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    CQF January 2017 M3S4 Exercises Updated

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    Nasim Akhtar
    This document contains 5 exercises related to understanding volatility from a CQF lecture: 1) It asks to explain actual and implied volatilities and their relationship, and name three assumptions made in estimating actual volatility from market option prices. 2) It asks how to find the implied volatility of a European put option given its market price, strike, expiration, and stock value. 3) It asks to solve an integral equation to show the relationship between implied volatility and the actual volatility function over time for a European option. 4) It asks to show that for piecewise constant actual volatility, the total variance between observation dates is given by a difference of implied volatilities. 5) It

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    CQF January 2017 M3S4 Exercises Updated

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    Nasim Akhtar
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    This document contains 5 exercises related to understanding volatility from a CQF lecture: 1) It asks to explain actual and implied volatilities and their relationship, and name three assumptions made in estimating actual volatility from market option prices. 2) It asks how to find the implied volatility of a European put option given its market price, strike, expiration, and stock value. 3) It asks to solve an integral equation to show the relationship between implied volatility and the actual volatility function over time for a European option. 4) It asks to show that for piecewise constant actual volatility, the total variance between observation dates is given by a difference of implied volatilities. 5) It

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    This document contains 5 exercises related to understanding volatility from a CQF lecture: 1) It asks to explain actual and implied volatilities and their relationship, and name three assumptions made in estimating actual volatility from market option prices. 2) It asks how to find the implied volatility of a European put option given its market price, strike, expiration, and stock value. 3) It asks to solve an integral equation to show the relationship between implied volatility and the actual volatility function over time for a European option. 4) It asks to show that for piecewise constant actual volatility, the total variance between observation dates is given by a difference of implied volatilities. 5) It

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    76 views1 page

    CQF January 2017 M3S4 Exercises Updated

    Uploaded by

    Nasim Akhtar
    This document contains 5 exercises related to understanding volatility from a CQF lecture: 1) It asks to explain actual and implied volatilities and their relationship, and name three assumptions made in estimating actual volatility from market option prices. 2) It asks how to find the implied volatility of a European put option given its market price, strike, expiration, and stock value. 3) It asks to solve an integral equation to show the relationship between implied volatility and the actual volatility function over time for a European option. 4) It asks to show that for piecewise constant actual volatility, the total variance between observation dates is given by a difference of implied volatilities. 5) It

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    of 1

    CQF Lecture 3.

    3 Understanding Volatility
    Exercises

    1. Explain what actual and implied volatilities are, and what is their relationship? Name
    three assumptions made in estimation of actual volatility from the market option prices.

    2. The market price for a European put with strike 100, expiration one year, interest rate
    is 5% p.a. is quoted at $5.57 for stock value at $100. How do you find its implied
    volatility?

    3. Assume a time-dependent volatility function σ(t). Consistent with Black-Scholes


    framework, the implied volatility σi (t, T ) measured at time t of an European option
    expiring at time T must satisfy
    s
    Z T
    1
    σi (t, T ) = σ 2 (s) ds
    T −t t

    Solve the inverse problem (an integral equation) to show that, at calibration time t∗ ,
    the volatility function σ(t) must be consistent the implied volatility σi as follows:
    ∂σi (t∗ , t)
    σ 2 (t) = 2(t − t∗ ) σi (t∗ , t) + σi2 (t∗ , t)
    ∂t

    4. Suppose implied volatilities are observable at Ti , i = 0, 1, 2, · · · , n, with T0 = t∗ is the


    date of calibration (fitting). Assuming that the actual volatility function is piecewise
    constant, show that for Ti−1 < t < Ti the total variance is (this is discretised Q3)
    (Ti − t∗ ) σi2 (t∗ , Ti ) − (Ti−1 − t∗ ) σi2 (t∗ , Ti−1 )
    σ 2 (t) =
    Ti − Ti−1

    5. Denote the actual volatility by σa and implied volatility by σi , where subscript ‘a’
    means actual and ‘i’ means implied. Similarly, ∆a means ∆ is calculated using actual
    volatility in N (d1 ), and ∆i means ∆ is calculated by using implied volatility. Assume
    that an asset follows the GBM with continuous dividend rate D, and an option written
    on this asset is denoted by V (S, t; σ).
    Within the Black-Scholes framework, what is the Mark-to-Market profit if one hedges
    the option by using actual volatility to calculate Delta. How is this profit going to be
    realised (guaranteed or not)?
    What about the Mark-to-Market profit if hedging with the implied volatility?

    The exercises have been edited by CQF Faculty, Richard Diamond, [email protected]

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