Explanation
Volatility Smile Definition:
The volatility smile refers to the pattern where implied volatility varies with the exercise price (strike price) of options with the same expiration date.
Key Characteristics:
- X-axis: Exercise price (strike price)
- Y-axis: Implied volatility
- Pattern: Typically shows higher implied volatility for deep in-the-money and deep out-of-the-money options compared to at-the-money options
Why It's Called a "Smile":
- When plotted, the curve often resembles a smile shape
- Higher implied volatility at both low and high strike prices
- Lower implied volatility at near-the-money strike prices
Causes of Volatility Smile:
- Market expectations of extreme price movements (fat tails in return distribution)
- Supply and demand imbalances for different strike options
- Market crash fears leading to higher demand for out-of-the-money puts
Correct Answer: B (exercise price)
The volatility smile specifically describes how implied volatility changes with respect to different exercise prices for options with the same expiration date.
