Implied volatility

Financial Mathematics Clinic

SLAS – University of Kent

Financial Mathematics Clinic SLAS – University of Kent 1 / 17

1 Introduction

2 Glossary

3 Motivation

4 Implied volatility

5 Possible Solutions

Financial Mathematics Clinic SLAS – University of Kent 2 / 17

1 Introduction

2 Glossary

3 Motivation

4 Implied volatility

5 Possible Solutions

Financial Mathematics Clinic SLAS – University of Kent 3 / 17

Introduction

These slides are (mainly) aimed to

Last-stage undergraduate students.

Postgraduate students.

Financial Mathematics Clinic SLAS – University of Kent 4 / 17

Introduction

These slides are (mainly) aimed to

Last-stage undergraduate students.

Postgraduate students.

Objective

Understand one of the greatest limitations of the Black-Scholes-Merton

model and possible ways to address it.

Financial Mathematics Clinic SLAS – University of Kent 4 / 17

1 Introduction

2 Glossary

3 Motivation

4 Implied volatility

5 Possible Solutions

Financial Mathematics Clinic SLAS – University of Kent 5 / 17

Glossary

Frictionless market. A market is frictionless when there are no trans-

actions costs, no dividends and no delays in obtaining information or
taking decisions.
Convex function. A real-valued function is convex if the line segment
between any two points lies above the graph of the function.
At the money (ATM) call (put). ATM are calls and puts whose strike
is close to the market price.
In the money (ITM) call (put). A call (put) option is ITM if the market
price is above (below) the strike.
Out the money (OTM) call (put). A call (put) option is OTM if the
market price is below (above) the strike.
Financial Mathematics Clinic SLAS – University of Kent 6 / 17
1 Introduction

2 Glossary

3 Motivation

4 Implied volatility

5 Possible Solutions

Financial Mathematics Clinic SLAS – University of Kent 7 / 17

Motivation

The Black-Scholes-Merton (BSM) model is one of the most important

and influential financial models of all time.

Financial Mathematics Clinic SLAS – University of Kent 8 / 17

Motivation

The Black-Scholes-Merton (BSM) model is one of the most important

and influential financial models of all time.

It is widely consider to be an equation that changed the world.

Financial Mathematics Clinic SLAS – University of Kent 8 / 17

Motivation

The Black-Scholes-Merton (BSM) model is one of the most important

and influential financial models of all time.

It is widely consider to be an equation that changed the world.

However, it builds on assumptions that are not perfectly practical (e.g.

frictionless market, constant risk-free rate and constant volatility σ).

Financial Mathematics Clinic SLAS – University of Kent 8 / 17

Motivation

The Black-Scholes-Merton (BSM) model is one of the most important

and influential financial models of all time.

It is widely consider to be an equation that changed the world.

However, it builds on assumptions that are not perfectly practical (e.g.

frictionless market, constant risk-free rate and constant volatility σ).

There is a need to consider more sophisticated models that overcome

these limitations.

Financial Mathematics Clinic SLAS – University of Kent 8 / 17

1 Introduction

2 Glossary

3 Motivation

4 Implied volatility

5 Possible Solutions

Financial Mathematics Clinic SLAS – University of Kent 9 / 17

Smile effect

The smile effect is an empirical fact that the BSM model fails to explain. In
order to analyse it we need to consider:

Financial Mathematics Clinic SLAS – University of Kent 10 / 17

Smile effect

The smile effect is an empirical fact that the BSM model fails to explain. In
order to analyse it we need to consider:

The dynamics of a stock St (with S0 = 1), i.e.

dSt = µSt dt + σWt .

Financial Mathematics Clinic SLAS – University of Kent 10 / 17

Smile effect

The smile effect is an empirical fact that the BSM model fails to explain. In
order to analyse it we need to consider:

The dynamics of a stock St (with S0 = 1), i.e.

dSt = µSt dt + σWt .

The rational price of the standard European call option, i.e.

C = C (σ, K , T ) = S0 Φ(d1 ) − Ke −rT Φ(d2 ).

Financial Mathematics Clinic SLAS – University of Kent 10 / 17

Smile effect

The smile effect is an empirical fact that the BSM model fails to explain. In
order to analyse it we need to consider:

The dynamics of a stock St (with S0 = 1), i.e.

dSt = µSt dt + σWt .

The rational price of the standard European call option, i.e.

C = C (σ, K , T ) = S0 Φ(d1 ) − Ke −rT Φ(d2 ).

The actual market prices, which we define as Ĉ (T , K ).

