Explicit Constructions of Martingales Calibrated to Given Implied Volatility Smiles

35 Pages Posted: 28 Oct 2010 Last revised: 5 Jul 2011

Peter Carr

New York University (NYU) - Courant Institute of Mathematical Sciences

Laurent Cousot

BNP Paribas

Date Written: June 6, 2011

Abstract

The construction of martingales with given marginal distributions at given times is a recurrent problem in financial mathematics. From a theoretical point of view, this problem is well-known as necessary and sufficient conditions for the existence of such martingales have been described. Moreover several explicit constructions can even be derived from solutions to the Skorokhod embedding problem. However these solutions have not been adopted by practitioners, who still prefer to construct the whole implied volatility surface and use the explicit constructions of calibrated (jump-) diffusions, available in the literature, when a continuum of marginal distributions is known.

In this paper, we describe several new constructions of calibrated martingales, which do not rely on a potentially risky interpolation of the marginal distributions but only on the input marginal distributions. These calibrated martingales are intuitive since the continuous-time versions of our constructions can be interpreted as time-changed (jump-) diffusions. Moreover, we show that the valuation of claims, depending only on the values of the underlying process at maturities where the marginal distributions are known, can be extremely efficient in this setting. For example, path-independent claims of this type can be valued by solving a finite number of ordinary (integro-) differential equations. Finally, an example of calibration to the S&P 500 market is provided.

Keywords: martingale, marginal distribution, diffusion, jump-diffusion, calibration, option, time change

JEL Classification: C02, C60, G12, G13

Suggested Citation

Carr, Peter and Cousot, Laurent, Explicit Constructions of Martingales Calibrated to Given Implied Volatility Smiles (June 6, 2011). Available at SSRN: https://ssrn.com/abstract=1699002 or http://dx.doi.org/10.2139/ssrn.1699002

Peter P. Carr

New York University (NYU) - Courant Institute of Mathematical Sciences ( email )

251 Mercer Street
New York, NY 10012
United States

Laurent Cousot (Contact Author)

BNP Paribas ( email )

Paris
France

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