The multivariate mixture dynamics: Consistent no-arbitrage single-asset and index volatility smiles

Abstract

ABSTRACTWe introduce a new arbitrage-free multivariate dynamic asset pricing model that allows us to reconcile single name and index/basket volatility smiles using a tractable and explicit dependence structure that goes beyond instantaneous correlation. Each asset volatility smile is modeled according to a density-mixture dynamical model while the same property holds for the multivariate process of all assets whose density is a mixture of multivariate basic densities. After introducing the model, we derive tractable index option smile formulas resulting from the model and related closed-form solutions for multivariate densities taking the form of multivariate mixtures. Using Markovian projection techniques, we relate our model to a multivariate uncertain volatility model and show a consistency result with geometric baskets with hints on possible uses in investigating triangular relationships between foreign exchange rates and the related smiles in practice. We also derive closed-form solutions for a number of terminal statistics of dependence and derive a precise relationship with a simpler, but less tractable, model based on a basic instantaneous correlation structure. Finally, closed-form solutions for volatility/asset correlations illuminating the relationship with the uncertain volatility model are introduced. The model tractability makes it particularly suited for calibration and risk management applications, where speed of calculations and tractability are essential. A few numerical examples on basket and spread options pricing conclude the article.