If the volatility implied from an at-the-money put stock option were used to price other put options on the stock, 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
D
The volatility smile for equity options shows that at-the-money put options have lower implied volatilities than out-of-the-money put options and a higher volatility than in-the-money put options. This means that using at-the-money implied volatilities for out-of-the-money put options would lead to underpricing and using at-the-money implied volatilities for in-the-money put options would lead to overpricing . Hence the correct answer is D.
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