Dear David,
Question 410.2 (page 7) and Problem 19.1 (page 28) of your Question Set appear to be the same but the answers are different.
For Problem 19.1 (b), the question is What volatility smile is likely to be observed when b) The right tail is heavier, and the left tail is less heavy, than that of a lognormal distribution?
The answer given in your Question Set is, (b) When the right tail is heavier and the left tail is less heavy, Black-Scholes will tend to produce relatively low prices for out-of-the-money calls and in-the-money puts. It will tend to produce relatively high prices for out-of-the-money puts and in-the-money calls. This leads to implied volatility being an increasing function of strike price.
I would think that Black-Scholes would produce higher prices for OTM calls and ITM puts and not lower for Problem 19.1 (b). To me this is a mirror of the volatilty skew for Equity Options where the right tail is lighter and the left tail is heavier. Please advise if my understanding is incorrect. Thanks
Question 410.2 (page 7) and Problem 19.1 (page 28) of your Question Set appear to be the same but the answers are different.
For Problem 19.1 (b), the question is What volatility smile is likely to be observed when b) The right tail is heavier, and the left tail is less heavy, than that of a lognormal distribution?
The answer given in your Question Set is, (b) When the right tail is heavier and the left tail is less heavy, Black-Scholes will tend to produce relatively low prices for out-of-the-money calls and in-the-money puts. It will tend to produce relatively high prices for out-of-the-money puts and in-the-money calls. This leads to implied volatility being an increasing function of strike price.
I would think that Black-Scholes would produce higher prices for OTM calls and ITM puts and not lower for Problem 19.1 (b). To me this is a mirror of the volatilty skew for Equity Options where the right tail is lighter and the left tail is heavier. Please advise if my understanding is incorrect. Thanks
