Research

D. Chance, T. Hanson, W. Li, J. Muthuswamy: The Impact of Computational Error on the Volatility Smile

April 4, 2013

It is well-known that the market prices of options produce implied volatilities that inexplicably vary by exercise price in a pattern often referred to as the volatility smile. This paper shows that not only do market prices produce volatility smiles, but so do model prices. This result occurs because of root finding algorithms, tolerance assumptions, numerical precisions, and quotation finiteness. Moreover, some assumptions result in patterns that resemble the smirks, and skews sometimes observed in market data.