Explanation:
The BSM can in some ways be considered a mapping device that maps inputs (stock prices, time, risk-free rates, volatility) to the output, call option prices. The problem is that the volatility estimate is difficult to determine accurately. One can, however, reverse engineer the volatility estimate using the map set by the BSM model to determine the volatility input that causes the model to be equivalent to market prices.
(Book 2, Module 23.1, LO 23.b)
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Question 61
A recent hire at Institutional Options, Inc. is learning about the Black-Scholes-Merton (BSM) model to determine option prices. There are various inputs to the model, including stock price, time to expiration, strike price, etc. One of the more problematic inputs she learns is the volatility factor. Her colleague indicates that she should calculate the implied volatility. "That's where the real information comes," the colleague adds. Which of the following indicates the best approach for the recent hire to follow when determining implied volatility using the BSM?
A
Collect the last 250 days’ stock returns and use them to calculate simple returns in order to calculate the volatility that should be used in the BSM.
B
Collect consensus-implied volatility estimates from Wall Street analysts that should be used in the BSM.
C
Collect current market stock prices, risk-free rates, time to expiration, and strike prices as inputs into the BSM, and then determine the volatility that sets the BSM price equivalent to the current call option price.
D
Collect the last 250 days’ stock returns and use them to calculate continuous returns in order to calculate the volatility that should be used in the BSM.
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