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      No-Arbitrage Deep Calibration for Volatility Smile and Skewness

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          Abstract

          Volatility smile and skewness are two key properties of option prices that are represented by the implied volatility (IV) surface. However, IV surface calibration through nonlinear interpolation is a complex problem due to several factors, including limited input data, low liquidity, and noise. Additionally, the calibrated surface must obey the fundamental financial principle of the absence of arbitrage, which can be modeled by various differential inequalities over the partial derivatives of the option price with respect to the expiration time and the strike price. To address these challenges, we have introduced a Derivative-Constrained Neural Network (DCNN), which is an enhancement of a multilayer perceptron (MLP) that incorporates derivatives in the output function. DCNN allows us to generate a smooth surface and incorporate the no-arbitrage condition thanks to the derivative terms in the loss function. In numerical experiments, we apply the stochastic volatility model with smile and skewness parameters and simulate it with different settings to examine the stability of the calibrated model under different conditions. The results show that DCNNs improve the interpolation of the implied volatility surface with smile and skewness by integrating the computation of the derivatives, which are necessary and sufficient no-arbitrage conditions. The developed algorithm also offers practitioners an effective tool for understanding expected market dynamics and managing risk associated with volatility smile and skewness.

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          Author and article information

          Journal
          25 October 2023
          Article
          2310.16703
          a8588c20-7722-4408-8ff5-2da9ff7f7969

          http://arxiv.org/licenses/nonexclusive-distrib/1.0/

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          Custom metadata
          9 pages, 7 figures
          q-fin.CP

          Computational finance
          Computational finance

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