The effect of divergence of investor beliefs on implied volatility smile

This project aims to theoretically and empirically examine the implications that the divergence of investor belief could have on the implied volatility smile in stock options. In light of theoretical and empirical results in previous studies, the paper establishes various hypotheses describing the relationship between the volatility smile slope and factors widely used as proxies for investor belief. With the sample data on Options and firm-specific variables of 38 listed firms in the London Stock Exchange (LSE), the hypotheses put forward are tested using the regression tool. Investigation of the empirical results from the regression suggests that firms with smaller size and higher price to earnings ratios (P/E ratios), which are the two factors widely used proxies for investor belief, would have more pronounced volatility smile, i.e. steeper slope. Similarly, dispersion in earnings forecasts made by financial analysts, Open interest of options and Stock trading volume, which are further factors commonly used as proxy for investor belief, are also found to be in positive correlation with the steepness of smile slope. However, no evidence is found for the existence of the relationship between price to book ratios (P/B ratios) and the skewness of FTSE 100 index options.