medium · FRM Part 2 Market Risk
A risk analyst is looking at a 'symmetric' smile for a currency pair.
If the market's risk-neutral distribution is leptokurtic (fat tails), how will the Black-Scholes model price deep out-of-the-money (OTM) and deep in-the-money (ITM) options relative to the market?
- Black-Scholes will underprice ATM options because they are the most sensitive.
- Black-Scholes will underprice both deep OTM and deep ITM options.
- The Black-Scholes model remains accurate as long as volatility is adjusted daily.
- Black-Scholes will overprice OTM options but underprice ITM options.
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