26 lines
1.7 KiB
Plaintext
26 lines
1.7 KiB
Plaintext
Term Structure of Volatility
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Term structure of volatility—also called monthly skew or horizontal skew
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—is the relationship among the IVs of options in the same class with the
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same strike but with different expiration months. IV, again, is often
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interpreted as the market’s estimate of future volatility. It is reasonable to
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assume that the market will expect some months to be more volatile than
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others. Because of this, different expiration cycles can trade at different IVs.
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For example, if a company involved in a major product-liability lawsuit is
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expecting a verdict on the case to be announced in two months, the one-
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month IV may be low, as the stock is not expected to move much until the
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suit is resolved. The two-month volatility may be much higher, however,
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reflecting the expectations of a big move in the stock up or down,
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depending on the outcome.
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The term structure of volatility also varies with the normal ebb and flow
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of volatility within the business cycle. In periods of declining volatility, it is
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common for the month with the least amount of time until expiration, also
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known as the front month, to trade at a lower volatility than the back
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months, or months with more time until expiration. Conversely, when
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volatility is rising, the front month tends to have a higher IV than the back
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months.
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Exhibit 3.3 shows historical option prices and their corresponding IVs for
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32.5-strike calls on General Motors (GM) during a period of low volatility.
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EXHIBIT 3.3 GM term structure of volatility.
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In this example, no major news is expected to be released on GM, and
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overall market volatility is relatively low. The February 32.5 call has the
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lowest IV, at 32 percent. Each consecutive month has a higher IV than the |