Implied Volatility Smile Explained

This question asks the candidate to interpret why implied volatility, when graphed against strike price for a given maturity, often forms a smile or skew shape instead of a flat line. The setup is the standard equity or FX options market, where traders quote implied vol rather than raw option prices, and the visual pattern of that vol across strikes encodes information about market beliefs. It probes whether the candidate understands the gap between idealized option pricing models and how options are actually priced and traded, a theme that appears frequently in sell-side derivatives and volatility trading interviews.

To answer well, a candidate needs familiarity with the core assumptions of Black–Scholes, properties of asset return distributions, and how tail risk, jumps, and asymmetry show up in option prices. Good answers reference higher moments such as skewness and kurtosis, risk premia embedded in option markets, and the difference between real-world and risk-neutral distributions. Interviewers listen for an intuitive explanation linking rare-event probabilities, put and call demand, and hedging pressures to the observed non-flat implied volatility profile.

What it tests

The shape of the implied volatility curve across different strike prices is governed by the mismatch between model assumptions and real-world asset return distributions. Standard models like Black-Scholes assume a constant volatility and lognormal returns, which would yield a flat implied volatility surface. However, actual asset returns often display leptokurtosis—meaning fatter tails and a higher peak than the normal distribution. This means extreme price movements are more likely than the model predicts, so options far from the money are worth more than the model suggests. To reconcile observed market prices with the model, implied volatilities must be adjusted upward for these strikes, producing the characteristic smile or skew.