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From characteristic functions to implied volatility expansions

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  • Antoine Jacquier
  • Matthew Lorig

Abstract

For any strictly positive martingale $S = \exp(X)$ for which $X$ has a characteristic function, we provide an expansion for the implied volatility. This expansion is explicit in the sense that it involves no integrals, but only polynomials in the log strike. We illustrate the versatility of our expansion by computing the approximate implied volatility smile in three well-known martingale models: one finite activity exponential L\'evy model (Merton), one infinite activity exponential L\'evy model (Variance Gamma), and one stochastic volatility model (Heston). Finally, we illustrate how our expansion can be used to perform a model-free calibration of the empirically observed implied volatility surface.

Suggested Citation

  • Antoine Jacquier & Matthew Lorig, 2012. "From characteristic functions to implied volatility expansions," Papers 1207.0233, arXiv.org, revised Jun 2014.
    • Handle: RePEc:arx:papers:1207.0233
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    File URL: http://arxiv.org/pdf/1207.0233
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    References listed on IDEAS

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    1. Leif Andersen & Alexander Lipton, 2012. "Asymptotics for Exponential Levy Processes and their Volatility Smile: Survey and New Results," Papers 1206.6787, arXiv.org.
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