Can anyone solve the smile problem? volatility models were the local volatility models 1 . They inferred a volatility dependent on the stock price level and time that accommodates the market price of vanillas within the Black-Scholes framework (Dupire (1994), Derman & Kani (1994), Rubinstein (1994). Indeed, local volatility models postulate that the underlying follows a lognormal diffusion process equation
IntroductionThe smile problem has raised immense interest among practitioners and academics. Since the market crash in October 1987, the volatilities implied by the market prices of traded vanillas have been varying with strike and maturity, revealing inconsistency with the Black-Scholes (1973) model which assumes a constant volatility. Ever since, a multitude of volatility smile models have been developed. The earliest of the Abstract One of the most debated problems in the option smile literature today is the so-called "smile dynamics." It is the key both to the consistent pricing of exotic options and to the consistent hedging of all options, including the vanillas. Smiles models(e.g. local volatility, jump-diffusion, stochastic volatility, etc.) may agree on the vanilla prices and totally disagree on the exotic prices and the hedging strategies. Smile dynamics are heuristically classified as "sticky-delta" at one extreme, and "sticky-strike" at the other, and the classification of models follows accordingly. The real question this distinction is hinging upon, however, is space homogeneity vs. inhomogeneity. Local volatility models are inhomogeneous. The simplest stochastic volatility models are homogeneous. To be able to control the smile dynamics in stochastic volatility models, some authors have reintroduced some degree of inhomogeneity, or even worse, have proposed "mixtures" of models. We show that this is not indispensable and that spot homogeneous models can reproduce any given smile dynamics, provided a step is taken into incomplete markets and the true variable ruling smile dynamics is recognized. We conclude with a general reflection on the smile problem and whether it can be solved.