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From characteristic functions to implied volatility expansions

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  • Antoine Jacquier
  • Matthew Lorig
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    Abstract

    For any strictly positive martingale $S = \exp(X)$ for which $X$ has a characteristic function, we provide an expansion for the implied volatility. This expansion is explicit in the sense that it involves no integrals, but only polynomials in the log strike. We illustrate the versatility of our expansion by computing the approximate implied volatility smile in three well-known martingale models: one finite activity exponential L\'evy model (Merton), one infinite activity exponential L\'evy model (Variance Gamma), and one stochastic volatility model (Heston). Finally, we illustrate how our expansion can be used to perform a model-free calibration of the empirically observed implied volatility surface.

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    File URL: http://arxiv.org/pdf/1207.0233
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    Bibliographic Info

    Paper provided by arXiv.org in its series Papers with number 1207.0233.

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    Date of creation: Jul 2012
    Date of revision: Jun 2014
    Handle: RePEc:arx:papers:1207.0233

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