Collateral smile |
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| Institution: | 1. Department of Applied Mathematics and Statistics, SUNY, Stony Brook, NY 11794, USA;2. College of Business, SUNY, Stony Brook, NY 11794, USA;3. FinAnalytica Inc., New York, NY 10017, USA;1. Economics Department, Lancaster University Management School, LA1 4YX, United Kingdom;2. Isenberg School of Management, University of Massachusetts-Amherst, 90 Campus Center Way, 209A Flint Lab, Amherst, MA 01003, United States;3. The University of Kent, Kent Business School, Canterbury, Kent, United Kingdom;1. UTS Business School, University of Technology Sydney, NSW 2007, Australia;2. Department of Economics, University of Leicester, LE17RH, UK;1. University of Sussex, United Kingdom;2. Lancaster University Management School, United Kingdom;1. School of Management, University of San Francisco, San Francisco, CA 94117, USA;2. Antai College of Economics & Management, Shanghai Jiao Tong University, Shanghai 200052, China;3. Retail Banking Academy, 1 Lyric Square, London W6 0NB, United Kingdom;4. Telfer School of Management, University of Ottawa, Ottawa, ON K1N 6N5, Canada |
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| Abstract: | We analyze the impact of funding costs and margin requirements on index options traded on the CBOE. Assuming differential borrowing and lending rates, we derive no-arbitrage bounds for European options. We show that funding costs and the CBOE’s margin requirements lead to a price increase, which translates into skew and smile patterns for implied volatility curves even under constant volatilities. Empirical tests confirm that our model-implied slopes have significant statistical power in explaining the slopes observed in the market. Hence, at least in part, funding costs and collateral requirements offer an institutional explanation of the volatility smile phenomenon. |
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| Keywords: | Collateral requirements Funding costs Volatility smile Option pricing |
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