age !

of "

Implied Volatility
Definition and Estimation
ln Lhe early 1970's, llsher 8lack, Myron Scholes and 8oberL MerLon made a huge
advancemenL on Lhe evaluaLlon of opLlon prlces. 1hls work has been Lhe cause of a sLrong lmpacL on
Lhe meLhods used by Lhe Lraders elLher for Lhe opLlon valuaLlon or for Lhe elaboraLlon of hedglng
meLhods. lL has also been Lhe beglnnlng of Lhe specLacular developmenL of Lhe flnanclal englneerlng.
1hey have produced equaLlons Lo geL Lhe prlce of an opLlon from dlfferenL parameLers such as Lhe
volaLlllLy based on Lhe 8lack-Scholes model and lLs hypoLheses.
1here are Lhree maln klnds of volaLlllLy, Lhe hlsLorlcal volaLlllLy (based on Lhe pasL evoluLlon
of Lhe underlylng asseL, see Lhe Lab volaLlllLy-v0.4 for more lnformaLlon), Lhe lmplled volaLlllLy and
Lhe sLochasLlc volaLlllLy (lL requlres Lo change some hypoLhesls of Lhe 8lack-Scholes model, lL wlll noL
be developed ln Lhls paper). 1he second one ls used by Lhe Lraders for glvlng Lhem an ldea on Lhe
markeL behavlor aL a cerLaln Llme. lL ls calculaLed from Lhe prlces of Lhe opLlons quoLed on Lhe
markeL. As we wlll dlscuss ln Lhls documenL Lhey are few ways Lo calculaLe Lhe lmplled volaLlllLy of an
opLlon. lL ls lmposslble Lo exLracL lL dlrecLly from Lhe 8lack-Scholes equaLlons so we use numerlcal
procedures such as Lhe newLon-8aphson algorlLhm. We won'L dlscuss auLoregresslve volaLlllLy
forecasLlng models whlch need more perqulslLe knowledge. 1hls documenL ls an lnLroducLlon Lo Lhe
lmplled volaLlllLy and lLs calculaLlon. lL also sLarLs brlefly by explalnlng how Lhls volaLlllLy could be
lnLerpreLed and used.
lL ls organlzed as follows: SecLlon 1 lnLroduces Lhe 8lack-Scholes model and Lhe equaLlons Lo
calculaLe Lhe prlce of an opLlon.
SecLlon 2 proposes an overvlew of Lhe maln meLhods Lo compuLe Lhe lmplled volaLlllLy and develops
Lhe newLon-8aphson algorlLhm and lLs appllcaLlon, SecLlon 3 presenLs a slmple lnLerpreLaLlon and
use of Lhe lmplled volaLlllLy. SecLlon 4 provldes an exerclse Lo demonsLraLe how Lhe dlscussed
models work. ln Lhese secLlons, we use some noLaLlons and assumpLlons LhaL are presenLed ln Lable
1.
Variable Description Value (Data available vs Calculation needed)
!
!"#
Price of a call quoted on the market Data
!
!"#
Price of a put quoted on the market Data
!
!
Original spot price of the underlying share of
the option
Data
r
Risk-free rate of interest (annual rate)
Data
K Strike price of the option Data
T Time to maturity of the option (in year) Data
! Implied Volatility of the option Calculation-Some proxies and models are presented in
section 2
!
!"
Price of a call from the Black-Scholes
equations
Calculation- Refer to equation 1
!
!"
Price of a put from the Black-Scholes equations Calculation- Refer to equation 2
N(x) Normal cumulative distribution function
(mean=0, standard-deviation=1)
Data The value can be calculated by many tools like
MatLab, Excel
!!"#

Vega of the option
Partial derivative of the Black-Scholes function
!
!"
(or !
!"
! with respect to the volatility !
!
!
; t!0 Standard Brownian motion Equation purpose (no need to be detailed)
!
!
Price of the underlying asset at the time t Equation purpose
!"
!
!
!
Infinitesimal evolution of !
!
Equation purpose (no need to be detailed)
Table 1: Notations and assumption
age # of "

