Implied volatility
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In financial mathematics, the implied volatility of a financial instrument is the volatility implied by the market price of a derivative based on a theoretical pricing model. For instruments with log-normal prices, the Black-Scholes formula or Black-76 model is used.
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Examples
Example: suppose the price of a £10,000 notional interest rate cap struck at 4% on the 1 year GBP LIBOR rate maturity 2 years from now is £691.60. (The 1 year LIBOR rate is an annualised interest rate for borrowing money for three months). Suppose also that the forward rate for 2 year into 1 year LIBOR is .5% and the current discount factor for value of money in two years' time is 0.9, then the Black formula shows that:
- <math> 691.60 = 10,000*0.9(0.045*N(d_1) - 0.04*N(d_2)) </math>,
where
- <math>d_1 = \frac{log(\frac{0.045}{0.04}) + \sigma^2}{\sigma\sqrt 2}</math>,
- <math>d_2 = d_1 - \sigma\sqrt 2</math>,
where
- <math>\sigma</math> (pronounced "sigma") is the implied volatility of the forward rate and <math>N(.)</math> is the standard cumulative Normal distribution function.
Note that the only unknown is the volatility. We can not invert the function analytically (see inverse function) however we can find the unique value of <math>\sigma</math> that makes the equation above hold by using a root finding algorithm such as Newton's method. (N.B. In the common case where a closed-form option pricing model such as Black-Scholes is not available, it turns out Brent's method is a much more efficient root finding algorithm.) In this example the implied volatility is 0.2 or 20%.
Observations
Interestingly the implied volatility of options rarely corresponds to the historical volatility (i.e. the volatility of a historical time series). This is because implied volatility includes future expectations of price movement, which are not reflected in historical volatility.
Implied volatility also is inaccurate due to the fact that in the US and Europe, many listed options have a market place where there is a 2-sided market with a bid (where you can sell and a marketmaker can buy) and an offer or ask (where you can buy and a marketmaker can sell). Therefore if someone buys an option on the offer the implied vol is higher for the same option than if it trades as if sold on the bid.
Expanded
By computing the volatility for all strikes on a particular underlying we obtain the Volatility Smile.
Chicago Board Options Exchange Volatility Index
The Chicago Board Options Exchange Volatility Index (VIX), measures how much premium investors are willing to pay for options as insurance to hedge their equity positions. The VIX is calculated using a weighted average of implied volatility of At-The-Money and Near-The-Money striked in options on the S&P 500 Index futures.
There also exists the VXN index (Nasdaq 100 index futures volatility measure) and QQV (QQQQ volatility measure).