Collateral Smile

We analyze the impact of funding costs and margin requirements on prices of index options traded on the CBOE. We propose a model that gives upper and lower bounds for option prices in the absence of arbitrage in an incomplete market with differential borrowing and lending rates. We show that funding costs and margin requirements cause a substantial increase in option prices, which translates into skew and smile patterns for implied volatility curves even under constant volatilities. Empirical tests show that the slopes our model generates have signicant statistical power in explaining the slopes observed in the market.