Volatility smirk as an externality of agency conflict and growing debt
International Journal of Economic Theory , Volume 11 - Issue 4 p. 389- 404
Since the work of Black in the mid-1970s, the source of the stock market volatility smirk has remained controversial. The volatility smirk is a side effect of agency conflict, and occurs in the optimum, even after resolving the agency conflict. The slope of the smirk increases with the severity of the initial agency conflict between management and investors. It is predicted that the higher is the compensation of the manager, the steeper is the volatility smirk, for both time series and cross-sections of companies. These results help to disentangle the leverage effect from alternative explanations such as volatility feedback, time-varying risk premium, and down-market effects.