Chapter 20 Volatility Smiles

How close are the market prices of options to those predicted by the Black–Scholes– Merton model? Do traders really use the Black–Scholes–Merton model when determining a price for an option? Are the probability distributions of asset prices really log-normal? This chapter answers these questions. It explains that traders do use the Black–Scholes–Merton model—but not in exactly the way that Black, Scholes, and Merton originally intended. This is because they allow the volatility used to price an option to depend on its strike price and time to maturity.

A plot of the implied volatility of an option with a certain life as a function of its strike price is known as a volatility smile. This chapter describes the ...

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