Explanation:
The equity options volatility pattern is different from the currency option smile. The pattern is more of a “smirk,” than a smile.
The company’s leverage and equity value are indirectly correlated, which has an impact on the equity’s risk and volatility.
An increase in a firm’s equity results in a decrease in leverage, which tends to decrease the riskiness of the firm. This lowers the volatility of the underlying asset. On the other hand, a decrease in the firm’s equity results in an increase in leverage, which makes the firm riskier. This increases the volatility of the underlying asset.
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Q.1715 Which of the following holds true for equity options smirk?
I. Leverage is identified as one of the main reasons for the smirk in equity options
II. It is said that when a company's equity declines in terms of value, the company's leverage then increases making equity riskier, and its volatility increases
III. It is said that when a company's equity increases in terms of value, the company's leverage then decreases making equity less risky, and its volatility decreases
A
Both I and II
B
Both I and III
C
All of the above
D
None of the above
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