Shapes of Implied Volatility with Positive Mass at Zero

Abstract

We study the shapes of the implied volatility when the underlying distribution has an atom at zero and analyze the impact of a mass at zero on at-the-money implied volatility and the overall level of the smile. We further show that the behavior at small strikes is uniquely determined by the mass of the atom up to high asymptotic order, under mild assumptions on the remaining distribution on the positive real line. We investigate the structural difference with the no-mass-at-zero case, showing how one can---theoretically---distinguish between mass at the origin and a heavy-left-tailed distribution. We numerically test our model-free results in stochastic models with absorption at the boundary, such as the constant elasticity of variance (CEV) process, and in jump-to-default models. Note that while Lee's moment formula [R. W. Lee, Math. Finance, 14 (2004), pp. 469--480] tells us that implied variance is at most asymptotically linear in log-strike, other celebrated results for exact smile asymptotics such as...