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Alternative asset-price dynamics and volatility smile

Listed author(s):
  • Damiano Brigo
  • Fabio Mercurio
  • Giulio Sartorelli

We review the general class of analytically tractable asset-price models that was introduced by Brigo and Mercurio (2001a Mathematical Finance—Bachelier Congr. 2000 (Springer Finance) ed H Geman, D B Madan, S R Pliska and A C F Vorst (Berlin: Springer) pp 151-74), where the considered asset can be an exchange rate, a stock index or even a forward Libor rate. The class is based on an explicit SDE under a given forward measure and includes models featuring (i) explicit asset-price dynamics, (ii) a virtually unlimited number of parameters and (iii) analytical formulae for European options. We also review the fundamental case where the asset-price density is given, at every time, by a mixture of log-normal densities with equal means. We then introduce two other cases: the first is still based on log-normal densities, but it allows for different means in the distributions; the second is based on processes of hyperbolic-sine type. Finally, we test the goodness of calibration to real market data of the considered models, choosing a particularly asymmetric volatility surface. As expected, the model based on hyperbolic-sine density mixtures achieves the lowest calibration error.

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Article provided by Taylor & Francis Journals in its journal Quantitative Finance.

Volume (Year): 3 (2003)
Issue (Month): 3 ()
Pages: 173-183

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Handle: RePEc:taf:quantf:v:3:y:2003:i:3:p:173-183
DOI: 10.1088/1469-7688/3/3/303
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