Understanding the volatility smile of options markets through microsimulation

TL;DR

This paper uses microsimulation with active traders to explore the causes of the volatility smile in options markets, highlighting the roles of heterogeneous trading behaviors and liquidity differences.

Contribution

It introduces a simple microsimulation model incorporating speculators and arbitrageurs to replicate observed volatility smile patterns in options markets.

Findings

Volatility smile arises from heterogeneous trader behaviors.

Liquidity differences significantly influence implied volatility curves.

Model replicates empirical IV patterns despite simplicity.

Abstract

In this work, we aim to gain a better understanding of the volatility smile observed in options markets through microsimulation (MS). We adopt two types of active traders in our MS model: speculators and arbitrageurs, and call and put options on one underlying asset. Speculators make decisions based on their expectations of the asset price at the option expiration time. Arbitrageurs trade at different arbitrage opportunities such as violation of put-call parity. Difference in liquidity among options is also included. Notwithstanding its simplicity, our model can generate implied volatility (IV) curves similar to empirical observations. Our results suggest that the volatility smile is related to the competing effect of heterogeneous trading behavior and the impact of differential liquidity.