Explanation:
The term ‘volatility smile’ refers to a pattern that emerges when the implied volatility of an option with a specific life span is plotted as a function of its strike price. This pattern is called a 'smile' because of its characteristic shape, which resembles a smile when graphed. The ‘volatility smile’ is a crucial concept in financial risk management as it provides insights into the market’s perception of risk and uncertainty. It is particularly useful in equity and foreign exchange markets where traders use it to price options and manage risk. The ‘volatility smile’ can also indicate potential market anomalies and arbitrage opportunities.
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Q.1706 The term “volatility smile” carries significant value in the scope of Financial Risk Management, and is used traders in equity and foreign currency markets. Which of the following statements gives the correct definition of a volatility smile?
A
The plot of volatility (implied) of financial markets determining prices of options.
B
The plot of volatility (implied) of an option with a defined life span acting as a function of its strike price.
C
The plot of volatility (implied) of an option with an infinite life span acting as a function of its stated price.
D
None of the above.