Understanding Volatility Smile in Option Markets
Understanding Volatility Smile in Option Markets
It is well known that the Black-Scholes model cannot account for the volatility smile observed in financial markets. To explain the deviations of option prices from the Black-Scholes formula, models based on processes other than the geometric Brownian motion, such as stochastic volatility and jump diffusion processes, have been proposed. While these models can include the smile effect on the valuation of options to some extent, they do not explain the origin of the smile phenomenon.
In this work, we aim to get a better understanding of volatility smile through microsimulation of option markets. Within our model, we adopt traders of only two types: speculators and arbitrageurs, and put and call options on only one underlying asset with different strikes. Speculators make decisions based on their expectations of the price of the underlying asset in the future. In addition, their expected prices are influenced by news over time. Arbitrageurs trade at different arbitrage opportunities such as violation of the put-call parity. Difference of liquidity between out-of-the-money options and in-the-money options is also included in the model. Price changes of the options are proportional to their excess demand.
Peter Sloot talks research