1. The Black-Scholes model/equations
1.1 The model and its hypotheses
ln order Lo obLaln Lhe equaLlons of Lhe prlce of an opLlon, llsher 8lack, Myron Scholes and
8oberL MerLon flrsL deflned a model of Lhe Llme-evoluLlon of a share prlce on a markeL. 1hey
have assumed LhaL Lhe prlce of Lhe underlylng asseL (Lyplcally a sLock) follows a geomeLrlc
8rownlan moLlon (lL ls a sLochasLlc moLlon whlch lnvolves sLochasLlc probablllLy [1]). 1haL ls,
!!
!
!
!
! !"# !!"!
!
! !! ! !
1hls equaLlon descrlbes Lhe lnflnlLeslmal evoluLlon of !
!
LhaL ls Lo say Lhe dlfference
beLween !
!
and !
!!!
when h Lends Lo 0. ! ls Lhe rlsk-free raLe of lnLeresL and ! ls Lhe volaLlllLy,
Lhey are boLh assumed Lo be consLanL over Llme.
1hey added several hypoLheses Lo Lhe equaLlon, whlch LogeLher forms Lhe 8lack-Scholes
model. 1he assumpLlons are,
- 1here ls no arblLrage opporLunlLles (maklng proflL wlLh a nll or a negaLlve lnvesLmenL [2])
- 1he Llme ls a conLlnuous funcLlon
- lL ls posslble Lo pracLlce shorL selllng (selllng an asseL LhaL we don'L possess buL we
guaranLee LhaL we wlll buy lL lf Lhere wlll be a dellvery)
- 1here ls no LransacLlon fee
- 1here ls a known and consLanL rlsk-free raLe of lnLeresL (! ln Lhe equaLlon, [3])
- Lvery underlylng asseL ls fully dlvlslble (e.g. lL ls posslble Lo buy 1/100 of a share)
- ln Lhe case of a share, Lhls one pays no dlvldend beLween Lhe momenL of Lhe evaluaLlon
of Lhe opLlon and lLs maLurlLy
1hese assumpLlons appear very resLrlcLlve buL Lhey are all necessary Lo demonsLraLe Lhe
8lack-Schole formula (also known as Lhe arLlal ulfferenLlal LquaLlon of 8lack-Scholes [4]). lL ls
noL Lhe purpose of Lhls documenL Lo explaln or demonsLraLe Lhe formula whlch requlres a sLrong
maLhemaLlcal knowledge. Powever, lL ls lmporLanL Lo undersLand LhaL Lhe equaLlons of Lhe prlce
of a Luropean opLlon come from Lhe resoluLlon of Lhe 8lack-Scholes formula.

1.2 The equations of the price of a European option
1he 8lack-Scholes equaLlons permlL Lo calculaLe, aL Lhe daLe zero, Lhe value of a Luropean
call (!
!"
) or a Luropean puL (!
!"
) on a share whlch doesn'L pay any dlvldend. 1hey are,
!
!"
! !
!
! !
!
!!!
!!"
!!!
!
! (1)

!
!"
! !!
!!"
! !!
!
!!
!
! !!
!
(2)
Where !
!
!
!"
!
!
!
! !!
!
!
!
!
! !
and !
!
! !
!
! ! !
1he funcLlon !!!! ls Lhe normal cumulaLlve dlsLrlbuLlon funcLlon wlLh a mean equal Lo zero and
a sLandard-devlaLlon equal Lo 1.
age $ of "

