Smooth and Bid-Offer Compliant Volatility Surfaces Under General Dividend Streams

Olivier Bachem, Gabriel G. Drimus and Walter Farkas
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Olivier Bachem: ETH Zürich
Gabriel G. Drimus: University of Zürich
Walter Farkas: University of Zurich, Ecole Polytechnique Fédérale de Lausanne, Swiss Finance Institute, and ETH Zürich

No 13-68, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

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 modeling aspect of key importance in option markets.

Keywords: implied volatility surface; risk neutral density; discrete dividends (search for similar items in EconPapers)
JEL-codes: C63 G13 (search for similar items in EconPapers)
Pages: 26 pages
Date: 2013-12
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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp1368

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