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Smooth and Bid-Offer Compliant Volatility Surfaces Under General Dividend Streams

Author

Listed:
  • Olivier Bachem

    (ETH Zürich)

  • Gabriel G. Drimus

    (University of Zürich)

  • Walter Farkas

    (University of Zurich, Ecole Polytechnique Fédérale de Lausanne, Swiss Finance Institute, and ETH Zürich)

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 modeling aspect of key importance in option markets.

Suggested Citation

  • Olivier Bachem & Gabriel G. Drimus & Walter Farkas, 2013. "Smooth and Bid-Offer Compliant Volatility Surfaces Under General Dividend Streams," Swiss Finance Institute Research Paper Series 13-68, Swiss Finance Institute.
    • Handle: RePEc:chf:rpseri:rp1368
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    File URL: http://ssrn.com/abstract=2172256
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    More about this item

    Keywords

    implied volatility surface; risk neutral density; discrete dividends;
    All these keywords.

    JEL classification:

    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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