Volatility smile

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A view that the probabilities of very large market movements - positive or negative - are greater than predicted by a simple random walk model of market prices.

In other words, the view that market shows trending behaviour in relation to large market movements: 'Both panic and over-exuberance are contagious'.

This view is reflected in deeply out-of-the money options having greater implied volatilities (calculated from their greater traded values) than at-the-money options.

This view is also a potential explanation for leptokurtic frequency distributions. (Which have longer 'tails' of extreme values than the simpler Normal frequency distributions often used for modelling and calculation purposes.)


See also