Implied Volatility Smiles : Empirical Tests

Implied volatility quot;smilesquot; have been documented in a number of option markets worldwide. The volatilities implied by the Black-Scholes (1973) model tend to be systematically related to the option's exercise price and time to expiration. Derman and Kani (1994), Dupire (1994), and Rubinstein (1994) offer an explanation for this behavior, that is, the volatility of the return of the underlying asset is a deterministic function of the asset price level and time. Their option valuation methodology, dubbed the quot;implied binomial treequot; approach, describes (perfectly) the observed structure of options prices and purportedly provides more accurate hedge ratios. We systematically evaluate the empirical properties of the implied binomial tree approach to option valuation using Samp;P 500 index options during the period June 1988 and December 1993