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**I NSTI TUTE O F PHYSI CS PUBLI SHI NG quant.iop.org
**

Deterministic implied volatility

models

P Balland

Merrill Lynch Financial Centre, 2 King Edward Street, London EC1, UK

E-mail: philippe balland@ml.com

Received 20 September 2001

Published 4 February 2002

Online at stacks.iop.org/Quant/2/31

Abstract

In this paper, we characterize two deterministic implied volatility models,

deﬁned by assuming that either the per-delta or the per-strike implied

volatility surface has a deterministic evolution. Practitioners have recently

proposed these two models to describe two regimes of implied

volatility (see Derman (1999 Risk 4 55–9)). In an arbitrage-free sticky-delta

model, we show that the underlying asset price is the exponential of a process

with independent increments under the unique risk neutral measure and that

any square-integrable claim can be replicated up to a vanishing risk by

trading portfolios of vanilla options. This latter result is similar in nature to

the quasi-completeness result obtained by Bjork et al (1997 Finance

Stochastics 1 141–74) for interest rate models driven by Levy processes.

Finally, we show that the only arbitrage-free sticky-strike model is the

standard Black–Scholes model.

1. Introduction

In classic extensions of the Black–Scholes (1973) model that

accounts for the smile effect, the underlying asset price S is

driven by one or two Brownian motions. These models are

referredas local volatilitymodels as theydiffer fromthe Black–

Scholes model by simply allowing the local volatility σ

t

of the

underlying asset price to be stochastic:

dS

t

/S

t

= µ

t

dt + σ

t

dW

t

.

Two types of local volatility models have been proposed: the

so-called deterministic and stochastic local volatility models.

In the deterministic local volatility models, the local volatility

satisﬁes σ

t

= σ(t, S

t

) as in Dupire (1994) and Derman

and Kani (1994). Deterministic local volatility models

are complete and complex options are replicated using the

underlying S alone! In the stochastic local volatility models,

ν

t

= σ

2

t

is a stochastic process characterized by its mean-

reversion rate, its volatility and its correlation with S

t

as in

Hull and White (1987) and Heston (1993):

dv

t

= (α

t

−κv

t

) dt + ξ

√

v

t

dB

t

(Heston)

dv

t

/v

t

= α

t

dt + ξ dB

t

(Hull–White)

The processes B and W are Brownian motions with correlation

ρ and are deﬁned under the risk-neutral measure. This risk-

neutral measure is unique and the stochastic local volatility

models are complete if call options are traded instruments.

The parameters α

t

, κ, ξ and ρ are implied by calibration to

the initial smile surface. When inferred from historical data,

these parameters are typically much lower. The reason for

this can be understood if we observe that in stochastic models,

d ln S

t

has a normal conditional distributionwithvariance σ

2

t

dt

as in the Black–Scholes model. Consequently, the calibration

of a stochastic local volatility model to a short-dated smile

curve, which typically has large variations near the at-the-

money strike, results in unrealistically large correlation ρ and

volatility ξ. To compensate for these large parameters, the

calibration to a long-dated smile curve, which is typically

ﬂatter, implies a large mean-reversion rate κ. Deterministic

local volatility models have similar problems despite accurate

calibrations. The local volatility function inferred from the

initial smile surface, has typically ‘unrealistically’ large slope

and convexity for small maturity while it is almost ﬂat for large

maturity.

1469-7688/02/010031+14$30.00 © 2002 IOP Publishing Ltd PII: S1469-7688(02)32504-1 31

P Balland QUANTI TATI VE FI NANCE

It is important to understand that a complex option will

be hedged efﬁciently using a smile model only if the model

implies a dynamic of the smile that is sufﬁciently ‘realistic’ and

‘stationary’ for the model to not require frequent re-calibration.

Local volatility models are, in this sense, unsatisfactory. The

dynamic of the implied volatility surface is entirely speciﬁed

once the model has been calibrated with the initial smile

surface, leaving thus no control on this dynamic.

To illustrate further this point, consider the foreign-

exchange market, where implied volatilities are quoted per

delta. The underlying S is typically traded more frequently

than vanilla options and thus, the implied volatilities do

not change as frequently as S does. In a deterministic

local volatility model such as the Dupire model, the implied

volatilities are however functions of S. Hence, over a short

time interval during which implied volatilities do not change,

the model will still need re-calibration every time S changes!

