{"id":34851,"date":"2023-11-13T02:04:12","date_gmt":"2023-11-13T02:04:12","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=34851"},"modified":"2026-04-29T17:23:39","modified_gmt":"2026-04-29T17:23:39","slug":"volatility-skew-and-smile","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/cfa-level-iii\/volatility-skew-and-smile\/","title":{"rendered":"Volatility Skew and Smile"},"content":{"rendered":"<p><script type=\"application\/ld+json\">\n{\n  \"@context\": \"https:\/\/schema.org\",\n  \"@type\": \"QAPage\",\n  \"mainEntity\": {\n    \"@type\": \"Question\",\n    \"name\": \"In the case of a volatility smile, implied volatility and prices for in-the-money options relative to at-the-money options are least likely to be?\",\n    \"text\": \"In a volatility smile scenario, implied volatility for in-the-money options relative to at-the-money options is least likely to be:\",\n    \"answerCount\": 3,\n    \"upvoteCount\": 0,\n    \"dateCreated\": \"2025-01-01T00:00:00+00:00\",\n    \"author\": {\n      \"@type\": \"Organization\",\n      \"name\": \"AnalystPrep\"\n    },\n    \"acceptedAnswer\": {\n      \"@type\": \"Answer\",\n      \"text\": \"The correct answer is A. In a volatility smile scenario, implied volatility for in-the-money options is often higher than at-the-money options due to increased demand for protection in volatile markets.\",\n      \"dateCreated\": \"2025-01-01T00:00:00+00:00\",\n      \"upvoteCount\": 0,\n      \"author\": {\n        \"@type\": \"Organization\",\n        \"name\": \"AnalystPrep\"\n      }\n    },\n    \"suggestedAnswer\": [\n      {\n        \"@type\": \"Answer\",\n        \"text\": \"B is incorrect. Implied volatility for in-the-money options is typically higher, not lower, compared to at-the-money options due to increased demand for downside protection.\",\n        \"dateCreated\": \"2025-01-01T00:00:00+00:00\"\n      },\n      {\n        \"@type\": \"Answer\",\n        \"text\": \"C is incorrect. Market conditions and investor sentiment influence the prices of in-the-money options, but not all cases with a volatility smile indicate that they are over-priced.\",\n        \"dateCreated\": \"2025-01-01T00:00:00+00:00\"\n      }\n    ]\n  }\n}\n<\/script><br \/>\n<script type=\"application\/ld+json\">\n{\n  \"@context\": \"https:\/\/schema.org\",\n  \"@type\": \"ImageObject\",\n  \"url\": \"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2023\/11\/r_17_losH_img1.jpg\",\n  \"caption\": \"Changes in Volatility for Options\",\n  \"width\": 1005,\n  \"height\": 710,\n  \"copyrightNotice\": \"\u00a9 2024 AnalystPrep\",\n  \"acquireLicensePage\": \"https:\/\/analystprep.com\/license-info\",\n  \"creditText\": \"AnalystPrep Design Team\",\n  \"creator\": {\n    \"@type\": \"Organization\",\n    \"name\": \"AnalystPrep\"\n  }\n}\n<\/script><\/p>\n<p><script type=\"application\/ld+json\">\n{\n  \"@context\": \"https:\/\/schema.org\",\n  \"@type\": \"ImageObject\",\n  \"url\": \"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2023\/11\/r_17_losH_img2.jpg\",\n  \"caption\": \"Volatility Skew vs Volatility Smile\",\n  \"width\": 1220,\n  \"height\": 550,\n  \"copyrightNotice\": \"\u00a9 2024 AnalystPrep\",\n  \"acquireLicensePage\": \"https:\/\/analystprep.com\/license-info\",\n  \"creditText\": \"AnalystPrep Design Team\",\n  \"creator\": {\n    \"@type\": \"Organization\",\n    \"name\": \"AnalystPrep\"\n  }\n}\n<\/script><\/p>\n<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/chI7ynB4E00\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><\/iframe><\/p>\n<p>To understand volatility skews and smiles, candidates must first grasp the concept of implied volatility and its limitations.<\/p>\n<h2>Implied Volatility<\/h2>\n<p><em>Implied volatility<\/em> can be described as the outlook of a derivative contract\u2019s expected standard deviation of returns. It is the degree and intensity to which derivative contracts are likely to persist.<\/p>\n<p>The term &ldquo;implied&rdquo; in implied volatility refers to the market&#8217;s indications and expectations regarding future volatility. When using the Black-Scholes Merton Model (BSM) to calculate option prices, implied volatility is the parameter adjusted to make the calculated option price match the current market price. It acts as a &ldquo;plug figure&rdquo; to achieve this equilibrium.<\/p>\n<p>A criticism of the BSM is its assumption of a uniform volatility distribution across strike prices. In other words, it assumes that the volatility of an in-the-money put would be the same as that of an at-the-money option. However, as we will explore further, this assumption is not always valid in the financial markets. \u2003<\/p>\n<div style=\"text-align: center; margin: 22px 0;\"><a style=\"display: inline-flex; align-items: center; justify-content: center; padding: 10px 18px; border: 2px solid #1e5bd8; color: #1e5bd8; border-radius: 9999px; text-decoration: none; font-weight: 600;\" href=\"https:\/\/analystprep.com\/free-trial\/\" target=\"_blank\" rel=\"noopener noreferrer\">Master volatility skew and smile concepts with a free trial  <\/a><\/div>\n<h3>Volatility Smile<\/h3>\n<p>Volatility smiles are frequently observed in near-term equity options and currency options. They represent a departure from a flat volatility distribution, as both in-the-money and out-of-the-money options exhibit higher implied volatilities than at-the-money options.