LO 15.3: Com pare the shape o f the volatility smile (or skew) to the shape o f the

LO 15.3: Com pare the shape o f the volatility smile (or skew) to the shape o f the im plied distribution o f the underlying asset price and to the pricing o f options on the underlying asset.
Actual option prices, in conjunction with the BSM model, can be used to generate implied volatilities which may differ from historical volatilities. When option traders allow implied volatility to depend on strike price, patterns of implied volatility are generated which resemble volatility smiles. These curves display implied volatility as a function of the options strike (or exercise) price. In this topic, we will examine volatility smiles for both currency and equity options. In the case of equity options, the volatility smile is sometimes referred to as a volatility skew since, as we will see in LO 15.5, the volatility pattern for equity options is essentially an inverse relationship.
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Topic 15 Cross Reference to GARP Assigned Reading – Hull, Chapter 20
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