Model-free stochastic collocation for an arbitrage-free implied volatility, part II
Fabien Le Floch (TU Delft - Electrical Engineering, Mathematics and Computer Science)
Cornelis W. Oosterlee (Centrum Wiskunde & Informatica (CWI), TU Delft - Electrical Engineering, Mathematics and Computer Science)
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Abstract
This paper explores the stochastic collocation technique, applied on a monotonic spline, as an arbitrage-free and model-free interpolation of implied volatilities. We explore various spline formulations, including B-spline representations. We explain how to calibrate the different representations against market option prices, detail how to smooth out the market quotes, and choose a proper initial guess. The technique is then applied to concrete market options and the stability of the different approaches is analyzed. Finally, we consider a challenging example where convex spline interpolations lead to oscillations in the implied volatility and compare the spline collocation results with those obtained through arbitrage-free interpolation technique of Andreasen and Huge.
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