Beyond Surrogate Modeling: Learning the Local Volatility Via Shape Constraints

Marc Chataigner, Areski Cousin, St\'ephane Cr\'epey, Matthew Dixon and Djibril Gueye

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Abstract: We explore the abilities of two machine learning approaches for no-arbitrage interpolation of European vanilla option prices, which jointly yield the corresponding local volatility surface: a finite dimensional Gaussian process (GP) regression approach under no-arbitrage constraints based on prices, and a neural net (NN) approach with penalization of arbitrages based on implied volatilities. We demonstrate the performance of these approaches relative to the SSVI industry standard. The GP approach is proven arbitrage-free, whereas arbitrages are only penalized under the SSVI and NN approaches. The GP approach obtains the best out-of-sample calibration error and provides uncertainty quantification.The NN approach yields a smoother local volatility and a better backtesting performance, as its training criterion incorporates a local volatility regularization term.

Date: 2022-12
New Economics Papers: this item is included in nep-cmp and nep-rmg
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Published in Short Communication: Beyond Surrogate Modeling: Learning the Local Volatility via Shape Constraints, SIAM Journal on Financial Mathematics 12(3), SC58-SC69, 2021

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Persistent link: https://EconPapers.repec.org/RePEc:arx:papers:2212.09957

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