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Keep on Smiling: Market Imbalance, Option Pricing, and the Volatility Smile

  • Paper
  • Sep 17, 2022
  • #Pricing #CapitalMarkets
David Orrell
@d_orrell
(Author)
papers.ssrn.com
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The Black-Scholes model, which is widely used to price financial options, assumes that volatility is constant as a function of strike price. However when market option prices are us... Show More

The Black-Scholes model, which is widely used to price financial options, assumes that volatility is constant as a function of strike price. However when market option prices are used to infer the volatility that is implied by those prices, it often exhibits a marked dependence on strike price which is characterised by a smile or skew shape. This paper argues that the volatility smile is “real” in the sense that volatility and price change are correlated through the degree of market imbalance. We test a formula for the volatility smile, derived from a quantum oscillator model of stock markets, against historical market data. It is seen that the Black-Scholes model systematically misprices options, but that option pricing performance can be improved by taking the smile into account.

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Blair Fix @blair_fix · Feb 11, 2023
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An interesting paper from @d_orrell and Larry Richards. It argues that there's a major flaw in the Black-Scholes model of options pricing. The problem? Price volatility seems to be a function of the strike price.
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