%&'()*+ !- We wanL Lo calculaLe Lhe prlce of a Luropean call on an AnZ share whlch has
a spoL prlce equal Lo 110Auu. 1he sLrlke prlce ls 100Auu, Lhe Llme Lo maLurlLy ls 6 monLhs, Lhe
volaLlllLy ls 20 and Lhe rlsk-free raLe of lnLeresL ls 10. We have !
!
! !"", k = 110, 1 = 0.3,
o = 0.2, ! # $%&
1haL ls Lo say, !
!
!
!"
!!"
!""
! !!!!
!!!
!
!
!!!
!!! !!!
! !!!"#$
and !
!
! !!!"#$ ! !!! !!! ! !!!"#$
so !
!"
! !!"! !!!"#$ !!""!
!!!!!!!!
! !!!"#$ ! !"!!"#$ from Lhe equaLlon (1)
1he prlce of Lhls call ls 16.02Auu (wlLh Lhe same reasonlng Lhe prlce of Lhe maLchlng puL ls
1.14Auu).

2. The implied volatility computation
2.1 Numerical procedures
ln Lhe prevlous example Lhe volaLlllLy was a known daLa. When we wanL Lo exLracL lL from
Lhe 8lack-Scholes equaLlons lL becomes Lhe lmplled volaLlllLy. lor pracLlcal purposes Lhe prlce of
an opLlon ls Lhe resulL of Lhe law of supply and demand. 1he prlce can be observed on Lhe
markeL (!
!"#
or !
!"#
) as well as Lhe oLher parameLers (!
!
, k, r, 1) excepL for Lhe volaLlllLy. 1he
8lack-Scholes equaLlon of Lhe prlce of a Luropean opLlon became a funcLlon of Lhe volaLlllLy
(!
!"
!!!). 1he lmplled volaLlllLy ls Lhe volaLlllLy (!
!
) where Lhe 8lack-Scholes esLlmaLed prlce ls
equal Lo Lhe markeL prlce of Lhe opLlon. 1hus, Lo calculaLe Lhe lmplled volaLlllLy requlres solvlng
Lhe followlng equaLlons:
!
!"
! ! !
!
! !
!
! !!
!!"
! !
!
! !
!"#
(3)

!
!"
! ! !!
!!"
! !!
!
!!
!
! !
!
! !
!"#
(4)

We can see ln Lhe equaLlons LhaL Lhe normal cumulaLlve dlsLrlbuLlon funcLlon ls lnvolved.
! ! !
!
!!
!
!
!
!
!
!
!"
!
!!


1haL ls Lo say Lhe 8lack-Scholes equaLlons lnvolve lnLegrals so lL ls necessary Lo use numerlcal
procedures Lo approxlmaLe Lhe soluLlon. 1here are Lhree maln numerlcal procedures used Lo
approxlmaLe Lhe lmplled volaLlllLy: Lhe blsecLlon meLhod (#), Lhe secanL meLhod (#) and Lhe
newLon-8aphson meLhod.

1he blsecLlon meLhod requlres flndlng a flrsL lnLerval whlch conLalns Lhe soluLlon. 1hen Lhls
lnLerval ls dlvlded ln Lwo equal lnLervals (one wlLh Lhe soluLlon, Lhe oLher wlLhouL). 8y dolng Lhls
many Llmes, Lhe lnLerval whlch conLalns Lhe soluLlon geL smaller and Lhe soluLlon ls
approxlmaLed by Lhe mean of Lhe Lwo llmlLs of Lhe smallesL lnLerval.
age . of "

1he secanL meLhod uses a successlon of rooLs of secanL llnes Lo beLLer approxlmaLe a rooL of
a funcLlon. Lach secanL llnes passes Lhrough Lwo polnLs of Lhe funcLlon whlch encapsulaLe lLs
rooL. As Lhe Lwo polnLs geL closer Lo Lhe rooL Lhe approxlmaLlon geL beLLer.
Lach of Lhese procedures ls lLeraLlve. 1hey requlre LhaL Lhe consldered funcLlon ls
conLlnuous. Many lLeraLlons are necessary Lo obLaln a good approxlmaLlon. 1he newLon-
8aphson meLhod ls fasLer buL requlres knowlng Lhe derlvaLlve of Lhe funcLlon.


