Volatility smile as relativistic effect
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Abstract: We give an explicit formula for the probability distribution based on a relativistic extension of Brownian motion. The distribution 1) is properly normalized and 2) obeys the tower law (semigroup property), so we can construct martingales and self-financing hedging strategies and price claims (options). This model is a 1-constant-parameter extension of the Black-Scholes-Merton model. The new parameter is the analog of the speed of light in Special Relativity. However, in the financial context there is no "speed limit" and the new parameter has the meaning of a characteristic diffusion speed at which relativistic effects become important and lead to a much softer asymptotic behavior, i.e., fat tails, giving rise to volatility smiles. We argue that a nonlocal stochastic description of such (Levy) processes is inadequate and discuss a local description from physics. The presentation is intended to be pedagogical.
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Cited in
(6)- Option volatility and the acceleration Lagrangian
- Does NVIX matter for market volatility? Evidence from Asia-Pacific markets
- On volatility smile and an investment strategy with out-of-the-money calls
- Smearing distributions and their use in financial markets
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