Volatility Skew in BookRunner®
By Eric Carriere, Business Analyst, RiskAdvisory
Most option pricing theories hold the assumption that volatility is the same for all strike prices. This is intuitive because the volatility is associated with the underlying asset, so the strike of an option should have no effect whatsoever. This theory is completely contradicted by what is experienced in the market. The supply and demand for options that are at or near the money is different than for options that are deep in the money or deep out of the money. This causes implied volatilities to be different for options that have the same parameters other than strike price. Companies using the same volatility across all strike prices run the risk of having significant inaccuracies in their option valuation.
A form in BookRunner® allows volatilities to be entered for a particular strike on an index and whether it is for a call or put. Some companies utilize BookRunner® ’s call to the FEA function to calculate implied volatilities, while other companies employ various methods to input those values directly. The form in BookRunner® gives users the option to do either. The user can input the value themselves, or have BookRunner® perform the calculation. A flag on the form indicates which method was chosen for each record.
In recognizing the large amount of data that might require input, BookRunner® provides upload functionality. Users can upload data from *.csv files with the same method used for other uploaded data in BookRunner® . Once again, the user has the option to either upload a particular value, or leave the volatility cell blank and have BookRunner® calculate the implied volatility from the option’s price.
It is best practice to use implied volatility and to compensate for volatility skew when valuing options. BookRunner® elegantly captures volatility skew which allows companies to more accurately assess their risk and as a result, make better decisions going forward. For further enquiries about this article, please contact ecarriere@riskadvisory.com or call (403) 263-7475.