2.2 The Newton-Raphson method
1hls algorlLhm ls uslng Lhe 1aylor serles (#) for a funcLlon whlch ls dlfferenLlable aL leasL
once. Clven a funcLlon f, lf we guess !
!
a flrsL approxlmaLlon of Lhe soluLlon of Lhe equaLlon
! ! ! !, a beLLer approxlmaLlon of Lhe soluLlon would be:
!
!
! !
!
!
!!!
!
!
!
!
!!
!
!


1hls process can be repeaLed unLll !
!!!
and Lhe recurrence formula becomes:
!
!!!
! !
!
!
!!!
!
!
!
!
!!
!
!
wlLh n a poslLlve lnLeger (3)

!
!
converges very fasL Lo Lhe soluLlon as shown ln flgure 1.


Figure 1: Newton-Raphson algorithm illustration

uslng Lhe newLon-8aphson algorlLhm ls chooslng a flrsL approxlmaLlon !
!
(can be done
arblLrarlly) and Lhen calculaLlng Lhe !
!
flrsL approxlmaLlons for Lhe n flrsL lLeraLlons of Lhe
recurrence. 1he more Lhere are lLeraLlons Lhe beLLer Lhe approxlmaLlon ls. lL ls also posslble Lo
choose an lnLerval Lo sLop Lhe procedure as soon as Lhe !
!
Lh approxlmaLlon ls ln Lhls lnLerval.

soluLlon
age / of "

2.3 Computing the implied volatility using the Newton-Raphson algorithm
1he newLon-8aphson algorlLhm ls a fasL and efflclenL meLhod Lo approxlmaLe Lhe lmplled
volaLlllLy. We wlll only use Lhe equaLlon wlLh Lhe prlce of a call for Lhe demonsLraLlon buL Lhe
reasonlng for Lhe puL ls exacLly Lhe same. We are looklng for Lhe soluLlon !
!
of Lhe equaLlon
!
!"
! ! !
!"#

lf !
!
!
ls Lhe n-Lh approxlmaLlon of Lhe lmplled volaLlllLy, Lhe recurrence equaLlon (3)
becomes: !
!!!
!
! !
!
!
!
!
!"
!
!
!
!!
!"#
!!
!"
!
!
!
!"
wlLh n a poslLlve lnLeger (6)
1he dlfference beLween Lhe boLh recurrence formulas (3 and 6) ls LhaL Lhe funcLlon
for ! ! !
!
ls noL equal Lo 0 anymore buL Lo !
!"#
. We wlll assume LhaL Lhe funcLlon !
!"
! ls
conLlnuous, dlfferenLlable and sLrlcLly lncreaslng for ' ln [0,+~[ (can be easlly demonsLraLed)
hence Lhe equaLlon !
!"
! ! !
!"#
has only one soluLlon.
1he only unknown funcLlon ln Lhe equaLlon (6) ls Lhe derlvaLlve of Lhe funcLlon !
!"
wlLh
respecL Lo Lhe varlable !. 1hls funcLlon ls called Lhe vega and belongs Lo a seL called Lhe
Creeks" (even lf vega ls noL a greek leLLer, [4]). lL ls Lhe parLlal derlvaLlve of Lhe prlce of an
opLlon wlLh respecL Lo Lhe volaLlllLy, lLs expresslon ls:
!"#$ !
!!
!"
!"
!
!!
!"
!"
!
!
!
!
!!
!
!
!
!
!
!
(7)
Slnce all Lhe varlables are known, lL ls posslble Lo sLarL Lhe recurrence equaLlon Lo calculaLe
Lhe lmplled volaLlllLy !
!
.

