Arbitrage-free smoothing of the implied volatility surface
Journal
Quantitative Finance
ISSN
1469-7688
ISSN-Digital
1469-7696
Type
journal article
Date Issued
2009-06-09
Author(s)
Abstract
The pricing accuracy and pricing performance of local volatility models depends on the absence of arbitrage in the implied volatility surface. An input implied volatility surface that is not arbitrage-free can result in negative transition probabilities and consequently mispricings and false greeks. We propose an approach for smoothing the implied volatility smile in an arbitrage-free way. The method is simple to implement, computationally cheap and builds on the well-founded theory of natural smoothing splines under suitable shape constraints.
Language
English
Keywords
Implied volatility surface
Local volatility
Cubic spline smoothing
No-arbitrage constraints
HSG Classification
contribution to scientific community
Refereed
Yes
Publisher
Routledge
Publisher place
Abingdon [u.a.]
Volume
9
Number
4
Start page
417
End page
428
Pages
12
Subject(s)
Eprints ID
86933