Arbitrage-free market models for option prices: the multi-strike case (Q2271718)

The goal of the paper is to establish a framework for pricing and hedging (possibly exotic) derivatives in an arbitrage-free way, using all the liquid tradables as hedging instruments. The authors characterize the absence of arbitrage in terms of drift restrictions and provide a general existence result for the case of a single option. This is done in order to illustrate where one meets difficulties with classical implied volatilities when passing to models with multiple strikes. The main contribution is the following: instead of modeling stock price and (classical) implied volatilities, they introduce price level and local implied volatilities for the set of call prices, and these local implied volatilities parameterize in a natural and simple way all possible arbitrage-free option prices. Explicit formulas for these new quantities as functions of stock price and classical implied volatilities, and vice versa, are established. Explicit and fairly general examples of arbitrage-free dynamic models for the price level and the local implied volatilities are provided.