%&'()*+ #- We wlll Lake Lhe same daLa from Lhe example 1. We know LhaL Lhe prlce of a
Luropean call on a 110Auu AnZ share ls !"!!"#$Auu on Lhe AusLrallan SLock Lxchange. 1he
sLrlke prlce of Lhls opLlon ls 110Auu, Lhe rlsk-free raLe of lnLeresL ls 10 and Lhe Llme Lo maLurlLy
ls 6 monLhs. We are golng Lo calculaLe Lhe lmplled volaLlllLy of Lhls opLlon uslng Lhe newLon-
8aphson algorlLhm. We have Lhe dlfferenL parameLers, !
!"#
! !"!!"#$, !
!
! !!", ! ! !"",
! ! !!!! ! ! !!!
1he flrsL sLep ls Lo choose an lnlLlal value for !
!
, leL's Lake !
!
!
! !"# ! !!!
1hen we can calculaLe !
!
!
!"
!!"
!""
! !!!!
!!!
!
!
!!!
!!! !!!
! !!!"#", !
!
! !!!"#" ! !!! !!! ! !!!"#!,
!"#$ !
!!" !!!
!!
!
!
!!!"#"
!
!
! !"!!"#$ from Lhe equaLlon (7)
and !
!"
! !!"! !!!"#" !!""!
!!!!!!!!
! !!!"#! ! !"!!"#$ from Lhe equaLlon (1)
So wlLh Lhe equaLlon (6) !
!
!
! !!! !
!"!!"#$ !!"!!"#$
!"!!"#$
! !!!"!#
1he nexL values are !
!
!
! !!!"#$, !
!
!
! !!!""", . !
!"
!
! !!!"""
1hus slnce Lhe 3
rd
sLep we have already found Lhe value of !
!
! !"#. 1hls resulL ls conflrmed ln
Lhe example 1.
age 0 of "

3. Interpretation and use of the implied volatility

ln Lhls secLlon we wlll show Lhe maln dlfference beLween Lhe 8lack-Scholes model and Lhe
sLudy of Lhe emplrlcal prlces of opLlons on Lhe markeL. We wlll also lnLroduce Lhe lnLerpreLaLlon
of Lhe lmplled volaLlllLy and lLs use.
As lL ls explalned ln Lhe lnLroducLlon, Lhe Lraders use Lhe lmplled volaLlllLy of opLlons for
glvlng Lhem an ldea on Lhe markeL behavlor aL a cerLaln Llme. Powever, Lhe 8lack-Scholes
model assumes LhaL Lhe volaLlllLy of an opLlon ls consLanL over Llme. lL ls easy Lo undersLand
LhaL Lhls ls noL Lrue on Lhe markeL. 1he Lraders are uslng curves of Lhe lmplled volaLlllLy of an
opLlon for dlfferenL sLrlke prlces. 1hese curves are called volaLlllLy smlles" ([3]) due Lo Lhelr
speclflc aspecL. lf Lhe 8alck-Scholes model was correcL, Lhe lmplled volaLlllLy of an opLlon would
noL change due Lo dlfferenL sLrlke prlces. 1he graph ln llgure 2 represenLs Lhe curve of Lhe
lmplled volaLlllLy for dlfferenL sLrlke prlces aL Lhe same Llme Lo maLurlLy. 1he opLlons consldered
were Luropean Calls on Lhe Coogle share ($390.80 Lhe 10/03/2011 on nASuAC, [6]). 1helr
explry daLe was Lhe 13/04/2011 and Lhey were quoLed on Lhe 10/03/2011 (36 days Lo
maLurlLy).

Figure 2: Volatility smile from empirical data on calls for the Google Share

1hus, Lhe evoluLlon of Lhe lmplled volaLlllLy of an opLlon observed on Lhe markeL ls noLhlng
buL consLanL unllke Lhe 8lack-Scholes model assumes. 1he process Lo geL Lhe volaLlllLy smlle" ls
very slmple. AL a daLe 1, Lhe Lrader geLs Lhe quoLed prlce (on Lhe markeL) of Lhe asseL he ls
lnLeresLed ln. 1hen he geLs Lhe quoLed prlces (on Lhe markeL) of Lhe opLlon (call/puL) on Lhe
underlylng asseL for dlfferenL sLrlke prlces buL for Lhe same explry daLe. 1he rlsk-free lnLeresL
0
0.3
1
1.3
2
2.3
3
4
8
0

