The Smile of Certain Lévy-Type Models

Abstract

We consider a class of assets whose risk-neutral pricing dynamics are described by an exponential Lévy-type process subject to default. The class of processes we consider features locally dependent drift, diffusion, and default intensity as well as a locally dependent Lévy measure. Using techniques from regular perturbation theory and Fourier analysis, we derive a series expansion for the price of a European-style option. We also provide precise conditions under which this series expansion converges to the exact price. Additionally, for a certain subclass of assets in our modeling framework, we derive an expansion for the implied volatility induced by our option pricing formula. The implied volatility expansion is exact within its radius of convergence. As an example of our framework, we propose a class of CEV-like Lévy-type models. Within this class, approximate option prices can be computed by a single Fourier integral and approximate implied volatilities are explicit (i.e., no integration is required). Furthermore, the class of CEV-like Lévy-type models is shown to provide a tight fit to the implied volatility surface of S&P500 index options.