These frequent re-calibrations cause the hedging strategies

implied by the model to be ‘inefﬁcient’ as reported by Dumas

et al (1998). In a stochastic local volatility model, implied

volatilities depend on t , the local volatility σ

t

and on the

percentage-in-the-money S

t

/K. This last dependence implies

a greater stability of the corresponding hedging strategies.

However, to be consistent with market smiles, such a model

over-estimates, as previously explained, the volatility of

volatility and the correlation of volatility with S and, as a

consequence, the cost of hedging is not accurately accounted

for.

The need for smile models that are calibrated to an

initial smile surface and that imply a ‘realistic’ evolution of

implied volatility explains the recent interest in the so-called

implied volatility models. These models are deﬁned by direct

assumptions on the stochastic evolution of the smile surface

from an initial surface, as in Schonbucher (1999) and in Cont

and da Fonseca (2001). It is important to stress, however, that

these models need severe restrictions to be arbitrage-free.

In this paper, we characterize two recently proposed

deterministic implied volatility models, deﬁned by assuming

that either the per-delta or the per-strike implied volatility

surface has a deterministic evolution. In arbitrage-free sticky-

delta models, we show that the underlying asset price is the

exponential of a process with independent increments under

the risk neutral measure and that any square-integrable claim

can be replicated up to a vanishing risk by trading portfolios of

vanilla options. Finally, we show that the only arbitrage-free

sticky-strike model is the Black–Scholes model.

2. The option market and the implied

volatility models

We consider a continuous trading economy on a ﬁnite horizon

[0, T ] with traded assets at time t , a ﬁnancial asset S, the money

market account B, the call and the put options on S with strike

K > 0 and maturity in (t, t + x

m

). We also assume that static

portfolios consisting of a continuum of traded vanilla options

are traded instruments as in Breeden and Litzenberger (1978)

and Carr and Madan (1998).

We assume that only short-dated vanilla options are traded

assets because in typical option markets, only short-dated

options have liquid enough prices to be regarded as traded

instruments. In typical foreign exchange markets for example,

only the vanilla options with maturity less than a couple of

years have liquid prices.

We denote by S

t

> 0, C

t

(x, K) > 0 and P

t

(x, K) > 0

the price at time t of one unit of S, of one call and of one put

option on S with maturity t + x ∈ (t, t + x

m

) and with strike

K > 0.

We assume no transaction costs. We assume deterministic

interest rates and we denote by P

t x

the price at time t of a

discount bond with maturity t + x and by B

t

≡ 1/P

0t

the

money-market account. We denote by F

t x

the forward price at

time t of receiving one unit of S at time t + x t .

We assume that there exists a real bounded function µ(t )

such that

F

t x

/S

t

= exp

__

t +x

t

µ(s) ds

_

≡ m

t x

.

We assume that there exists a stochastic basis (, ` =

`

T

, {`

t

: t ∈ [0, T ]], P) with a right-continuous, complete,

increasing ﬁltration with respect to which S

t

and 1/S

t

are

cadlag quasi-left continuous square-integrable processes and

sup{E[S

2

t

+ S

−2

t

] : 0 t T ] < ∞,

C

t

(x, K) = P

t x

E

t

[(S

t +x

−K)

+

],

P

t

(x, K) = P

t x

E

t

[(K −S

t +x

)

+

].

We assume that the map (x, K) .→ C

t

(x, K) from (0, x

m

)

[0, +∞) into (0, +∞) is of class C

1

(resp. C

2

) in the ﬁrst

(resp. second) variable for all t ∈ (0, T ). The market ﬁltration

{`

t

: t ∈ [0, T ]] is the ﬁltration generated by all primary traded

asset prices.

Deﬁnition 2.1. A family {C

t

(x, K), P

t

(x, K), S

t

: (x, K)

∈ (0, x

m

) (0, +∞)} satisfying the above assumptions is

called an implied volatility model.

We use the terminology of implied volatility models

instead of option price models because implied volatilities

rather than option prices are the ﬁnancial observable (see

section 1). It is clear, however, that a process S

t

and a

two-parameter family of implied volatility processes deﬁne

an implied volatility model providing that this speciﬁcation is

arbitrage-free. Our deﬁnition of implied volatility models is

based on option prices to ensure our implied volatility models

are arbitrage-free.

