If the volatility implied from an at-the-money put stock option were used to price other put options on the stock,which of the following would be true?
A) Out-of-the money and in-the-money prices would be too high
B) Out-of-the money and in-the-money prices would be too low
C) Out-of-the-money option prices would be too high and in-the-money option prices would be too low
D) Out-of-the-money option prices would be too low and in-the-money option prices would be too high

Question

Quizplus · Accepted Answer

The volatility smile for equity options shows that at-the-money put options have lower implied volatilities than out-of-the-money put options and a higher volatility than in-the-money put options.This means that using at-the-money implied volatilities for out-of-the-money put options would lead to underpricing and using at-the-money implied volatilities for in-the-money put options would lead to overpricing .Hence the correct answer is D.

If the Volatility Implied from an At-The-Money Put Stock Option