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Arbitrage-free smoothing of the implied volatility surface
[journal article]
Abstract The pricing accuracy and pricing performance of local volatility models depend 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 into mispricings and false gre... view more
The pricing accuracy and pricing performance of local volatility models depend 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 into 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.... view less
Classification
Economic Statistics, Econometrics, Business Informatics
Basic Research, General Concepts and History of Economics
Method
theory application
Free Keywords
Implied volatility surface; Local volatility; Cubic spline smoothing; No-arbitrage constraints
Document language
English
Publication Year
2009
Page/Pages
p. 417-428
Journal
Quantitative Finance, 9 (2009) 4
DOI
https://doi.org/10.1080/14697680802595585
Status
Postprint; peer reviewed
Licence
PEER Licence Agreement (applicable only to documents from PEER project)