Smooth and bid-offer compliant volatility surfaces under general dividend streams

Olivier Bachem, Gabriel Drimus and Walter Farkas

Quantitative Finance, 2013, vol. 13, issue 11, 1801-1812

Abstract: Given bid-offer quotes for a set of listed vanilla options, a fundamental need of option market makers is to interpolate and extrapolate the available quotes to a full arbitrage-free surface. We propose a methodology which directly controls the trade-off between smoothness and bid-offer compliance of the resulting volatility surface. Unlike previous literature, the method applies simultaneously to all listed maturities and aims to smooth the implied risk-neutral densities. Additionally, we consider asset dynamics which allow for general dividend streams--continuous, discrete yield and discrete cash--a modelling aspect of key importance in option markets.

Date: 2013
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DOI: 10.1080/14697688.2013.842652

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