Arbitrage-free smoothing of the implied volatility surface

Matthias Fengler

Quantitative Finance, 2009, vol. 9, issue 4, 417-428

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.

Keywords: Implied volatility surface; Local volatility; Cubic spline smoothing; No-arbitrage constraints (search for similar items in EconPapers)
Date: 2009
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Citations: View citations in EconPapers (59)

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Working Paper: Arbitrage-free smoothing of the implied volatility surface (2005)
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DOI: 10.1080/14697680802595585

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