options

[student_actuary]

On Page C6 of JAM it says : Buy option at higher assumed volatility than can sell option, which means terminating caps and floors can be expensive"

Dear God , someone please help me understand this!!!

[torrent]

Originally Posted by student_actuary

On Page C6 of JAM it says : Buy option at higher assumed volatility than can sell option, which means terminating caps and floors can be expensive"

Dear God , someone please help me understand this!!!

I think it means that the asked prices are more volatile than the bid prices for options.

[oscar peterson]

If you buy an option at higher assumed volatility, then the increased assumed volatility increases option prices (relative to lower assumed vol).

If you sell at lower assumed volatility, then the lowered volatility decreases option prices (relative to higher assumed vol).

Thus, these differing assumptions yield a bid-ask spread of sorts. I'd be curious to know whether this is in addition to a typical transaction cost. Anyone know? Thanks.

[BC]

In 8V it talks about the "bid-ask" spread of volatility, so I'd say it's probably "in addition".

[oscar peterson]

Yeah, it would make sense that such spreads be 'in addition' -- given that the authors are making a point of the expense of terminating caps/floors....... txs