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Answer: The price of the option on ABC stock would be relatively low and the price of the option on USD/GBP FX rate would be relatively high compared to those computed from the lognormal counterparts.
The correct answer is B. The implied distribution of underlying equity prices, derived from the general volatility smile of equity options, has a heavier left tail and a less heavy right tail compared to a lognormal distribution. This results in deep-out-of-the-money call options on the underlying equity being priced relatively low when using the implied distribution instead of the lognormal distribution. Conversely, the implied distribution of underlying foreign currency prices, derived from the general volatility smile of foreign currency options, has heavier tails than a lognormal distribution. This causes deep-out-of-the-money call options on the foreign currency to be priced relatively high when using the implied distribution instead of the lognormal distribution.
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What key issues is the risk committee of Company ABC addressing in relation to the pricing of deeply out-of-the-money call options on ABC's stock and the USD/GBP exchange rate using the Black-Scholes-Merton model? Additionally, how does employing an implied risk-neutral probability distribution derived from the volatility smile compare to using a lognormal distribution for pricing these two types of options when they have identical maturity and moneyness?
A
The price of the option on ABC stock would be relatively high and the price of the option on USD/GBP FX rate would be relatively low compared to those computed from the lognormal counterparts.
B
The price of the option on ABC stock would be relatively low and the price of the option on USD/GBP FX rate would be relatively high compared to those computed from the lognormal counterparts.
C
The price of the option on ABC stock would be relatively low and the price of the option on USD/GBP FX rate would be relatively low compared to those computed from the lognormal counterparts.
D
The price of the option on ABC stock would be relatively high and the price of the option on USD/GBP FX rate would be relatively high compared to those computed from the lognormal counterparts