The asymmetric response of volatility to market changes and the volatility smile: Evidence from Australian options

• In ASX, market volatility is more responsive to negative market shocks than positive return shocks.
• The IV responses of ITM options– but not OTM options – are consistent with the observed pattern.
• The differences may be understood in relation to loss aversion behaviour.
• These different preferences and expectations explain the trend of the volatility smile.

We document that in Australian markets, the impact on stock market volatility is higher following negative market shocks than following positive shocks of the same magnitude. We find that the implied volatility responses of in-the-money (ITM) options are consistent with the observed pattern. However, the implied volatilities of out-of-the-money (OTM) options are largely unresponsive to such shocks. We conclude that ITM options create different prospects for gains and losses compared with OTM options, and that the differences may be understood in relation to loss aversion behaviour. These different preferences and expectations explain the trend of the volatility smile as increasing implied volatility with in-the-moneyness.