We shall need the following technical restriction to ensure

that S has bounded local characteristics. This restriction is

fairly mild and met by most local volatility models.

Deﬁnition 2.2. An implied volatility model is regular if

(i) lim

x→0

E[f (S

t +x

)[S

t

= S] = f (S), (f ∈ C

0

),

(ii) sup

x

∂

x

E[(S

t +x

/F

t x

)

2

[S

t

] is locally bounded,

(iii) sup

t

E[sup

x

[∂

x

E

t

[(S

t +x

/F

t x

)

±2

][] < ∞.

We write C

0

for the space of continuous functions

vanishing at zero and inﬁnity. We refer to Derman and Kani

(1998), Schonbucher (1999) and Cont and da Fonseca (2001)

for examples of stochastic implied volatility models. We now

restrict our attention to two deterministic implied volatility

models.

32

QUANTI TATI VE FI NANCE Deterministic implied volatility models

3. The sticky-delta and the sticky-strike

implied volatility models

The Black–Scholes function is denoted C

BS

(V, F, K) with

C

BS

(V, F, K) = F N(d) −KN(d −

√

V),

d = ln(F/K)/

√

V +

1

2

√

V.

We denote

BS

(V, F, K) = ∂

F

C

BS

(V, F, K),

BS

(V, F, K) = ∂

2

F

C

BS

(V, F, K).

We recall that

∂

V

C

BS

(V, F, K) =

1

2

F

2

BS

(V, F, K).

Deﬁnition 3.1. Let (x, I) ∈ (0, x

m

) (0, +∞). The

per-delta implied volatility denoted σ

t

(x, I) where I stands

for the forward moneyness ratio, is the unique positive

solution of the equation

P

t x

C

BS

(xσ

t

(x, I)

2

, F

t x

, F

t x

I) = C

t

(x, F

t x

I).

The per-strike implied volatility denoted

t

(x, K) is the

unique positive solution of the equation

P

t x

C

BS

(x

t

(x, K)

2

, F

t x

, K) = C

t

(x, K).

Since the function C

BS

(V, F, K) is strictly increasing

with respect to V, we conclude that

t

(x, K) = σ

t

(x, K/F

t x

),

lim

x↓0

xσ

t

(x, I)

2

= lim

x↓0

x

t

(x, K)

2

= 0.

At a given time t , the volatility functions (x, I) .→

σ

t

(x, I) and (x, K) .→

t

(x, K) are of class C

1

in the

ﬁrst variable and C

2

in the second variable in (0, x

m

)

(0, +∞). For (x, I) ∈ (0, x

m

) (0, +∞), the implied

volatility processes σ

t

(x, I) and

t

(x, I) are cadlag quasi-left

continuous processes adapted to the market ﬁltration.

Following Derman (1999) and Reiner (1999), we propose

the following deﬁnition of sticky-delta and sticky-strike

implied volatility models.

Deﬁnition 3.2. An implied volatility model is sticky-delta if

the per-delta volatility process σ

t

(x, I) is deterministic on

[0, T ] for all (x, I) in (0, x

m

) (0, +∞).

An implied volatility model is sticky-strike if the per-strike

volatility process

t

(x, K) is deterministic on [0, T ] for all

(x, K) in (0, x

m

) (0, +∞).

We observe that the Black–Scholes model is an implied

volatility model deﬁned by σ

t

(x, I) =

t

(x, K) = σ

t

(x, 1).

4. Characterization of the sticky-delta

implied volatility models

For a sticky-delta implied volatility model, we deﬁne the

following deterministic function:

c(t, x, I) = C

BS

(xσ

t

(x, I)

2

, 1, I). (4.1)

Since y

2

< 2(e

y

+ e

−y

) for all real y and S

t

, 1/S

t

are

square-integrable, ln S

t

is square-integrable. Finally, we have

the following result.

Theorem 4.1. In a sticky-delta implied volatility model

deﬁned on [0, T ], the market ﬁltration {`

t

: 0 t T ]

coincides with the ﬁltration generated by S, all risk-neutral

probability measures are equal to the probability measure P

on the σ-algebra `

T

and the stochastic process ln S

t

has

independent increments under P.

