Monday, December 19, 2016

Why does the volatility smile flatten as maturities increase?


First, I can't find a purely "financial" explanation for this.


Also the only mathematical explanation I've found so far was using the large deviations theory, which is quite complex.


Is there a rather simple mathematical explanation ?


Thanks !



Answer



The central limit theorem guarantees, under fairly general assumptions, that the sum of returns becomes more normally distributed as the number of returns grows (technically, defining a return as log(St+Δt/St), nilog(St+Δti/St+Δt(i1)N(,) as n). Thus, as T gets larger, the Black Scholes assumption of normally distributed log returns becomes more and more valid. This is exemplified by the flattening implied volatility smile.


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