Resource title

Arbitrage-free smoothing of the implied volatility surface

Resource image

image for OpenScout resource :: Arbitrage-free smoothing of the implied volatility surface

Resource description

The pricing accuracy and pricing performance of local volatility models crucially depends on absence of arbitrage in the implied volatility surface: an input implied volatility surface that is not arbitrage-free invariably results in negative transition probabilities and/ or negative local volatilities, and ultimately, into mispricings. The common smoothing algorithms of the implied volatility surface cannot guarantee the absence arbitrage. Here, we propose an approach for smoothing the implied volatility smile in an arbitrage-free way. Our methodology is simple to implement, computationally cheap and builds on the well-founded theory of natural smoothing splines under suitable shape constraints. Unlike other methods, our approach also works when input data are scarce and not arbitrage-free. Thus, it can easily be integrated into standard local volatility pricers.

Resource author

Matthias R. Fengler

Resource publisher

Resource publish date

Resource language

eng

Resource content type

text/html

Resource resource URL

http://hdl.handle.net/10419/25038

Resource license

Adapt according to the presented license agreement and reference the original author.