A committee of risk management practitioners discusses the difference between pricing deep out-of-the-money call options on FBX stock and pricing deep out-of-the-money call options on the EUR/JPY foreign exchange rate using the Black-Scholes-Merton (BSM) model. The practitioners price these option based on two distinct probability distributions of underlying asset prices at the option expiration date:
A lognormal probability distribution
An implied risk-neutral probability distribution obtained from the volatility smile for options of the same maturity
Using the lognormal instead of the implied risk-neutral probability distribution will tend to
A. Price the option on FBX relatively high and price the option on EUR/JPY relatively low
B. Price the option on FBX relatively low and price the option on EUR/JPY relatively high
C. Price the option on FBX relatively low and price the option on EUR/JPY relatively low
D. Price the option on FBX relatively high and price the option on EUR/JPY relatively high
Answer:A
Explanation: The implied distribution of the underlying equity prices derived using the general volatility smile of equity options has a heavier left tail and a less heavy right tail than a lognormal distribution of underlying prices. Therefore , using the lognormal distribution of prices causes deep-out-of-the-money call options on the underlying to be priced relatively high.
The implied distribution of underlying foreign currency prices derived using the general volatility smile of foreign currency options has heavier tails than a logmormal distribution of underlying prices. Therefore, using the lognormal distribution of prices causes deep-out-of-the-money call options on the underlying to be priced relatively low.