4
9
0

3
0
0

3
1
0

3
2
0

3
2
3

3
3
0

3
3
3

3
4
0

3
4
3

3
3
0

3
3
3

3
6
0

3
6
3

3
7
0

3
7
3

3
8
0

3
8
3

3
9
0

3
9
3

6
0
0

6
0
3

6
1
0

1()*2+3 45*'6*278
97:2;+ <:2=+
45*'6*278 9(2*+
>*'=;?9=@5*+A (53+* B5*'6*278
!CDC$D#C!!
age E of "

raLe chosen from Lhe yleld curve raLes has Lo maLch Lhe Llme Lo maLurlLy. lor lnsLance,
conslderlng an opLlon on an asseL quoLed on Lhe nASuAC (u.S.) Lhe rlsk-free lnLeresL raLe wlll
be chosen from Lhe uS Lreasury yleld curve raLes ([7]). 1he mosL approprlaLed raLe wlll be Lhe
one whlch maLches Lhe explry daLe of Lhe opLlon (e.g. 0.11 for 1 monLh or 0.13 for 3 monLh,
0.11 ls Lhe rlghL rlsk-free lnLeresL raLe for a 43 days Llme Lo maLurlLy). WlLh Lhese daLa Lhe
Lrader can calculaLe Lhe lmplled volaLlllLy (wlLh Lhe newLon-8aphson algorlLhm for lnsLance) for
Lhe dlfferenL sLrlke prlces and dlsplay Lhem on a graph.
8esldes sLudylng Lhe evoluLlon of Lhe lmplled volaLlllLy for dlfferenL sLrlke prlces, Lhe Lraders
are also used Lo observe Lhe behavlor of Lhe lmplled volaLlllLy for dlfferenL explry daLes. 1he
process remalns Lhe exacL same as Lhe one descrlbed above excepL LhaL lnsLead of flxlng Lhe
explry daLe and varylng Lhe sLrlke prlce, Lhe sLrlke prlce ls flxed and Lhe Llme Lo maLurlLy varles,
Lhe rlsk-free raLe of lnLeresL should be recallbraLed as Lhe Llme Lo maLurlLy ls changlng.
8y comblnlng Lhe Lwo processes Lhe Lrader obLalns an lmplled volaLlllLy maLrlx. lL ls a Lable
whlch conLalns Lhe lmplled volaLlllLles, of an opLlon klnd, calculaLed wlLh dlfferenL sLrlke prlces
and Llmes Lo maLurlLy. Pe usually dlsplays Lhe maLrlx as an lmplled volaLlllLy surface on a 3-u
graph. 1he Lwo axls of Lhe base are Lhe sLrlke prlce and Lhe Llme-Lo maLurlLy and Lhe Lhlrd one ls
Lhe lmplled volaLlllLy. 1he followlng example ls Lhe volaLlllLy surface of calls on Lhe Coogle share
quoLed on Lhe 14/03/2011 ($376.71 on nASuAC, [8]).

Figure 3: Implied volatility surface from empirical data on calls on the Google Share

As Lhe volaLlllLy smlle (dlfferenL sLrlke prlces) can be recovered by cuLLlng Lhe lmplled
volaLlllLy surface wlLh a verLlcal plan for a flxed Llme Lo maLurlLy, we can see LhaL Lhe smlle" ls
more obvlous as Lhe Llme Lo maLurlLy geLs smaller. 1he volaLlllLy smlle and Lhe lmplled volaLlllLy
surface presenLed ln Lhe Lwo prevlous examples are Lyplcal for equlLy opLlons. 1he lmplled
volaLlllLy ls a decreaslng funcLlon of Lhe sLrlke prlce. When Lhe prlce of Lhe underlylng asseL ls
much hlgher Lhan Lhe sLrlke prlce (very ln-Lhe-money call or very ouL-of-Lhe-money puL), Lhe
6
34
97
188
314
0
0.3
1
1.3
2
340
330
360
370
373
380
390
600
610
1.3-2
1-1.3
0.3-1
0-0.3
F2(+ 75
G'7H:278

