A Smiling GARCH（543-555）.pdfVIP

26 A Smiling GARCH* Key words: econometrics, Monte Carlo simulation, implied volatility, GARCH model 26.1 Problem Statement In equity markets, empirical option prices document a well-known anomaly of the Black and Scholes formula. Volatility as implied by traded premia changes with re- spect to the exercise price and the maturity of an option. As shown in Fig. 26.1, once plotted against different exercise prices and maturities, implied volatility – the volatility value deduced from feeding observed option premia to the Black and Scholes formula – presents a characteristic convex shape which resembles a smirk (the smile effect). If we define option moneyness as the ratio between spot price and strike price,1 in the stock option market we often observe that deep-in-the-money call options (that are call options with moneyness significantly larger than one), or deep- out-of-the-money put options, typically present an implied volatility greater than at- the-money options. Conversely, deep-out-of-the-money call options or deep-in-the- money put options admittedly show smaller implied volatility. The immediate explanation of this phenomenon relates to the assumptions on stock price distribution embedded in the Black and Scholes formula. More precisely, since the latter assumes equity prices to be lognormally distributed, convexities in implied volatility arise because observed equity prices distribute with a thinner right tail and a fatter left tail than the canonical lognormal form. In fact, if the theoretical ∗ with Mariano Biondelli, Enrico Michelotti and Marco Tarenghi. 1 Moneyness equals one if an option is at-the-money (ATM); whilst it is greater or lower than one if a call option is in- or out-of-the-money (ITM or OTM), respectively. 544 26 A Smiling GARCH Fig. 26.1. Garch estimated versus market implied volatility surface. assumption of lognormal distribution were to be perfectly confirmed in the mar