Sunday, May 21, 2017

black scholes - Log-normal Volatility Approximation


In a comment to this question, it is mentioned that, under the log-normal distribution, vol(k)vol(atm)×atmk. Here, k is the strike, atm is the at-the-money strike, and vol(k) is the implied volatility corresponding to strike k. I have difficulty to derive this approximation. Any suggestion is appreciated.



Answer




Page 3 of this document ad-co.com/analytics_docs/ALevin_QP_2012.pdf shows the result, originally given in Risk Magazine by Blyth and Uglum.


The intuition for the formula is given in my comment above. The original motivation for such a formula was for interest rate options in the 1990s. Everyone had a lognormal pricing model, but traders understood that the distribution of interest rates may be closer to normal. Hence we needed a formula to plug in the right lognormal vol into our models.


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