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Answer: Demand for option protection against steep drops in equity prices leads to higher prices in out-of-the-money puts relative to out-of-the-money calls, which creates a downward-sloping implied volatility skew in these options.
The correct answer is C. The explanation provided in the file content states that demand for protective puts increases the price of these puts, which in turn increases their implied volatilities. This leads to a downward sloping volatility skew in equity options. The other options, A, B, and D, are incorrect because they do not accurately reflect the relationship between implied volatility and option pricing as described in the file content. Option A incorrectly describes the direction of the implied volatility smile in equity options, option B incorrectly describes the volatility smile in foreign exchange rate options, and option D incorrectly assumes that central bank announcements would shape the volatility curve with higher implied volatilities at-the-money. In reality, unexpected events like central bank announcements would likely lead to a volatility smile, where out-of-the-money options are more expensive due to the increased demand for protection against large price movements.
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An investment bank's option pricing analyst is delegated the responsibility of preparing a report to examine the relationship between option pricing and implied volatility curves. During the analysis, the analyst notes that the implied volatility curves differ noticeably in shape for various underlying assets. The report aims to elucidate these variations. Which of the following assertions would be appropriately accurate to include in the report?
A
The implied volatility smile commonly seen in equity options is due to the higher probability of a greater than three standard deviation price change than would be expected if prices are lognormally distributed.
B
The implied volatility smile commonly seen in foreign exchange rate options is due to the higher probability of a price change of between one and two standard deviations from the mean than would be expected if prices are lognormally distributed.
C
Demand for option protection against steep drops in equity prices leads to higher prices in out-of-the-money puts relative to out-of-the-money calls, which creates a downward-sloping implied volatility skew in these options.
D
Demand for option protection against the impact of unexpected central bank announcements on foreign exchange rates leads to higher prices, and higher implied volatilities, for at-the-money options relative to out-of-the-money options.