The Exact Implied Volatility Smile for Exponential Lévy Models

Abstract

For any strictly positive martingale S=e^X for which X has an analytically tractable characteristic function, we provide an expansion for the implied volatility. This expansion is explicit in the sense that it involves no integrals, but only polynomials in log(K/S 0 ). We illustrate the versatility of our expansion by computing the approximate implied volatility smile in three well-known martingale models: one finite activity exponential Levy model (Merton), one infinite activity exponential Levy model (Variance Gamma), and one stochastic volatility model (Heston). We show how this technique can be extended to compute approximate forward implied volatilities and we implement this extension in the Heston setting. Finally, we illustrate how our expansion can be used to perform a model-free calibration of the empirically observed implied volatility surface.