A risk manager is examining a firm’s equity index option price assumptions.The observed volatility skew for a particular equity index slopes downward to the right.Compared to the lognormal distribution,the distribution of option prices on this index implied by the Black-Scholes-Merton(BSM)model would have:
A.A fat left tail and a thin right tail.
B.A fat left tail and a fat right tail.
C.A thin left tail and a fat right tail.
D.A thin left tail and a thin right tail.
Answer:A
Explanation:A downward sloping volatility skew indicates that out of the money puts are more expensive than predicted by the Black-Scholes-Merton model and out of the money calls are cheaper than expected predicted by the Black-Scholes-Merton model.The implied distribution has fat left tails and thin right tails.