Financial Risk Manager Part 2

Get started today

Ultimate access to all questions.

Explanation:

B is correct. For a foreign currency option, the implied distribution gives a relatively high price for the option. The implied volatility is relatively low for at-the-money options, but it becomes higher as the option moves either in-the-money or out-of-the-money. Thus, the implied distribution has heavier tails than the lognormal distribution.

Key Points:

The volatility smile pattern described (low at-the-money volatility, higher volatility for both in-the-money and out-of-money options) indicates that the market is pricing in higher probabilities of extreme price movements in both directions
This results in an implied distribution with fatter/heavier tails compared to the lognormal distribution assumed in Black-Scholes
Heavier tails mean higher probabilities of extreme price movements in both directions (left and right)
This pattern is commonly observed in foreign exchange markets where both large upward and downward movements are considered more likely than what the lognormal distribution would predict

Explanation:

Key Points:

The volatility smile pattern described (low at-the-money volatility, higher volatility for both in-the-money and out-of-money options) indicates that the market is pricing in higher probabilities of extreme price movements in both directions
This results in an implied distribution with fatter/heavier tails compared to the lognormal distribution assumed in Black-Scholes
Heavier tails mean higher probabilities of extreme price movements in both directions (left and right)
This pattern is commonly observed in foreign exchange markets where both large upward and downward movements are considered more likely than what the lognormal distribution would predict

Comments (0)

No comments yet.

A risk analyst at an investment bank is examining the assumptions the bank uses in its foreign exchange (FX) option pricing model. Currently, the implied volatility in a particular FX pair is relatively low if an option is at-the-money and becomes progressively higher as the option moves either more in-the-money or more out-of-the-money. How does the distribution of option prices on this FX pair implied by the Black-Scholes-Merton model compare to a lognormal distribution with the same mean and standard deviation?

Real Exam

Community

LLeetQuiz

The implied distribution has a heavier left tail and a less heavy right tail.

8.3%

The implied distribution has a heavier left tail and a heavier right tail.

91.7%

The implied distribution has a less heavy left tail and a heavier right tail.

The implied distribution has a less heavy left tail and a less heavy right tail.