Option prices and Black-Scholes-Merton formula
If the distribution is skewed to the right,:
a)Black-Scholes overprices out-of-the-money puts and in-the-money calls. It underprices in-the-money puts and out-of-the-money calls.
b)Black-Scholes overprices out-of-the-money calls and in-the-money puts. It underprices out-of-the-money puts and in-the-money calls.
c)Black-Scholes underprices out-of-the-money and in-the-money calls and puts.
d)Black-Scholes overprices out-of-the-money and in-the-money calls and puts
Which of these above statements are correct?
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1 solution
If the stock price log returns distribution is skewed to the right, then mode<median<mean in most of the cases.
The strike price of an OTM calls lies to the right of the current price. So the demand for an OTM calls are low as the probability that they will turn into an ITM calls is less.
As a result, volatility is lower than BSM formula assumption. So, their prices will go up. But BSM formula assumes constant volatility. So it underprice an OTM calls and ITM puts.