Volatility

Abstract

The most up-to-date estimation for the volatility of a risk factor can be obtained when the risk factor is the underlying of a liquid option. Since the option is liquid, it is traded with a volume which ensures that the bid-ask spreads are sufficiently small to define a precise option price. The volatility can then be determined from the pricing model valid for the valuation of the option in the market if all other factors influencing the price of the option (interest rates, price of the underlying, etc.) are known. The parameter volatility is then varied in the model until the it yields the market price of the option. In this way, the implied volatility is determined. If there is agreement in the market as to which model should be used for the determination of the option price, then there is a one-to-one relation between option price and this implied volatility; if one of these values is known, the other can be uniquely determined. This method is so common in the market that many options are quoted directly in terms of their implied volatility instead of their price.