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Can Someone Explain to me what this term means, and how it's used?

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Depending on the context, I think this might mean the same thing as "Black Implied Volatility." The Black Model is to FX Options, Caplets, etc as Black Scholes is to Equity Options. So Black-Equivalent Volatility is likely the volatility that, if using the closed form Black model pricing formula, gives the same price as the market. –  phlsmk Feb 8 '11 at 13:08
    
I think what you said makes sense. I came to the same realization. –  dragunov Feb 9 '11 at 10:51

1 Answer 1

up vote 4 down vote accepted

Quite a lot of options on asset $S(t) > 0$ have a payoff at tinme $T$ equal (at least approximately -- it's a bit more complicated in the case of e.g. credit index options)

$ (S(T) - K)^+ $

You can always find a number $\sigma$ such that, when plugged into Black formula together with strike $K$, spot price $S(t)$, interest rate $r$ and time to expiry $T-t$, you will recover the market price of the option $V(t)$. This number is called the Black implied volatility of the option. Basically, it's a quoting convention for the option prices. Traders use it because:

  • it makes it easier for them to compare prices of options on different days, with different strikes
  • Black vols tend to be similar across strikes and expiries (not always!)
  • it is better (in the sense: you're less likely to suffer lots of arbitrage) to interpolate market prices in the $\sigma$ space then directly; that is, if prices for strikes $K_1$ and $K_2$ are quoted, it's better to use some interpolation method on their Black vols $\sigma_1$ and $\sigma_2$ than on their prices $V_1$ and $V_2$
  • it fits their intution better (a paramount argument)
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Thanks, very informative post :-) –  dragunov Feb 9 '11 at 10:52

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