in the implied standard deviation of the idiosyncratic return component
(
).
The average (median) value of the implied idiosyncratic volatility across 50 firms is 1.45%
per day. Also, median of the ratio of a firms implied idiosyncratic variance divided by its
total implied variance for each firm for each day is 0.755. This indicates that the substantial
majority of a firms volatility is idiosyncratic.
III. The Dynamic Relation between Stock Returns and Expected Volatility Innovations
A. Correlation Analysis
Table 2 shows the correlation between stock return and implied volatility innovation.

Table 2. Correlation Analysis

Based on the result reported in Table 2, we find a number of findings. Those are as follow:
The correlation between the S&P 100 index return (CRSP index return) and the index
volatility innovation is negative and large at -0.679.
The correlation at the index level is over four times the average value for the
individual stock.
The correlation between individual stock returns and the index volatility innovation is
more negative than the correlation between the individual stock returns and the
respective own-firm volatility innovation for 46 of the 50 firms.
Overall, the result in table 2 suggests that the APV is more related to systematic rather than
idiosyncratic.
B. Multivariate Analysis
We investigate the dynamic relation between stock return and expected volatility
innovations in a multivariate framework that allows for conditional heteroskedasticity in the
return residual. Then we estimate the following system,
mean equation
variance equation
The estimation result is explained in Table 3.
Table 3. Multivariate Analysis

*For Panels A and B, the numbers in brackets indicate the number of firms where the respective coefficient is
positive/negative and significant at a 1% level. For panel C, t-statistics are reported in parentheses.

Below are the explanation of the result in Panels A, B, and C:

Panel A reports the firm-level results using only the
and
explanatory terms
in the mean equation ( =0). The
coefficients are negative and statistically
significant at 1% level. The
coefficients are also tend to be negative, but only 28
out of 50 firms having significant coefficients. Also, if we look at R-squared value in the
right-three columns in the Panel A, we can conclude that the relation between return and
index volatility innovations is stronger than the relation between the firm return and ownfirm volatility innovation.
Panel B reports the firm-level results using only the
explanatory terms in the
mean equation (
=0). The estimated coefficients of
term are negative and
significant for only 13 of the 50 firms. Also, the average R-squared value is quite small
compared to the R-squared in Panel A. Sub period results are consistent.

 Panel C reports stock index result. We find a very reliable negative relation between the
index return and the index volatility innovation. The R-squareds are very substantial at
46.9% for the S&P 100 and 43.8% for the CRSP index, as compared to the firm-level
result.
Thus, the findings in Table 3 reinforce the findings in Table 2 which indicate that the
negative relation between stock returns and expected volatility innovation is primarily related
to the market-wide of component of expected volatility.
IV. Daily changes in implied volatility and the future volatility
Daily changes in individual stock implied volatilities may contain relatively little
incremental information about future stock return volatility. However, the daily stock
options implied volatility innovation (
) over period t-1 contains reliable incremental
information for conditional volatility of period t. In other words the stock options implied
volatility is more capable of predicting the future stock return volatility.
Consider the two following system:

: Daily return of individual stock i.

: Market-level stock return.
: The return residual.
: The conditional variance of .
: The implied daily variance of stock i at the end of period t-2 to t-1.
: Estimated coefficients.
The coefficient of interest is on
. This coefficient aims to gauge the impact of
the stock options implied volatility innovation (
) on the future stock return volatility.
50 firms are used in the estimation analysis. According to the estimation results, for 37 of
them, the estimated coefficient ( ) is positive and statistically significant at a 5% level or
better. Therefore, it is undeniable that the stock options implied volatility innovation
contains reliable incremental information to predict the conditional future stock return
volatility.
The implied volatility innovation of the stock option in the index level also has reliable
incremental information for conditional volatility of the future index return.
Consider the above conditional mean equation and the following conditional variance
equation:

: The one-day change in the implied variance of the S&P 100 index from the
end of period t-2 to the end of period t-1.

The coefficient of interest is

on

. It has the same goal as

, gauging the

impact of the index options implied volatility innovation (

) on the future index
return volatility. The same number (50) of firms is used in the analysis. According to the
estimation results, the estimates are positive and statistically significant for 14 of the 50
firms at the 5% level; while only for 1 firm the estimate is negative, but statistically
significant at the 5% level. However, the number of
estimates that are statistically
significant seems modest for the individual stocks. Furthermore, for 49 of the 50 firms, the
likelihood function value for the first system of equations is more than the second system.
This indicates that there is more incremental volatility information from own-firm implied
volatility changes than from index volatility changes. Therefore, the daily implied volatility
innovation can be used as a proxy for the change in the expected return volatility at both the
firm and market level.
Finally, the informative nature of the implied idiosyncratic volatility is proven as
followed. Here is the evaluation model:

: Daily return of individual stock i.

