BFS 2002

Contributed Talk

Quadratic Volatility Smiles

Haim Reisman

The paper assumes that the implied volatility of options with some fixed expiration is a quadratic function of the moneyness with stochastic coefficients. In addition, the options that are close to being at-the-money are traded without frictions where options that are away from the money are traded with frictions. The implied convenience yield of an illiquid option is defined as the rate of risk-less profit obtained from hedging this option using the liquid at-the-money options as hedging instruments. The paper assumes the convenience yield for the liquid options is zero and derives an explicit formula for the implied convenience yield of the non-liquid options and for the hedging coefficients.