Asymmetric Option Price Distribution and Bid-Ask Quotes: Consequences for Implied Volatility Smiles

24 Pages Posted: 3 Mar 2002

See all articles by Lars L. Norden

Lars L. Norden

Stockholm University - Stockholm Business School

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Abstract

This study presents a model, which can be used to estimate the asymmetry of option values with respect to option bid-ask spreads. The model provides an extension to the model in Chan and Chung (1999), since it does not require knowledge of the actual option value to evaluate the asymmetry. Using data from the Swedish market for equity options, results show clear evidence of asymmetry in call and put option values, where the option values tend to be closer to bid than to ask quotes. Significant differences are found with respect to option moneyness; in- and out-of-the-money calls and puts show a higher degree of asymmetry than options which are close to at-the-money. These results imply that representing an option value with the bid-ask midpoint results in a bias, overestimating the value. The possible linkage between the asymmetry at the options markets and the so-called volatility smile is recognised. The estimated asymmetry parameters for call and put option values are used in an out-of-sample analysis of option-implied volatility. Comparisons are made with the benchmark case under the assumption of no asymmetry in option values, i.e. when the bid-ask midpoints are used in the estimation of implied volatility. When the implied volatilities are adjusted for asymmetry effects, there is considerably less evidence of a smile, relative to the benchmark case. This study is believed to be the first to account for asymmetry effects in option values when calculating implied volatility.

Keywords: Option bid-ask spread, asymmetry, volatility smile

JEL Classification: G10, G13, G14

Suggested Citation

Nordén, Lars L., Asymmetric Option Price Distribution and Bid-Ask Quotes: Consequences for Implied Volatility Smiles. Available at SSRN: https://ssrn.com/abstract=302129 or http://dx.doi.org/10.2139/ssrn.302129

Lars L. Nordén (Contact Author)

Stockholm University - Stockholm Business School ( email )

Sweden

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