IMPLIED VOLATILITY FUNCTION

MODEL
GROUP: IV
 What is implied volatility
• Implied volatility is used to monitor the market’s
opinion about the volatility of a particular stock.
• Traders like to calculate implied volatilities from
actively traded options on a certain asset and
interpolate between them to calculate the
appropriate volatility for pricing a less actively
traded option on the same stock.
 IVF MODEL
About the Model
• This Model is inverse of Black-Scholes Model for
finding option price at a given volatility.
• An ordinary option pricing model, such as Black-
Scholes, uses a variety of inputs to derive a
theoretical value for an option. Inputs to pricing
models vary depending on the type of option
being priced and the pricing model used.
However, in general, the value of an option
depends on an estimate of the future realized
volatility, σ, of the underlying. Or,
mathematically:
 .

f (S,t) SN(d1) Ker Tt N(d2)

Where ln
S
K

 r 

1
2

 2  T  t

d1 
 T  t 

And ln
S
K
 1 
  r   2  T  t 
 2 
d2 
 T  t

4
 Variables
Input Variables:
• S=Spot Price
• K=Strike Price
• T=time period to maturity
• σ= Volatility
• r= risk free rate of return
Output Variable
• C=Price of Call Option
• P= Price of Put Option
• This model is inversely used to find out implied
volatility of stock.
• We have been given price of call option or put
option, we assume volatility and the calculate
price through Black-Scholes Model.
• If calculated price is higher than given price, it
suggest that a given stock have lesser volatility
and vice a versa.
 Who Proposed it?
• Derman and Kani, Dupire and Rubinstein develop
this model in 1994.
 Uses
• IVF model is a tool to price exotic options
consistently with plain vanilla options.
• But this model is used only where options are
providing payoffs at just one time(e.g; all-or-
nothing and asset-or-nothing options) are priced
correctly by the IVF model.
• This means that exotic options such as compound
options and barrier options may be priced
incorrectly.
 Equation
dS = [r(t)-q(t)]S dt + (S,t)S dz
Implied volatility as measure of relative value
• Often, the implied volatility of an option is a more useful
measure of the option's relative value than its price. This is
because the price of an option depends most directly on
the price of its underlying security.
• If an option is held as part of a delta neutral portfolio, that
is, a portfolio that is hedged against small moves in the
underlier's price, then the next most important factor in
determining the value of the option will be its implied
volatility.
• Implied volatility is so important that options are often
quoted in terms of volatility rather than price, particularly
between professional traders.
 Example
• A call option is trading at $1.50 with
the underlying trading at $42.05. The implied volatility
of the option is determined to be 18.0%.
• A short time later, the option is trading at $2.10 with
the underlying at $43.34, yielding an implied volatility
of 17.2%.
• Even though the option's price is higher at the second
measurement, it is still considered cheaper on a
volatility basis. This is because the underlying needed
to hedge the call option can be sold for a higher price.