A question about Implied volatility

CFA Level III
#1

Hi guys,

I came across the question when I was reviewing the 2013 morning AM section, Q10 Part C, Scenario 2 “Implied volatility of US equities decline by 15%”.

CFAI gave the explanation that “Implied volatility falling would primarily concern option holders rather than long-only equity holders, and is usually associated with increase in equity valued”.

I am fine with the first sentense but not quite clear about the second part highlighted above - could someone please advise?is it due to the low risk would decrease the discount rate used to calculate stock price?

A consequence questino would be: what is the impact of implied volatility to equiries and bonds in general and what’s the rationale behind? I guess increase volatitliy increase both equities and bond prices due to increase volatity, and further increase discount rate used to calculate present value/price?

Please correct me and advise me. thanks

#2

Volatility of what?

#3

Implied Vol is associated with options - generally used by option traders. They look at buying and selling options as buying and selling volatility.

When they say “usually associated with increases in equity values” they just mean volatility is usually due to vol on the upside.

I wouldn’t worry about it too much for the exam - just know implied vol is used for options.

#4

Hi Smart, volatility of equity/bond market i meant to ask.

#5

Volatility of returns? Interest rates? Inflation?

All else equal higher volatility of returns will reduce the price, unless the underlying is embedded with options, then the value of the option goes up.

Implied volatility solves for the current price of the option. Whether through volatility of interest rates, or of the underlying returns.

#6

Hi Verse214, thanks for your inputs. I am not quite sure I get your explanation, could you please be more specify?

As it did mention in the real AM question quoted above and here “implied volatility of US equities decline by 15%”- can I interprete here as the volatility in the equity market?

And if so, is my explanation making sense to explain the stock price change from risk prermium perspective?

Thanks

#7

The intrinsic value of any company is the present value of its cash flows. When a company is risky, the discount rate used to value those cash flows increases, and the company’s intrinsic value decreases, and vice versa. Volatility is a form of risk. Thus, when volatility decreases, risk decreases, the discount rate used to value cash flows decreases, and the intrinsic value of the firm increases.

#8

Look at the historical relationship between the VIX and the level of the S&P…as the VIX falls, S&P price rises, and as the VIX rises S&P price falls.

#9

I doubt it’s important for the exam, but higher vol should require a higher risk premium, which would mean higher expected return.

If you look at the relationship of equities as an asset class compared to the GIM using the Singer Terhaar model, the higher the volatility of the asset class the higher the ERP for the asset class.