Displaced and mixture diffusions for analytically-tractable smile models
One of the erroneous assumptions of the Black-Scholes world is that the volatility of the underlying is constant. The implied volatility is the volatility value that makes the theoretical price of an option and its market price the same. The shape of the implied volatility versus strike price curve is called the smile, even though in some markets it shows considerable asymmetry, a skew. In the present paper, the authors propose two different classes of asset price models that allow skews and smiles in the options implied volatility. The first class is based on shifting the marginal distribution of a diffusion process for which analytical formulae for European options are known. As examples, the cases of a shifted CEV process with constant coefficients and a shifted log-normal process are studied. Explicit formulae for European call options are derived that lead to skewed implied volatility structures. The second class includes the models for which the marginal density of the underlying price process is the weighted average of known densities of some given diffusion processes. Then, if these basic densities are associated to asset-price dynamics that imply analytical option prices, so does their mixture. The authors apply these results to the case where the process density is a mixture of log-normal densities. The explicit option pricing expression leads to smiles in the implied volatility structure. For the entire collection see [Zbl 0978.00046].
- LOGNORMAL-MIXTURE DYNAMICS AND CALIBRATION TO MARKET VOLATILITY SMILES
- scientific article; zbMATH DE number 1222810
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