Documente Academic
Documente Profesional
Documente Cultură
ON
Submitted To:
Amity University
Submitted By:
Prayas Agarwal
A3179016010
B.Com(F&IA) Sem 6
AMITY COLLEGE OF COMMERCE AND FINANCE
K3- Block, 2nd Floor, Amity University, Noida, Uttar Pradesh, India
DECLARATION
K3- Block, 2nd Floor, Amity University, Noida, Uttar Pradesh, India
ACKNOWLEDGEMEMT
PRAYAS AGARWAL
A317901600
B.COM(F&IA) (2016-19)
AMITY COLLEGE OF COMMERCE AND FINANCE
K3- Block, 2nd Floor, Amity University, Noida, Uttar Pradesh, India
Date:
Associate Professor
Amity University
TABLE OF CONTENTS
Abstract
Chapter 1
Introduction
Chapter 2
Review of Literature
Chapter 3
Research Methodology
Chapter 4
Analysis of Findings
Chapter 5
Conclusion
Abstract
Implied Volatilities are usually used in the stock market to quote the price of options.
Regardless of all the criticism and limitations, Black-Scholes Merton Model remains
the mostly used option pricing model since 1973. Implied Volatility is one of the
inferences out of the model which has come out over the past two and half decades.
In this report, our aim is to create a smile of the Apple Stock Options and have a look
at the properties of regression with estimating the volatility function. The results were
quite straight out, higher the strike lower the implied volatility and vice versa in case
of equity options.
CHAPTER 1
1. INTRODUCTION
It is not possible to predict the shape of the volatility smile. Since its formation, the
Black-Scholes Merton Model has had its limitations which has been criticised since
then. Some of them are the assumption of constant values for the risk free rate of
return and volatility over the period for the option. Also dividend is something which
was questioned again and again since inception in 1973. However if we take a look at
the real world, the stock market shows actual prices of traded options and upon
observation we got to know some real results.
2. MEANING
The concept of Volatility Smile or Smile Curve is basically the relationship
between implied volatility and strike prices of for options with a certain
maturity.
In simple words, a volatility smile is a graphical plot of the implied volatility
of an option with a certain maturity along with its strike prices.
3. USES
The volatility of an option increases as the option becomes increasingly In The
Money or Out Of The Money. And being the lowest at At The Money with
reference to Strike Price and Implied Volatility on the axis.
4. LIMITATIONS OF USING THE VOLATILITY SMILE
Firstly, being the most important thing in this topic, we have to find out
whether our selected option being actually traded aligns with a smile or not.
This is one model that an option can align with but the implied volatility could
align more with a reverse skew or a forward skew/smirk.
Moreover due to some other factors in the market, for example supply and
demand, the volatility smile may not be a clean *u* shape as in my case. It
may be a choppy one with an image showing more or less implied volatility
than expected according to this model and the image stated above.
5. Key Takeaways of Smile Curve
o When options with the same expiration date and same underlying
asset, but different strike prices, are graphed for implied volatility
the tendency is for that graph to show a smile.
o The smile shows that the options that are furthest in- or out-of-
the-money have the highest implied volatility.
o Options with the lowest implied volatility have strike prices at- or
near-the-money.
o Not all options will have an implied volatility smile. Near-term
equity options and currency-related options are more likely to
have a volatility smile.
o A single option's implied volatility may also follow the volatility
smile as it moves more ITM or OTM.
o While implied volatility is one factor in options pricing, it is not the
only factor. A trader must be aware of what other factors are
driving an option's price and its volatility.
6. PREVIOUS FINDINGS
A review of previous literature and a brief theoretical overview will be
presented below. In section 2.1 we begin with a review of the Black-Scholes
formula. This section leads us into the discussion about implied volatility and
its informational content, which is presented in section 2.2. In section 2.3 we
go further into earlier work involving the characteristics of the implied
volatility surface. Finally we will discuss the implications of our
parameterisation choice.
Black- Scholes
Fischer Black and Myron Scholes released their by-now classic paper on
option pricing in 1973, and revolutionized the pricing and trade of derivatives
through their intuitive pricing formula (Black & Scholes, 1973). Despite its
initially theoretical application and its proven limitations when using it on live
options, it remains one of the most used option pricing techniques today, and
its inventors were awarded the 1993 Nobel Prize in Economics as a homage to
their work.
Implied Volatility
Implied volatility can be described as the market’s expected future volatility, and is
linked to an option’s market price. The measure should not be mistaken for historical
volatility, given that historical volatility is linked to the earlier performance of the
underlying, rather than the option price. Both measures have been widely studied
over the years, and both have received credit for being the most accurate forecast of
future volatility.
Whether or not implied volatility is an adequate measure of future volatility has been
subject to much research. Canina & Figlewski (1993) found that implied volatility
practically lacked any correlation with future volatility, when studying 17000 OEX
call options on the S&P100 index. More recent work by Christensen & Prabhala
(1998) and Fleming (1998) however find implied volatility to be a superior measure
compared to historical volatility when it comes to forecasting future volatility, in
their studies of S&P100 index options. Christensen & Prabhala use longer time series
and non-overlapping data, and is probably the most comprehensive study on the
subject to date.
