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Glossary
Risk reversal
Definition
The simultaneous purchase of an out-of-the-money call and sale of an out-of-the-money put, or the purchase of an out-of-the-money put and sale of an out-of-the-money call, usually with no up-front premium.
According to the Black–Scholes model, used to determine the price levels of European call options, the purchase and sale of options with similar deltas should be zero-cost. In practice, the market favours one side over the other.
In the simplest case, the implied volatility of out-of-the-money puts and calls of the same strike price and maturity date are different, and the extra cost of the favoured side is commonly known as the risk-reversal spread.
This spread reflects the market's perception that the relevant probability distribution is not symmetrical around the forward but is skewed in the direction of the favoured side.
Another way of interpreting this is to say that implied volatility is correlated with the spot, which is impossible in a Black–Scholes world.
According to the Black–Scholes model, used to determine the price levels of European call options, the purchase and sale of options with similar deltas should be zero-cost. In practice, the market favours one side over the other.
In the simplest case, the implied volatility of out-of-the-money puts and calls of the same strike price and maturity date are different, and the extra cost of the favoured side is commonly known as the risk-reversal spread.
This spread reflects the market's perception that the relevant probability distribution is not symmetrical around the forward but is skewed in the direction of the favoured side.
Another way of interpreting this is to say that implied volatility is correlated with the spot, which is impossible in a Black–Scholes world.