Why Equity Options Have a Volatility Skew

Summary

The document explains why equity options can have different implied volatilities across strike prices, while foreign exchange options may show a more uniform pattern away from at-the-money. It attributes the equity skew to a negative relationship between equity prices and volatility: falling prices are associated with higher risk and implied volatility.

Two proposed explanations are the leverage effect, where falling equity values raise the debt-to-equity ratio, and investor aversion to losses, which may increase demand for downside protection. The document says this negative relationship is supported by empirical evidence, but provides no data, citations beyond a linked answer, or model for measuring the effect. It offers a brief conceptual explanation rather than a detailed comparison of equity and foreign exchange volatility surfaces.

Key ideas

• Equity options can exhibit different implied volatilities at different strikes.
• The proposed skew reflects a negative association between equity prices and volatility.
• The leverage effect links falling equity values with greater financial risk.
• Loss aversion may increase demand for protection against downside moves.
• The document gives no quantitative evidence or detailed explanation for the foreign exchange comparison.

Tags

# Volatility Skew Theory


# Volatility Skew Theory












This is the case for equity options, however for foreign exchange options the volatility only decreased at ATM.

Why is it that the vol used for one type of out/in the money is higher than the other, unlike the uniform case for foreign exchange?

## Answer by Vitomir (score 1)

https://quant.stackexchange.com/a/46422

On the Equity side the Skew introduces correlation between volatility and future prices because of:

- leverage effect: when Equity prices go down the leverage debt/equity increases making the underlying more and more risky

- crashophobia/behavioural finance: due to disposition effect, investors are more concerned/afraid about losses than optimistic for gains

The negative relationship is empirically supported.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.