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dc.contributor.authorEderington, Louis Hen_NZ
dc.contributor.authorGuan, Weien_NZ
dc.date.available2011-04-07T03:19:02Z
dc.date.copyright2001-09-14en_NZ
dc.identifier.citationEderington, L. H., & Guan, W. (2001, September 14). Why are those options smiling? University of Otago Department of Finance Seminar Series. Presented at the University of Otago, Finance department, Seminar.en
dc.identifier.urihttp://hdl.handle.net/10523/1532
dc.description.abstractThis paper tests whether the true smile in implied volatilities is flat. The smile in observed Black-Scholes implied volatilities has often been attributed to deficiencies in the B-S model, such as the assumption of constant volatility, which cause the implied volatilities calculated using the B-S formula to differ from the true volatilities. If such deficiencies are the sole cause, then if the implied volatilities were calculated correctly (i.e., using the true though possibly unknown model), the smile should disappear or become flat. Using stock index options data, we test and reject the hypothesis that the true smile in stock index option prices is flat. If the true smile is flat, then a trading strategy in which one buys options at the bottom of the incorrect Black-Scholes smile and sells options at the top(s) should not be profitable even on a pre-transaction-cost basis. However, we find that such a delta-gamma neutral strategy yields substantial pre-transaction-cost profits. Moreover, the profits are large when the B-S model predicts large profits and small when small profits are predicted. Our results indicate that while part of the observed Black-Scholes smile appears due to deficiencies in the Black-Scholes model, a substantial part reflects a smile in the true implied volatilities. We argue that the true smile persists despite these substantial pretransaction-cost profits, because maintaining the trading portfolio’s original low risk profile requires frequent re-balancing which quickly eats away the profits.en_NZ
dc.format.mimetypeapplication/pdf
dc.relation.ispartofUniversity of Otago Department of Finance Seminar Seriesen_NZ
dc.relation.urihttp://www.business.otago.ac.nz/finc/research/seminars_01.htmlen_NZ
dc.subjectBlack-Scholes implied volatilitiesen_NZ
dc.subjectstock index optionsen_NZ
dc.subjectBlack-Scholes smileen_NZ
dc.subjectpre-transaction-cost basisen_NZ
dc.subject.lcshHF Commerceen_NZ
dc.subject.lcshHF5601 Accountingen_NZ
dc.subject.lcshHG Financeen_NZ
dc.titleWhy are those options smiling?en_NZ
dc.typeConference or Workshop Item (Seminar, Speech or Other Presentation)en_NZ
dc.description.versionUnpublisheden_NZ
otago.bitstream.pages47en_NZ
otago.date.accession2007-04-12en_NZ
otago.schoolFinanceen_NZ
otago.openaccessOpen
otago.place.publicationDunedin, New Zealanden_NZ
dc.identifier.eprints596en_NZ
dc.description.refereedNon Peer Revieweden_NZ
otago.school.eprintsFinance & Quantitative Analysisen_NZ
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otago.event.dates14 September 2001en_NZ
otago.event.placeDivisional Board Room, University of Otago, Dunedin, Otagoen_NZ
otago.event.typeotheren_NZ
otago.event.titleUniversity of Otago, Finance department, Seminaren_NZ
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