Tuesday, November 14, 2006
Volatility Smile
Volatility smile is the pattern of implied volatilities found in the market which forms a "smile" shape. This had been known long ago but theoriest still don't have satisfactory quantitative models. Volatility skew in equitiy market could reflect investors' fear of market crashes.
When corp investors are hedging with the Black-Scholes option pricing formula which assumes constant volatility, the smile implies people are hedging their risk based on a wrong assumption. When the market jump, investors who hedged wrongly have to rectify their error.
The Yield Curve is now inverted. The short term borrowing rate is now higher than the long term rate. In the last peak at year 2000, we also have an inverted yield curve.
Now, I am expecting a correction. In order to get a touch of the market, I buy some put option this morning.
When corp investors are hedging with the Black-Scholes option pricing formula which assumes constant volatility, the smile implies people are hedging their risk based on a wrong assumption. When the market jump, investors who hedged wrongly have to rectify their error.
The Yield Curve is now inverted. The short term borrowing rate is now higher than the long term rate. In the last peak at year 2000, we also have an inverted yield curve.
Now, I am expecting a correction. In order to get a touch of the market, I buy some put option this morning.
# posted by Lobo @ 1:22 AM 