Proof. We note that P is a risk-neutral measure. Consider a

forward-start call option with ﬁxing date t and maturity t + x

with x < x

m

. This option pays at maturity the quantity

(S

t +x

−kF

t x

)

+

/F

t x

.

At time t , this forward-start option is a regular call option

on S with strike kF

t x

, time-to-maturity x and notional 1/F

t x

.

At time t , the cost of replicating this option is P

t x

c(t, x, k).

This value is deterministic. Hence at time s t , the forward

value of this option is c(t, x, k) and thus independent of s.

Finally, we have proved that for any risk-neutral measure Q

and any s t , we have

E

Q

s

[(S

t +x

−kF

t x

)

+

/F

t x

] = c(t, x, k). (4.2)

Next, we note that

0 −

1

F

t x

∂

k

(S

t +x

−kF

t x

)

+

1. (4.3)

We can thus permute differentiation with respect to k and

Q-expectation in (4.2):

Pr

Q

{S

t +x

< kF

t x

[ `

s

] = 1 + ∂

k

c(t, x, k). (4.4)

The cumulative distribution of ln S

t +x

−ln S

t

conditional

on `

s

is thus independent of s t , S

s

and Q.

Let u

1

= ln S

r

− ln S

s

and u

2

= ln S

u

− ln S

t

with

s < r < t < u < T , 0 < r − u < x

m

and u − t < x

m

.

Equation (4.4) implies that for any risk-neutral measure Q, we

have

E

Q

[e

iαu

1

+iβu

2

] = E

Q

[e

iαu

1

] E

Q

[e

iβu

2

]. (4.5)

The variables u

1

and u

2

are thus independent and have

the same joint distribution under any risk-neutral measure Q.

This result is extended by convolution to n arbitrary non-

overlapping increments of ln S

t

in [0, T ]. It thus follows

that ln S

t

has independent increment in [0, T ] under any risk-

neutral measure.

33

P Balland QUANTI TATI VE FI NANCE

Finally, we show by induction that for any integer n, any

sequence {T

i

] ∈ [0, T ]

n

and any real U

i

:

Q{S

T

1

< U

1

, . . . , S

T

n

< U

n

] = P{S

T

1

< U

1

, . . . , S

T

n

< U

n

].

All risk-neutral probability measures Q coincide with P

on the algebra A of cylindrical sets {ω ∈ : S(T

1

, ω) <

U

1

, . . . , S(T

n

, ω) < U

n

]. Adirect application of the monotone

class theorem as in Jacod and Protter (1991, p 32) implies that

these probabilitymeasures coincide onσ(A) andthus on`

T

. ¬.

We note that the uniqueness of a risk-neutral measure

does not, however, imply completeness of the model since

the number of traded assets is inﬁnite (see Jarrow and Madan

1999). We have proved that in a sticky-delta implied volatility

model, there exists a cadlag square-integrable P-martingale X

with P-independent increments such that

S

t

= S

0

m

0t

exp(X

t

)/E[exp(X

t

)].

Examples of processes with independent increments are

Brownian motions, Poisson processes, Levy processes and

jump-diffusion processes. We refer to Protter (1995) for

the construction of stochastic integrals with respect to cadlag

square-integrable martingales. In this paper, the stochastic

integrals froma 0 to b are integrals on (a, b]. We recall that

the quadratic variationof a cadlagsquare-integrable martingale

Z is an increasing cadlag adapted process deﬁned by

[Z, Z]

t

= Z

2

t

−2

_

t

0

Z

u−

dZ

u

.

To ease notation, this process will also be denoted [Z]

t

or [Z

t

].

Restricting our attention to regular sticky-delta models

will ensure that X has ﬁnite moments and satisfy the

representation property of Nualart and Schoutens. This will

allowus toprove the quasi-completeness of regular sticky-delta

models. But ﬁrst, we needsome notationandsome preliminary

results.

Since S is assumed quasi-left continuous, the martingale

X has no ﬁxed points of discontinuity and can be decomposed

as in Jacod and Shiryaev (1987, p 77)

X

t

= (σ • W)

t

+ (x ∗ (N −n))

t

,

0<st

X

t

= (x ∗ N)

t

=

_

t

0

_

xN(dx ds),

where X

t

= X

t

−X

t −

is the jump of Xat time t , σ is a square-

integrable deterministic function, W is a Brownian motion,

N is a Poisson measure independent of W with deterministic

compensator n such that n

s

(dx) ds = E[N(dx ds)] where

N(dx ds) is the number of non-zero jumps of X in (s, s +

ds) (x, x + dx).

