Alternative Formulas to Compute Implied Standard Deviation

Review of Pacific Basin Financial Markets and Policies, Vol. 12, No. 2, pp. 159-176, 2009

Posted: 12 Oct 2009

See all articles by James S. Ang

James S. Ang

Florida State University; Florida State University - College of Law

Gwoduan David Jou

affiliation not provided to SSRN

Tsong-Yue Lai

California State University-Fullerton, Department of Finance

Date Written: June 2009

Abstract

We assume that the call option's value is correctly priced by Black and Scholes' option pricing model in this paper. This paper derives an exact closed-form solution for implied standard deviation under the condition that the underlying asset price equals the present value of the exercise price. The exact closed-form solution provides the true implied standard deviation and has no estimate error. This paper also develops three alternative formulas to estimate the implied standard deviation if this condition is violated. Application of the Taylor expansion on a single call option value derives the first formula. The accuracy of this formula depends on the deviation between the underlying asset price and the present value of the exercise price. Use of the Taylor formula on two call option prices with different exercise prices is used to develop the second formula, which can be used even though the underlying asset price deviates significantly from the present value of the exercise price. Extension of the second formula's approach to third options value derives the third formula. A merit of the third formula is to circumvent a required parameter used in the second formula. Simulations demonstrate that the implied standard deviations calculated by the second and third formulas provide accurate estimates of the true implied standard deviations.

Keywords: Implied volatility, options, option pricing model, implied standard deviation, Taylor formula

Suggested Citation

Ang, James S. and Jou, Gwoduan David and Lai, Tsong-Yue, Alternative Formulas to Compute Implied Standard Deviation (June 2009). Review of Pacific Basin Financial Markets and Policies, Vol. 12, No. 2, pp. 159-176, 2009. Available at SSRN: https://ssrn.com/abstract=1487909

James S. Ang (Contact Author)

Florida State University ( email )

College of Business
Tallahassee, FL 32306-1042
United States
904-644-8208 (Phone)

Florida State University - College of Law ( email )

425 W. Jefferson Street
Tallahassee, FL 32306
United States

Gwoduan David Jou

affiliation not provided to SSRN ( email )

Tsong-Yue Lai

California State University-Fullerton, Department of Finance ( email )

PO Box 6848
Fullerton, CA 92834-6848
United States
657-278-3855 (Phone)
657-278-2161 (Fax)

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