Stochastic volatility models are said to incorporate the "leverage" effect. The presence of the leverage effect
A) Results in a left skew in the options smile because stock price drops are associated with higher firm leverage and so with increased volatility.
B) Results in a right skew in the options smile because stock price increases are associated with higher firm leverage and so with increased volatility.
C) Results in a symmetric distribution of stock returns, resulting in higher option prices both in- and out-of-the-money.
D) All option models have a leverage effect because the option is a leveraged position in stock. The stochastic volatility model exacerbates this effect.

Question

Quizplus · Accepted Answer

The leverage effect refers to the phenomenon where stock price decreases are associated with increases in volatility, leading to a left skew in the options smile. This is because a drop in stock prices often results in higher leverage (debt-to-equity ratio) for a firm, which increases the firm's risk and thus its stock volatility.

Stochastic Volatility Models Are Said to Incorporate the "Leverage" Effect