97:2;+ <:2=+

1()*2+3
45*'6*278
1()*2+3 45*'72*278 AH:I'=+
age J of "

volaLlllLy used ls hlgher Lhan Lhe one used for Lhe valuaLlon of a very ln-Lhe-money puL or a very
ouL-of-Lhe-money call. We are speaklng of volaLlllLy skew. ln facL, Lhe volaLlllLy skew suggesLs
LhaL Lhe probablllLy LhaL crlLlcal evenLs on Lhe markeL (crlsls for lnsLance) happen ls hlgher LhaL
Lhe 8lack-Scholes model assumes. lndeed, Lhe volaLlllLy smlle on equlLy opLlons has been used
slnce Lhe crash of CcLober 1987 ([9]). 1he expllcaLlon of Lhls aspecL wlll noL be dlscussed ln Lhls
documenL as lL requesLs a sLrong knowledge ln probablllLles.

4. Exercise
ln Lhls secLlon we are observlng daLa whlch come from Lhe markeL and we are uslng Lhe
equaLlons and models developed ln Lhe prevlous secLlons ln a pracLlcal polnL of vlew. 1he
daLaseL comes from Lhe Coogle llnance webslLe (hLLp://www.google.com/flnance). We wlll
observe Lhe markeL prlces of calls on Lhe Coogle share, quoLed on Lhe 17/03/2011.
Dataset: ?ou have been glven Lwo excel flles (volaLlllLy_smlles&surface.xls and
lmplled_volaLlllLy_exerclse.xls). 1he flrsL one conLalns examples (calls and puLs prlces and
lmplled volaLlllLy on Coogle and Apple shares) used ln Lhls documenL and more. 1he second one
(calls prlces and lmplled volaLlllLy on Coogle share) wlll be used and fllled for Lhe exerclse.

Assignment: calculaLe dlfferenL measures of Coogle calls' prlces (uslng Lhe 8lack-Scholes
equaLlons) and lmplled volaLlllLy (uslng Lhe newLon 8aphson algorlLhm) uslng Lhe daLaseL
provlded. 1he flrsL excel flle could be used for helplng and undersLandlng purposes for Lhe
exerclse.

1- a) Cpen Lhe sheeL Coogle Call SLrlke rlce" ln Lhe exerclse flle. 1hls Lable conLalns Lhe
observed prlces on Lhe markeL of calls on Lhe Coogle share for dlfferenL sLrlke prlces buL for
Lhe same explry daLe. uslng Lhe lnformaLlon you have ln Lhls sheeL, calculaLe Lhe Lwo
mlsslng calls prlces wlLh Lhe 8lack-Scholes equaLlons. Choose Lhe correcL rlsk-free raLe of
lnLeresL from Lhe sheeL uS Lreasury yleld curve raLes". uon'L forgeL Lo annuallze Lhe Llme
Lo maLurlLy (e.g. Llme Lo maLurlLy: 17, annuallzed Llme Lo maLurlLy: 17/363).
b) CalculaLe Lhe Lwo mlsslng lmplled volaLlllLles uslng Lhe newLon-8aphson algorlLhm wlLh 4
lLeraLlons (0,1,2,3,4).
c) ulsplay Lhe volaLlllLy smlle and dlscuss lL.

