ON THE CONSISTENCY OF THE DETERMINISTIC LOCAL VOLATILITY FUNCTION MODEL ('IMPLIED TREE')

DOI10.1142/S0219024901001036zbMATH Open1153.91564arXivcond-mat/0001117OpenAlexW1528205212MaRDI QIDQ3523587FDOQ3523587

Authors: Karl Strobl 

Publication date: 3 September 2008

Published in: International Journal of Theoretical and Applied Finance (Search for Journal in Brave)

Abstract: We show that the frequent claim that the implied tree prices exotic options consistently with the market is untrue if the local volatilities are subject to change and the market is arbitrage-free. In the process, we analyse -- in the most general context -- the impact of stochastic variables on the P&L of a hedged portfolio, and we conclude that no model can a priori be expected to price all exotics in line with the vanilla options market. Calibration of an assumed underlying process from vanilla options alone must not be overly restrictive, yet still unique, and relevant to all exotic options of interest. For the implied tree we show that the calibration to real-world prices allows us to only price vanilla options themselves correctly. This is usually attributed to the incompleteness of the market under traditional stochastic (local) volatility models. We show that some `weakly' stochastic volatility models without quadratic variation of the volatilities avoid the incompleteness problems, but they introduce arbitrage. More generally, we find that any stochastic tradable either has quadratic variation -- and therefore a $Ga$-like P&L on instruments with non-linear exposure to that asset -- or it introduces arbitrage opportunities.

Full work available at URL: https://arxiv.org/abs/cond-mat/0001117

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zbMATH Keywords

exotic optionsmarket incompletenessstochastic local volatilityimplied treesskew modelsVega hedging

Mathematics Subject Classification ID

Stochastic partial differential equations (aspects of stochastic analysis) (60H15)

Cites Work

• Bond Pricing and the Term Structure of Interest Rates: A New Methodology for Contingent Claims Valuation
• Martingales and arbitrage in multiperiod securities markets
• Stochastic Implied Trees: Arbitrage Pricing with Stochastic Term and Strike Structure of Volatility
• Calibrating volatility surfaces via relative-entropy minimization
• Managing the volatility risk of portfolios of derivative securities: the Lagrangian uncertain volatility model
• Uncertain Parameters, an Empirical Stochastic Volatility Model and Confidence Limits

Cited In (3)

• The waterline tree for separable local-volatility models
• IMPLIED VOLATILITY TREES AND PRICING PERFORMANCE: EVIDENCE FROM THE S&P 100 OPTIONS
• Deterministic implied volatility models

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