Financial Mathematics Clinic SLAS – University of Kent 10 / 17

Smile effect (continuation)

We compare C (σ, T , K ) with Ĉ (T , K ) and define the implied volatility

σ̂ as the solution to

f (σ) = C (σ, T , K ) − Ĉ (T , K )

Financial Mathematics Clinic SLAS – University of Kent 11 / 17

Smile effect (continuation)

We compare C (σ, T , K ) with Ĉ (T , K ) and define the implied volatility

σ̂ as the solution to

f (σ) = C (σ, T , K ) − Ĉ (T , K )

We can use Newton-Rhapson to find the solution.

f (σn−1 ) √
σn = σn−1 − , f 0 (σ) = Sφ(d1 ) T − t = ν.
f 0 (σn−1 )

Financial Mathematics Clinic SLAS – University of Kent 11 / 17

Smile effect (continuation)

We compare C (σ, T , K ) with Ĉ (T , K ) and define the implied volatility

σ̂ as the solution to

f (σ) = C (σ, T , K ) − Ĉ (T , K )

We can use Newton-Rhapson to find the solution.

f (σn−1 ) √
σn = σn−1 − , f 0 (σ) = Sφ(d1 ) T − t = ν.
f 0 (σn−1 )

In practice σ̂ = σ(T , K ) is not constant.

1. Changes with T for fixed K and
2. Changes with K for fixed T as a convex function (hence the name smile
effect). This change appears to be more delicate.
Financial Mathematics Clinic SLAS – University of Kent 11 / 17
Real-data example

Using Facebook’s daily stock information (available for free at yahoo fi-
nance), we can plot the volatility smile of Facebook’s call-options for 5
March 2021. The closing price of the stock was 257.74.

Financial Mathematics Clinic SLAS – University of Kent 12 / 17

Insights

BSM model assumes constant volatility which is not true.

Financial Mathematics Clinic SLAS – University of Kent 13 / 17

Insights

BSM model assumes constant volatility which is not true.

ITM and OTM options have higher volatility.

Financial Mathematics Clinic SLAS – University of Kent 13 / 17

Insights

BSM model assumes constant volatility which is not true.

ITM and OTM options have higher volatility.

The lower volatilities are seen with ATM options.

Financial Mathematics Clinic SLAS – University of Kent 13 / 17

Insights

BSM model assumes constant volatility which is not true.

ITM and OTM options have higher volatility.

The lower volatilities are seen with ATM options.

Sometimes we see a smirk rather an a smile. Reverse skews, where ITM

options have higher volatility and Forward skews where OTM options
have higher volatility are examples of this.

Financial Mathematics Clinic SLAS – University of Kent 13 / 17

1 Introduction

2 Glossary

3 Motivation

4 Implied volatility

5 Possible Solutions

Financial Mathematics Clinic SLAS – University of Kent 14 / 17

Some of the modifications

Merton proposed considering µ = µ(t) and σ = σ(t).

Financial Mathematics Clinic SLAS – University of Kent 15 / 17

Some of the modifications

Merton proposed considering µ = µ(t) and σ = σ(t).

Local volatility. We consider µ = µ(t) and σ = σ(St , t) (Dupire).

Financial Mathematics Clinic SLAS – University of Kent 15 / 17

Some of the modifications

Merton proposed considering µ = µ(t) and σ = σ(t).

Local volatility. We consider µ = µ(t) and σ = σ(St , t) (Dupire).

Stochastic volatility. Replace σ for νt that models the variance of St

and consider the model
√
dSt = µSt dt + νt dWt

dνt = α(t, νt )dt + β(t, νt )dBt

Financial Mathematics Clinic SLAS – University of Kent 15 / 17

Some of the modifications

Merton proposed considering µ = µ(t) and σ = σ(t).

Local volatility. We consider µ = µ(t) and σ = σ(St , t) (Dupire).

Stochastic volatility. Replace σ for νt that models the variance of St

and consider the model
√
dSt = µSt dt + νt dWt

dνt = α(t, νt )dt + β(t, νt )dBt

For example,
√
Heston model: α(t, νt ) = θ(ω − νt ), β(t, νt ) = ξ νt

Financial Mathematics Clinic SLAS – University of Kent 15 / 17

Some of the modifications

Merton proposed considering µ = µ(t) and σ = σ(t).

Local volatility. We consider µ = µ(t) and σ = σ(St , t) (Dupire).

Stochastic volatility. Replace σ for νt that models the variance of St

and consider the model
√
dSt = µSt dt + νt dWt

dνt = α(t, νt )dt + β(t, νt )dBt

For example,
√
Heston model: α(t, νt ) = θ(ω − νt ), β(t, νt ) = ξ νt
GARCH model: α(t, νt ) = θ(ω − νt ), β(t, νt ) = ξνt

Financial Mathematics Clinic SLAS – University of Kent 15 / 17

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