If the volatility implied from an at-the-money put currency option were used to price other put options on the currency, which of the following would be true?
A. Out-of-the money and in-the-money prices would be too high
B. Out-of-the money and in-the-money prices would be too low
C. Out-of-the-money option prices would be too high and in-the-money option prices would be too low
D. Out-of-the-money option prices would be too low and in-the-money option prices would be too high
B
The volatility smile for currency options shows that at-the-money options have lower implied volatilities than out-of-the-money and in-the-money options. This means that using at-the- money implied volatilities for out-of-the-money or in-the-money options would lead to the volatility being too low so that there would be underpricing.
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