The multivariate mixture dynamics: consistent no-arbitrage single-asset and index volatility smiles
File(s)
Accepted version
Author(s)
Brigo, D
Rapisarda, F
Sridi, A
Type
Journal Article
Abstract
We introduce a new arbitrage-free multivariate dynamic asset pricing model that allows us to reconcile single name and index/basket volatility smiles using a tractable and explicit dependence structure that goes beyond instantaneous correlation. Each asset volatility smile is modeled according to a density-mixture dynamical model while the same property holds for the multivariate process of all assets, whose density is a mixture of multivariate basic densities. After introducing the model, we derive tractable index option smile formulas resulting from the model and related closed form solutions for multivariate densities taking the form of multivariate mixtures. Using Markovian projection techniques, we relate our model to a multivariate uncertain volatility model and show a consistency result with geometric baskets with hints on possible uses in investigating triangular relationships between foreign exchange rates and the related smiles in practice. We also derive closed form solutions for a number of terminal statistics of dependence, and derive a precise relationship with a simpler but less tractable model based on a basic instantaneous correlation structure. Finally, closed form solutions for volatility/assets correlations illuminating the relationship with the uncertain volatility model are introduced. The model tractability makes it particularly suited for calibration and risk management applications, where speed of calculations and tractability are essential. A few numerical examples on basket and spread options pricing conclude the paper.
Date Issued
2017-10-30
Date Acceptance
2017-08-09
Citation
IISE Transactions, 2017, 50 (1), pp.27-44
ISSN
0740-817X
Publisher
Taylor & Francis
Start Page
27
End Page
44
Journal / Book Title
IISE Transactions
Volume
50
Issue
1
Copyright Statement
© 2018 “IISE”. This is an Accepted Manuscript of an article published online by Taylor & Francis in IISE Transactions on 30 October 2017, available online: https://www.tandfonline.com/doi/full/10.1080/24725854.2017.1374581
Subjects
Science & Technology
Technology
Engineering, Industrial
Operations Research & Management Science
Engineering
Mixture dynamics
lognormal mixture dynamics
volatility smile
basket option
spread option
index option
Markovian projection
multivariate uncertain volatility models
terminal correlations
volatility asset correlations
OPTIONS
Publication Status
Published