By Kevin Mulhern: The volatility smile is one of those interesting phenomenon that no one in finance can fully explain. The Black Scholes formula for pricing a plain vanilla European option gives the value of the premium given inputs for spot price of the underlying security, strike price of the option, the market risk-free interest rate, the time until expiry of the option, and the implied volatility of the option. It is possible to take the market price for an option and the other four inputs and work backwards to determine what the market is implying in terms of future volatility in a security. Performing this same work-out for many different puts and calls of different strike prices for the same underlying produces a curve called the 'volatility smile'. According to Black-Scholes theory, the volatility smile should be entirely flat, meaning that implied volatility does not change for different derivatives on the same


Complete Story »

More...