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Collateral smile


Leippold, Markus; Su, Lujing (2015). Collateral smile. Journal of Banking and Finance, 58:15 - 28.

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.

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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1 citation in Web of Science®
1 citation in Scopus®
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Additional indexing

Item Type:Journal Article, refereed, original work
Communities & Collections:03 Faculty of Economics > Department of Banking and Finance
Dewey Decimal Classification:330 Economics
Language:English
Date:September 2015
Deposited On:18 Jan 2016 13:27
Last Modified:05 Apr 2016 19:55
Publisher:Elsevier
ISSN:0378-4266
Publisher DOI:https://doi.org/10.1016/j.jbankfin.2015.03.019
Related URLs:http://www.sciencedirect.com/science/article/pii/S0378426615000965 (Publisher)
Other Identification Number:merlin-id:12237

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