<\/p>\n<p><img loading=\"lazy\" decoding=\"async\" src=\"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2023\/11\/r_17_losH_img1.jpg\" alt=\"\" width=\"500\" height=\"380\" class=\"aligncenter size-medium wp-image-35595\" \/><\/p>\n<h3>Volatility Skew<\/h3>\n<p>Volatility skew refers to an asymmetric distribution of implied volatility across different strike prices. It creates a lopsided distribution, favoring either in-the-money or out-of-the-money options. In the example below, the blue line shows a skew with higher demand for in-the-money options. Skews are non-symmetrical and can vary in shape and intensity.\u2003<\/p>\n<p><img loading=\"lazy\" decoding=\"async\" src=\"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2023\/11\/r_17_losH_img2.jpg\" alt=\"\" width=\"550\" height=\"380\" class=\"aligncenter size-medium wp-image-35596\" \/><\/p>\n<h3>Causes and Implications<\/h3>\n<p>Implied volatility is not directly observable in the real world. It is derived by applying the BSM model to market prices and assuming that other variables can be estimated accurately. It is a supposition rather than a definitive value. Options prices in the real world can be influenced by various factors such as supply and demand. A volatility smile or skew indicates that the BSM model does not fully capture the dynamics of options prices.<\/p>\n<p>Options traders seek skews and smiles to exploit mispriced volatility. These discrepancies can occur due to supply and demand dynamics. Traders aim to buy undervalued volatility or sell overpriced volatility in such situations.<\/p>\n<p>\u2003<\/p>\n<blockquote>\n<h2>Question<\/h2>\n<p>In the case of a volatility smile, implied volatility and prices for in-the-money options relative to at-the-money options are <em>least likely<\/em> to be?<\/p>\n<ol type=\"A\">\n<li>Higher.<\/li>\n<li>Lower.<\/li>\n<li>Over-priced.<\/li>\n<\/ol>\n<p><strong>Solution<\/strong><\/p>\n<p><strong>The correct answer is A.<\/strong><\/p>\n<p>In a volatility smile scenario, implied volatility for in-the-money options is often higher than at-the-money options. This is because investors may be willing to pay more for the protection offered by in-the-money options in times of increased uncertainty.<\/p>\n<p><strong>B is incorrect.<\/strong> In a volatility smile scenario, implied volatility for in-the-money options is typically higher, not lower, compared to at-the-money options. This is because of the increased demand for downside protection in volatile markets.<\/p>\n<p><strong>C is incorrect.<\/strong> Market conditions and investor sentiment influence the prices of in-the-money options relative to at-the-money options. It&#8217;s not accurate to make a blanket statement that they are over-priced in all cases with a volatility smile.<\/p>\n<\/blockquote>\n<h2>Why Volatility Skew and Smile Matter in CFA Level III<\/h2>\n<p>Volatility skew and smile are important CFA Level III Derivatives concepts. Candidates may be tested on implied volatility patterns, option pricing assumptions, and how market demand can distort volatility across strike prices.<\/p>\n<p>Build confidence with the <a href=\"https:\/\/analystprep.com\/cfa-level-3\/\" target=\"_blank\">complete CFA Level III prep program<\/a> featuring guided lessons, essay practice, question banks, and realistic mock exams.<\/p>\n<p>Reading 17: Options Strategies<\/p>\n<p>Los 17 (h) Discuss volatility skew and smile<\/p>\n<div style=\"text-align: center; margin: 30px 0;\"><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\"> Start Free Trial \u2192 <\/a> <\/p>\n<p style=\"margin-top: 12px; font-size: 16px; line-height: 1.5;\">Practice CFA Level III derivatives questions covering volatility skew, volatility smile, option pricing behavior, and exam-style applications.   <\/p>\n<\/p><\/div>\n","protected":false},"excerpt":{"rendered":"<p>To understand volatility skews and smiles, candidates must first grasp the concept of implied volatility and its limitations. Implied Volatility Implied volatility can be described as the outlook of a derivative contract\u2019s expected standard deviation of returns. It is the&#8230;<\/p>\n","protected":false},"author":3,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[571],"tags":[],"class_list":["post-34851","post","type-post","status-publish","format-standard","hentry","category-cfa-level-iii","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v27.4 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Volatility Skew and Smile | CFA Level III<\/title>\n<meta name=\"description\" content=\"Learn volatility skew and smile in options markets. 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