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Arbitrage-free smoothing of the implied volatility surface

  • Matthias Fengler

The pricing accuracy and pricing performance of local volatility models depends on the absence of arbitrage in the implied volatility surface. An input implied volatility surface that is not arbitrage-free can result in negative transition probabilities and consequently mispricings and false greeks. We propose an approach for smoothing the implied volatility smile in an arbitrage-free way. The method is simple to implement, computationally cheap and builds on the well-founded theory of natural smoothing splines under suitable shape constraints.

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

Volume (Year): 9 (2009)
Issue (Month): 4 ()
Pages: 417-428

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Handle: RePEc:taf:quantf:v:9:y:2009:i:4:p:417-428
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