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Smooth and bid-offer compliant volatility surfaces under general dividend streams

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  • Olivier Bachem
  • Gabriel Drimus
  • Walter Farkas

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 modelling aspect of key importance in option markets.

Suggested Citation

  • Olivier Bachem & Gabriel Drimus & Walter Farkas, 2013. "Smooth and bid-offer compliant volatility surfaces under general dividend streams," Quantitative Finance, Taylor & Francis Journals, vol. 13(11), pages 1801-1812, November.
    • Handle: RePEc:taf:quantf:v:13:y:2013:i:11:p:1801-1812
    DOI: 10.1080/14697688.2013.842652
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