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Answer: The implied distribution has a heavier left tail and a heavier right tail.
The implied distribution of option prices for the FX pair, as described in the file content, has a heavier left tail and a heavier right tail compared to a lognormal distribution with the same mean and standard deviation. This is because the implied volatility is relatively low for at-the-money options but increases as the options become more in-the-money or out-of-the-money. The higher implied volatility for options that are not at-the-money leads to a higher probability of extreme outcomes, which is reflected in the heavier tails of the implied distribution. This phenomenon is often referred to as the "volatility smile" or "volatility skew" and is a common characteristic in financial markets where the market's expectation of future volatility is not constant across different strike prices. The correct answer, as provided in the file content, is B.
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An investment bank's risk analyst is evaluating the underlying assumptions of its Forex (FX) option pricing model. For a particular FX currency pair, it is observed that the implied volatility is relatively low for at-the-money (ATM) options and increases as the options become either more in-the-money (ITM) or out-of-the-money (OTM). How does the distribution of option prices for this FX pair, as implied by the Black-Scholes-Merton model, contrast with a lognormal distribution that shares the same mean and standard deviation?
A
The implied distribution has a heavier left tail and a less heavy right tail.
B
The implied distribution has a heavier left tail and a heavier right tail.
C
The implied distribution has a less heavy left tail and a heavier right tail.
D
The implied distribution has a less heavy left tail and a less heavy right tail.