Estimating implied volatility by inverting the Black-Scholes formula is subject to considerable error when option characteristics are observed with plausible errors. Especially for options away from the money, large changes in volatility produce small changes in option prices. Conversely, small errors in option prices and other option characteristics produce large errors in implied volatilities. In the presence of small measurement errors, unobserved truncation of option prices that violate lower bounds for absence of arbitrage can also lead to systematic volatility smiles. The paper proposes feasible GLS estimators that reduce the noise and bias in implied volatility estimates.

Public discussion about corporate use of derivatives focuses on whether firms use derivatives to reduce or increase firm risk. In contrast, em- pirical, academic studies of corporate derivatives-use take it for granted that firms hedge with derivatives. Using data from financial statements of 425 large u.s. corporations, we investigate whether firms systematically reduce or increase their riskiness with derivatives. We find that many firms manage their exposures with large derivatives positions. Nonetheless, compared to firms that do not use financial derivatives, firms that use derivatives display few, if any, measurable differences in risk that are associated with the use of derivatives.