Explain the Concept of “Volatility Smile” in Options Pricing and Its Financial Implication

The volatility smile is a pattern observed in options markets where options with strike prices significantly higher or lower than the current underlying asset price (out-of-the-money or deep in-the-money) have higher implied volatility than at-the-money options. The financial implication is that the market perceives a higher probability of extreme price movements (fat tails) than predicted by the standard Black-Scholes model, which assumes constant volatility.

This pattern suggests a market preference for insuring against large price moves.