The Mathematics of Volatility Surfaces

Miquel Noguer i Alonso

Papers from arXiv.org

Abstract: This paper develops a unified mathematical theory of implied, local, and learned volatility surfaces. Total variance $w_t(k,\tau)=\tau\sigma_t^2(k,\tau)$ is an infinite-dimensional state constrained by positivity, calendar monotonicity, and the butterfly differential inequality. We establish the topology and tangent geometry of this arbitrage set and prove that a nondegenerate Gaussian shock at an active constraint exits with probability tending to one half. Exact invariance therefore requires tangency, reflection, or confinement to an arbitrage-free manifold. We separate this static invariance problem from dynamic no-arbitrage, derive the Musiela maturity-transport identity, and identify the additional fixed-contract martingale restriction. We formulate Hilbert-space dynamics, prove an exact modal reduction with closed-form truncation error, derive Karhunen--Lo\`eve factors, identify the portfolio derivative as a vega field, and obtain the covariance-optimal hedge $\alpha^\ast=(H^\ast C H)^{-1}H^\ast C\nu$. The local-volatility chart completes the geometry: Dupire local variance is the ratio $a=\partial_\tau w/g[w]$ of the calendar and butterfly constraint functionals. Neural operators provide arbitrage-free universal approximation through simplex and cone heads. Normalizing-flow maps then add tractable conditional densities: we derive exact change-of-variables formulae for exponential local-variance flows and invertible stick-breaking price-simplex flows, while stating the quasi-invariance conditions required in genuine function space. Finally, fading-signature fields encode surface history and yield autonomous finite-dimensional controlled dynamics. The result is one framework for representation, dynamics, arbitrage, dimension reduction, likelihood-based learning, simulation, and hedging, together with a falsifiable empirical protocol.

Date: 2026-08
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