{"id":15148,"date":"2021-05-10T12:50:00","date_gmt":"2021-05-10T12:50:00","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=15148"},"modified":"2026-07-06T19:28:54","modified_gmt":"2026-07-06T19:28:54","slug":"implied-volatility","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/implied-volatility\/","title":{"rendered":"Implied Volatility"},"content":{"rendered":"\r\n<script type=\"application\/ld+json\">\r\n{\r\n  \"@context\": \"https:\/\/schema.org\",\r\n  \"@type\": \"QAPage\",\r\n  \"mainEntity\": {\r\n    \"@type\": \"Question\",\r\n    \"name\": \"An options dealer offers to sell a one-month in-the-money put on PayPal Holdings at 20% implied volatility and a two-month at-the-money call on the SET index option at 15% implied volatility. An options trader believes PayPal volatility should be closer to 16% and SET volatility should be closer to 22%. To benefit from this view, what should the trader most likely do?\",\r\n    \"answerCount\": 3,\r\n    \"acceptedAnswer\": {\r\n      \"@type\": \"Answer\",\r\n      \"text\": \"The correct answer is C. Sell the PayPal put and buy the SET call. The trader believes the PayPal put is overpriced because its implied volatility of 20% is above the trader's forecast of 16%. The trader also believes the SET call is underpriced because its implied volatility of 15% is below the trader's forecast of 22%. Therefore, the trader should sell the overvalued PayPal put and buy the undervalued SET call.\"\r\n    },\r\n    \"suggestedAnswer\": [\r\n      {\r\n        \"@type\": \"Answer\",\r\n        \"text\": \"Buy the PayPal put and the SET call.\"\r\n      },\r\n      {\r\n        \"@type\": \"Answer\",\r\n        \"text\": \"Sell the PayPal put and the SET call.\"\r\n      },\r\n      {\r\n        \"@type\": \"Answer\",\r\n        \"text\": \"Sell the PayPal put and buy the SET call.\"\r\n      }\r\n    ]\r\n  }\r\n}\r\n<\/script>\r\n<p>We have seen that both the BSM model and Black model require the parameter, \\(\\sigma\\) which is the volatility of the underlying asset price. However, future volatility cannot be observed directly from the market but rather estimated.<\/p>\r\n<p>One way of estimating volatility is by using an observed option price from the market and determining the volatility in line with this price. The values of other model parameters, including the underlying share price,\u00a0 the risk-free rate of interest, and the dividend yield, can be observed. This makes it possible to solve for the volatility as it will be the only unknown parameter in the formula. The resulting estimate is known as the <strong><em>implied volatility<\/em>.<\/strong><\/p>\r\n<div style=\"margin: 18px 0;\">\r\n  <a style=\"display: block; text-align: center; padding: 14px 18px; border: 2px solid #2F5BFF; border-radius: 18px; color: #ffffff; font-weight: 600; font-size: 16px; text-decoration: none; background-color: #1a73e8;\" href=\"https:\/\/analystprep.com\/free-trial\/\" target=\"_blank\" rel=\"noopener noreferrer\">\r\n    Master CFA Level 2 implied volatility concepts with AnalystPrep\u2019s Free Trial.\r\n  <\/a>\r\n<\/div>\r\n\r\n<p>The values of both European options are directly related to the volatility of the underlying asset. A call holder gains from the price increase but has limited downside risk. Moreover, the holder of put gains from the price decrease but has limited upside risk. Therefore, the value of options increases with an increase in volatility.<\/p>\r\n<p>Lastly, implied volatility gives an understanding of the investor\u2019s opinions on the volatility of the underlying asset. Higher implied volatility relative to the investor\u2019s volatility expectations suggests that the option is overvalued. Additionally, implied volatility helps in revaluing existing positions over time.<strong>\u00a0<\/strong><\/p>\r\n<blockquote>\r\n<h2>Question<\/h2>\r\n<p>An options dealer offers to sell a one-month in-the-money put on PayPal Holdings at 20% and a two-month at-the-money call on the SET index option at 15% implied volatility. Based on the current forecast, an options trader believes that PayPal volatility should be closer to 16%, and SET volatility should be closer to 22%. To benefit from his views, the trader should most likely:<\/p>\r\n<ol style=\"list-style-type: upper-alpha;\">\r\n<li>Buy the PayPal put and the SET call<\/li>\r\n<li>Sell the PayPal put and the SET call<\/li>\r\n<li>Sell the PayPal put and buy the SET call<\/li>\r\n<\/ol>\r\n<h2>Solution<\/h2>\r\n<p><strong>The correct answer is C:<\/strong><\/p>\r\n<p>The trader believes that the PayPal put is overvalued and that the SET call is undervalued. Thus, he expects the PayPal volatility to fall and that of SET to rise. Therefore, the PayPal put would be expected to decrease in value while the SET call would increase in value. The trader would then<\/p>\r\n<p>As a result, the FTSE call would be expected to increase in value, and the VOD put would be expected to decrease in value. The trader would then Sell the PayPal put and buy the SET call.<\/p>\r\n<\/blockquote>\r\n<p><em>Reading 38: Valuation of Contingent Claims<\/em><\/p>\r\n<p><em>LOS (n): Define implied volatility and explain how it is used in options trading.<\/em><\/p>\r\n\r\n<div style=\"text-align: center; margin: 30px 0;\">\r\n  <a style=\"display: inline-flex; align-items: center; justify-content: center; padding: 12px 26px; border-radius: 9999px; background: #1e5bd8; color: #ffffff; font-weight: bold; text-decoration: none;\" href=\"https:\/\/analystprep.com\/free-trial\/\" target=\"_blank\" rel=\"noopener noreferrer\">\r\n    Start Free Trial \u2192\r\n  <\/a>\r\n  <p style=\"margin-top: 12px; font-size: 16px; line-height: 1.5;\">\r\n    Build confidence in CFA Level 2 derivatives with study notes, practice questions, mock exams, and video lessons covering implied volatility, option pricing, and exam-style applications.\r\n  <\/p>\r\n<\/div>","protected":false},"excerpt":{"rendered":"<p>We have seen that both the BSM model and Black model require the parameter, \\(\\sigma\\) which is the volatility of the underlying asset price. However, future volatility cannot be observed directly from the market but rather estimated. One way of&#8230;<\/p>\n","protected":false},"author":5,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[102,302],"tags":[216,304,340,336],"class_list":["post-15148","post","type-post","status-publish","format-standard","hentry","category-cfa-level-2","category-derivatives","tag-cfa-level-2","tag-derivatives","tag-implied-volatility","tag-reading-38","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v27.6 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Implied Volatility | CFA Level 2<\/title>\n<meta name=\"description\" content=\"Learn what implied volatility is, how it is estimated from option prices, and what it reveals about market expectations. 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