Convertible Securities by Tracy V. Maitland

Author:Tracy V. Maitland
Language: eng
Format: epub
Publisher: McGraw Hill LLC
Published: 2022-01-15T00:00:00+00:00

Data: Advent Capital Management.

In corporate finance, equity risk is seen as a function of operational leverage and financial leverage. Under this logic, the equity risk of this company has increased by virtue of its stock price having declined, thereby increasing its financial leverage. It follows that heightened equity risk will feed into higher stock price volatility, establishing a link between stock price movements and volatility. Regardless of how much weight one wants to place on the leverage argument, there is statistical evidence of a correlation between stock price declines and heightened volatility.

The leverage argument has the benefit of helping to explain the tilted nature of the volatility smirk in the implied volatility of individual securities. The BSM model does not allow for any kind of correlation between share level and volatility, implying that it underestimates the possibility of large downward movements. If the market recognizes the correlation and correctly prices options, we would expect to see higher implied volatilities for very low strikes, which we do. In Section 9.4.2 we will explain the constant elasticity of variance (CEV) model, which seeks to improve on the BSM model by including an elasticity parameter that ties together volatility and price level.

However, it’s important to recognize that the leverage argument does not address the higher implied volatility we generally see at high 278strikes in individual securities. In fact, if we rely on leverage to explain the smile, we would expect implied volatility to be at its lowest at high strikes because volatility would go down relative to the BSM expectations as the company deleverages through stock price appreciation. The leverage idea also does not help us with FX options, which also have observable smiles. The leverage effect may help explain individual equity options, but it is not a universal explanation.

Download

Copyright Disclaimer:
This site does not store any files on its server. We only index and link to content provided by other sites. Please contact the content providers to delete copyright contents if any and email us, we'll remove relevant links or contents immediately.