: Daily S&P 100 index return.
: Idiosyncratic return residual.
: The implied daily idiosyncratic variance of stock i at the end of period t-2.
The daily change in the firms implied idiosyncratic variance.
: Coefficients to be estimated.
According to the estimation results both
and
are reliably positive. They are both
statistically significant. Thus,
and
are both respectively measure of
idiosyncratic volatility and change in implied idiosyncratic volatility.
V. Asymmetric Volatility: Lagged Firm-Level versus Market-Level Return Shocks
In the asymmetric volatility examination the conditional volatility can be estimated as a
function of the firm-level or market-level shocks return.
A. Asymmetric Volatility with lagged own-stock return shocks
The following models are estimated to evaluate the univariate asymmetric volatility
phenomenon in a given firms or indexs returns

: Daily return of individual stock i.

: Daily return of individual index i.
: The return residual.
: The conditional variance of .

: The implied daily variance of stock i at the end of period t-2.

: A dummy variable that equal 1 if
is negative and 0 otherwise.
: Coefficients to be estimated.
The primary coefficient of interest is
since it allows for the volatility asymmetry.
Its estimates are largely statistically significant. There is an inverse relation between the
conditional variance and the positive return shocks, -0.067 for the CRSP and -0.063 for
S&P100. There is a positive relation between the conditional variance and the negative
market return shocks, 0.117 for CRSP and 0.045 for S&P100.
Contrarily to the indices, the asymmetric volatility phenomenon related to the lagged ownfirms return shocks is much weaker.
B. Firm-level asymmetric volatility with lagged market-level return shocks
The asymmetric volatility relation between firm-level return volatility and lagged
market-level return shocks valuation is done using the previous mean equation and the
following conditional variance equation:
where
: The squared market-level return.
: A dummy variable that equals 1 if

is negative and 0 otherwise.

According to the results of the estimation the lagged market-level return shocks has
stronger impact on the firm-level returns volatility when compared to the previous case. In
sum, volatility is more reliably evident in the index returns than in the firm-level returns; and
asymmetric volatility is more sizable and reliably evident in firm-level volatility when
relating a firms conditional volatility to the lagged market-level return shock.
VI. Discussion of Results and Other Related Analysis
In section VI, the authors mentioned about how their research result related to other areas
of finance literature. Authors were guessed that relation between stock returns and volatility
innovations also related to subjects like the implied volatility smile, the bias in implied
volatility, and return skewness.
A. Implied Volatility Smile.
Implied Volatility Smile is one of interesting research topic among the financial
researchers. Consistent with the previous studies, researchers find that the implied
volatility slope across process for near at-the-money options is substantially negative
for the index options than for the individual stock options. Thus, the index versus
individual stock differences in the implied volatility smile are suggestive of the index
versus individual stock differences in the dynamic relation that they find between stock
returns and implied volatility innovations.
B. The Bias in Implied Volatility
Researchers concluded that their evidence that seems to be much smaller relation
between stock returns and volatility innovations for individual stocks than for indices. It

also seems intuitive that there would also be a smaller volatility risk premium in
individual stock option prices. These observations suggest that it is important to
distinguish between systematic and idiosyncratic volatility.
C. Return Skewness
They mentioned that their prior studies have noted link between negative return
skewness and Asymmetric Volatility Phenomenon. They have evaluated skewness in
continuously compounded returns for 50 firms and S&P 100 index. They find that the
S&P 100 index returns have large negative skewness of-0.520 versus a near-zero
skewness for firm-level stock returns with a median skewness of 0.043. These skewness
differences are suggested by the large differences that they find when comparing the
Asymmetric Volatility Phenomenon behavior of index versus individual stock returns.
Conclusion
There are four primary findings concerning the dynamic relation between stock returns
and expected volatility innovations.
1. Index returns have a large negative relation with innovations in expected index
volatility. Prior research has reported comparable index-level results but with methods
substantially different than ours.
2. Individual stock returns have only a modest negative relation with innovations in their
own expected volatility.
3. The negative relation between individual stock returns and index volatility innovations
is sizably stronger than the negative relation between individual stock returns and their
own-firm volatility innovations.
4. It decomposes the total implied volatility of the individual stocks into a systematic and
idiosyncratic component. We then find that the relation between individual stock
returns and their respective idiosyncratic volatility innovation is near zero, Subperiod
analysis yields consistent results for all these findings.