2- a) Cpen Lhe sheeL Coogle Call MaLurlLy". 1hls Lable conLalns Lhe observed prlces on Lhe
markeL of calls on Lhe Coogle share for dlfferenL explry daLes buL for Lhe same sLrlke prlce.
llll some blank boxes wlLh Lhe daLa of Lhe flrsL sheeL. llll Lhe rlsk-free raLes of lnLeresL uslng
Lhe sheeL uS Lreasury yleld curve raLe" and calculaLe Lhe mlsslng lmplled volaLlllLy uslng
Lhe newLon-8aphson algorlLhm wlLh 4 lLeraLlons (0,1,2,3,4).
b) CalculaLe Lhe mlsslng prlce of Lhe calls uslng Lhe 8lack-Scholes equaLlons.
c) ulsplay Lhe graph of Lhe lmplled volaLlllLy funcLlon of Lhe Llme Lo maLurlLy and dlscuss lL.

age " of "

3- a) Cpen Lhe sheeL Coogle call lv measures". 1hls Lable conLalns lmplled volaLlllLles of calls
on Lhe Coogle share for dlfferenL SLrlke prlces and dlfferenL Llmes Lo maLurlLy. llll Lhe blank
boxes wlLh Lhe daLa from Lhe prevlous Lable.
b) now you can bulld Lhe lmplled volaLlllLy maLrlx. Cpen Lhe sheeL lmplled volaLlllLy
MaLrlx" and flll Lhe Lable wlLh Lhe daLa of Lhe prevlous sheeL.
c) ulsplay Lhe lmplled volaLlllLy surface as follows: use Lhe 3-u surface graph consLrucLor of
Lxcel. 1he x axls wlll be Lhe sLrlke prlce, Lhe ? axls wlll be Lhe Llme Lo maLurlLy, Lhe Z axls wlll
be Lhe lmplled volaLlllLy.
d) ulscuss Lhe lmplled volaLlllLy surface. WhaL can you say abouL Lhe volaLlllLy smlle when
Lhe Llme Lo maLurlLy ls changlng? ulscuss Lhe dlfferences of Lhe lmplled volaLlllLy when Lhe
call ls aL-Lhe-money, ln-Lhe-money and ouL-of-Lhe-money for dlfferenL Llmes Lo maLurlLy.
1he lmplled volaLlllLy surface presenLed ln Lhe documenL ls Lhe same Lhan Lhe one you bullL
buL Lhe daLe of Lhe quoLaLlons ls older (surface of Lhe documenL: quoLaLlon on Lhe
14/03/2011, surface bullL: quoLaLlon on Lhe 17/03/2011). ulscuss Lhe dlfferences beLween
Lhe boLh lmplled volaLlllLy surfaces conslderlng Lhe sLock prlce dlfference.

4- WlLh Lhe language you prefer, program a funcLlon whlch reLurns Lhe lmplled volaLlllLy of
equlLy opLlon (call and puL) uslng Lhe newLon-8aphson algorlLhm and Lhe 8lack-Scholes
equaLlons. 1he lnpuL parameLers wlll be Lhe opLlon prlce, Lhe sLock prlce, Lhe sLrlke prlce,
Lhe Llme Lo maLurlLy (annuallzed), Lhe rlsk-free raLe of lnLeresL, Lhe Lype of Lhe opLlon
(call/puL) and Lhe number of lLeraLlons of Lhe recurrence.


5. References

[1] CpLlons, luLure, and CLher uerlvaLlves, !ohn Pull (chapLer 12)
[2] hLLp://en.wlklpedla.org/wlkl/ArblLrage
[3] hLLp://en.wlklpedla.org/wlkl/8lsk-free_lnLeresL_raLe
[4] hLLp://www.Lreasury.gov/resource-cenLer/daLa-charL-cenLer/lnLeresL-
raLes/ages/1exLvlew.aspx?daLa=yleld
[3] See Lhe aLLached Lxcel flle volaLlllLy_smlles&surface.xls" sheeL Coogle lmplled volaLlllLy
MaLrlx"
[6] CpLlons, luLure, and CLher uerlvaLlves, !ohn Pull (chapLer 13)
[7] CpLlons, luLure, and CLher uerlvaLlves, !ohn Pull (chapLer 16)
[8] See Lhe aLLached Lxcel flle volaLlllLy_smlles&surface.xls" sheeL Coogle Call SLrlke rlce"
[9] hLLp://en.wlklpedla.org/wlkl/8lack_Monday_(1987)