Exhibit 2Implied Volatility Curve
Strike Price Implied Volatility
700 18.71
710 17.98
720 17.38
730 16.69
740 15.83
750 15.40
760 14.50
770 14.03
780 13.21
790 12.11
800 11.09
Question
Which of the following would Messer most likely conclude from the implied volatility data in Exhibit 2 if he excludes the effects of moneyness and time to expiration?
A.Using out-of-the-money options to hedge is more expensive than establishing a long position with out-of-the-money options.
B.Using out-of-the-money options to establish a long position is more expensive than establishing a short position using out-of-the-money options.
C.Using out-of-the-money options to establish either long or short positions is more expensive than using at-the-money options.
Solution
A is correct. Implied volatility is higher for lower strike prices than for higher strike prices; therefore, out-of-the-money put options will generally be more expensive than out-of-the-money call options. Implied volatilities of options with lower strike prices are higher than those with higher strike prices.
B is incorrect. Implied volatility is higher for lower strike prices than for higher strike prices; therefore, out-of-the-money put options will generally be more expensive than out-of-the-money call options. Implied volatilities of options with lower strike prices are higher than those with higher strike prices.
C is incorrect. This is only the case if implied volatility is higher for out-of-the-money options than for at-the-money, as in a normal skew (volatility smile).
