Volatility in options formulae for general stochastic dynamics

Martingales with continuous parameter (60G44) Applications of stochastic analysis (to PDEs, etc.) (60H30) Stochastic models in economics (91B70) Derivative securities (option pricing, hedging, etc.) (91G20)

Abstract: It is well-known that the Black-Scholes formula has been derived under the assumption of constant volatility in stocks. In spite of evidence that this parameter is not constant, this formula is widely used by financial markets. This paper addresses the question of whether an alternative model for stock price exists for which the Black-Scholes or similar formulae hold. The results obtained in this paper are very general as no assumptions are made on the dynamics of the model, whether it be the underlying price process, the volatility process or how they relate to each other. We show that if the formula holds for a continuum of strikes and three terminal times, then the volatility must be constant. However, when it only holds for finitely many strikes, and three or more maturity times, we obtain a universal bound on the variation of the volatility. This bound yields that the implied volatility is constant when the sequence of strikes increases to cover the entire half-line. This recovers the result for a continuum of strikes by a different approach.

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In [Stochastics 80, No. 1, 97--102 (2008; Zbl 1140.60022)] the first two authors proved that if the Black-Scholes formula (with constant volatility) holds for all strikes and at least three maturities, then it must hold for all maturities and all strikes, implying that the implied volatility surface is entirely flat. With the additional assumption that the filtration of the stock price is that of a Brownian motion, the stock price is necessarily Black-Scholes. In the present paper, the authors extend this result in two directions. Their first result is as follows: Theorem: Let \(S\) and \(\theta\) be two adapted processes with \(\theta_0 = \sigma>0\) and \(S_0 = z_0>0\). Let further \(C_{\mathrm{BS}}(t,T,K,\sigma, S_t)\) denote the price of a European call option at time \(t\), with maturity \(T\) and strike \(K\) on the stock price \(S\) in the Black-Scholes model with volatility \(\sigma\). If \(S\) is nonnegative and if \(\mathbb{E}[(S_T-K)_+| \mathcal{F}_t] = C_{\mathrm{BS}}(t,T,K,\theta_t, S_t)\) for all strikes \(K\geq 0\) and at least three maturities \(T\in \{T_1, T_2, T_3\}\), then \(\theta_t = \sigma\) for all \(t\leq T_1\). Furthermore, if \(\mathcal{F}\) is the natural filtration of a Brownian motion \(W\) then, up to \(T_1\), \(S\) is the unique weak solution to \(dS_t = \sigma h(t) \beta(S_t) dW_t\), for some functions \(h\) and \(\beta\). The second extension concerns the case of finitely many strikes. The authors obtain a universal bound on the variation of the volatility, which in particular implies that the implied volatility becomes constant as the sequence of strikes increases to the whole positive half-line.

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