The equity stock options will be serving as the basis of our empirical analysis. In this
section, I have attached the option data which I have used in my analysis and
documented all the observed patterns in the Black/Scholes implied volatilities.
CHAPTER 2
LITERATURE REVIEW
1. Purpose of Study
Our primary goal is to understand how the volatility surface is driven and to predict
the smile accordingly. Rebonato(1999) states that the implied volatility of options is
“wrong number to plug into the wrong equation to get the right price”, which
summarises what makes the research regarding the matter so interesting.
As the volatility surface is a de facto trading tool, on which investors and traders base
multi-billion dollar decisions (CBOE, 2009), it is somewhat startling that the
specifics regarding its progression over time is still under scrutiny. With this thesis
we hope to bring some light on the matter, while also looking at the extent at which
external factors, closely linked to option pricing, can affect the shape of the volatility
surface.
Some of the other objectives are as follows:
• To study the concept Smile Curve and Options.
• To study the importance and role Smile Curve in Options.
• To analyze the overall impact of moneyness of the shape of the curve.
2. Contribution
Our results will be able to contribute to a more detailed understanding of the
structural change of the implied volatility surface and its evolution over time. A
deeper comprehension regarding the exogenous factors which affect the smile can i)
help in creating more precise pricing models for options, and also ii) come to use as
proxies for investors and traders to judge in which ways risk sentiments and prices
are moving. Our hope is that these results can add to current research regarding
option markets in general, and highly liquid markets such as the S&P500 in
particular. With the addition of some further research on lag power of our exogenous
variables, we believe that it would be possible to create a parsimonious model to
forecast the progression of the volatility surface.\
3. Type of Research
The research is of two types that are used for the study. One of the type of
research is based upon the measurement of quantity or amount which gets
applicable on the phenomenon which is expressed in quantity terms i.e.
numbers.
The other type of research is qualitative research which is concerned with the
qualitative aspects which is phenomena relating to the quality and the kind.
It is easy to analyse and express the factors affecting smile curve through only
one type of research as few impacts can only be expressed in terms of graphs
and numbers.
The questionnaire is a structured manner of the study which involves both
type of qualitative and quantitative and qualitative information which is not
relevant for my project.
4. Source of Data
Research design is partially descriptive, partially exploratory. The data for the
current study was collected from various sour ces such as Yahoo Finance,
Investopedia etc. To assess all the information, I have used the LINEST
function in excel to get the regression data and their co-efficient in excel
itself.
CHAPTER 4
ANALYSIS OF FINDINGS
Data Selection
My sample contains the observed prices of Apple Stock Options which are traded on
the New York Stock Exchange(NYSE) during the period of February 2019.
Originally, Apple Stock Options are traded at the NYSE and have the ticker symbol *
AAPL *.
During the initial sub-period, the option’s maturity is measured as the number of
calendar days between the trade date and expiry date. After the initial period, the
number of days to expiry is equal to the number of calendar days remaining less one.
Data Analysis
• My data collection started with taking data of option expiring in the months of
March, April, May, June, July and October.
• Then I arranged all the options within a range of 150-200(174 being the spot
price)
• After that I removed all the hyperlinks by copying the data into a new sheet.
• The next step was to calculate the maturity time of each option contract which
ranged from 15 days to 232 days.
• Then I converted the data for days into years(dividing it by 365)
• After that I calculated the Implied Volatility using the Black-Sholes Merton
Model(BSM Model) using macros.
• Then with the Implied Volatility, I tried to parameterize a0,a1,a2,a3,a4 and a5.
• Then I copied the Dumas Fleming Whaley Model for Implied Volatility.
• Then I created a column for K, K^2, T, T^2 and KT.
• After that I formatted the axis according to the data (150-200) and then plotted
the curve which is attached below.
• On the y-axis we have the Implied Volatility and on the x-axis we have Strike
Price.
Chart Title
0.5
0.375
ImpliedVolatility
IV true
0.25
Iv Fit
0.125
0.
150 163 175 188 200
Strike Price
CHAPTER 5
CONCLUSION
The conclusion for my project is that the ITM and OTM options have
a comparatively higher maturity in comparison to the ATM options
for the same maturity and other factors. It forms a simple smiling
curve in this case. Also , in case of equity options only , a smiling
curve is formed, but in case of currency options, it is the opposite.
Also it is been found, that in the higher and lower ranges of strike
price, the implied volatility is very high whereas in the middle ranges
of the strike price, the implied volatility is not volatile.
REFERENCES
1. https://www.investopedia.com/terms/v/volatilitysmile.asp
2. https://en.wikipedia.org/wiki/Volatility_smile
3. Volatility smiles revisited. Derivatives Week 4 (38) p 8 (1995). By Paul
Wilmott
4. https://people.ucsc.edu/~ealdrich/Teaching/Econ236/Slides/hull20.pdf
5.