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Answer: A fat left tail and a thin right tail.
## Explanation When the volatility skew slopes downward to the right (also known as a negative skew), this means: - **Lower strike prices (out-of-the-money puts)** have higher implied volatilities - **Higher strike prices (out-of-the-money calls)** have lower implied volatilities This pattern indicates that the market is pricing in: - **Higher probability of large downward moves** (fat left tail) - **Lower probability of large upward moves** (thin right tail) Compared to the lognormal distribution assumed in the Black-Scholes-Merton model (which has symmetric volatility and equal tail probabilities), the actual market-implied distribution has: - **Fat left tail** - Higher probability of extreme negative returns - **Thin right tail** - Lower probability of extreme positive returns This is consistent with option A: "A fat left tail and a thin right tail." The downward-sloping volatility skew is commonly observed in equity markets where investors are more concerned about downside risk (market crashes) than upside potential, leading them to pay higher premiums for downside protection (put options).
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Q-110. A risk manager is examining a firm's equity index option price assumptions. The observed volatility skew for a particular equity index slopes downward to the right. Compared to the lognormal distribution, the distribution of option prices on this index implied by the Black-Scholes-Merton (BSM) model would have:
A
A fat left tail and a thin right tail.
B
A fat left tail and a fat right tail.
C
A thin left tail and a fat right tail.
D
A thin left tail and a thin right tail.
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