Since ln S

t

and thus X

t

are square-integrable, we conclude

that for t in [0, T ]

E

_

0<ut

X

2

u

_

=

_

t

0

_

+∞

−∞

x

2

n

u

(dx) du < ∞,

_

t

0

σ

2

u

du < ∞.

We recall the following notation:

(H • W)

t

=

_

t

0

H

u

dW

u

,

(∗ (N −n))

t

=

_

t

0

_

u

(x){N(dx du) −n

u

(dx) du].

By applying Ito’s formula (see Jacod and Shiryaev

1987) to S

t

.→ E[(S

s

− K)

+

[S

t

], we derive the following

representation for the short-dated option prices:

ˆ

C

t,s−t,K

= C

0sK

+ (H

C

sK

• W)

t

+ (

C

sK

∗ (N −n))

t

(4.6)

ˆ

P

t,s−t,K

= P

0sK

+ (H

P

sK

• W)

t

+ (

P

sK

∗ (N −n))

t

. (4.7)

where

ˆ

X

t

= P

0t

X

t

. Jensen inequality implies that the

martingales P

0t

C

t

(s −t, K) and P

0t

P

t

(s −t, K) are square-

integrable. It follows that H

C

(s, K), H

P

(s, K) are in L

2

W

and

C

(s, K),

P

(s, K) are in L

2

n

with

L

2

W

=

_

H ∈ : E

__

T

0

H

2

u

du

_

< ∞

_

,

L

2

n

=

_

∈ ⊗B(R) : E

__

T

0

_

2

u

(x) n

u

(dx) du

_

< ∞

_

,

where is the predictable σ-algebra on [0, T ] , that is the

smallest σ-algebra making all adapted processes that are left

continuous with right limits, measurable (see Protter 1995).

Let V

u

(t, K) = P

0u

P

u

(t − u, K) and recall that the

quadratic variation of this process satisﬁes with equation (4.7)

(see Protter 1995)

[V(t, K), V(t, K)]

u

= V

0

(t, K)

2

+

_

u

0

H

P

s

(t, K)

2

ds

+

_

u

0

_

P

s

(t, K)(x)

2

N(dx ds). (4.8)

Let λ(K) be a square-integrable function. The Lebesgue–

Fubini theorem for positive integrand (Malliavin and Airault

1994, p 46) implies that the following Lebesgue integrals, if

ﬁnite, satisfy

E

_ _

+∞

0

_

T

0

λ(K)

2

d[V

t,K

]

u

dK

_

= E

__

T

0

__

+∞

0

(λ

K

H

P

ut K

)

2

dK

_

du

_

+E

_ _

T

0

_ __

+∞

0

(λ

K

P

ut K

(x))

2

dK

_

n

u

(dx) du

_

.

Since S

t

and 1/S

t

are assumed to be square-integrable, we

obtain that for all t in [0, T ] and all i 0

E[[ ln S

t

[

i

exp([ ln S

t

[)] < i! E[S

2

t

+ S

−2

t

]. (4.9)

It follows that for all i 0:

sup

t ∈[0,T ]

{E[S

t

[ ln S

t

[

i

] + E[S

−1

t

[ ln S

t

[

i

]] < ∞. (4.10)

With equation (4.10), we prove the following lemma that

will be useful in establishing our quasi-completeness result.

34

QUANTI TATI VE FI NANCE Deterministic implied volatility models

Lemma 4.1. For any integers p 0 and any real α > 0, we

have

E

_ _

α

0

_

t

0

(ln K)

2p

K

−4

d

u

[

ˆ

P

u,t −u,K

]dK

_

< ∞, (4.11)

E

_ _

+∞

α

_

t

0

(ln K)

2p

K

−4

d

u

[

ˆ

C

u,t −u,K

]dK

_

< ∞, (4.12)

where [M] ≡ [M, M],

ˆ

M ≡ M/B for a cadlag process M.

Proof. Since

ˆ

P

u

(t −u, K) is a P-martingale, we observe that:

E

_ _

t

0

d

u

[

ˆ

P

u

(t −u, K)]

_

= E[

ˆ

P

t

(0+, K)

2

] −

ˆ

P

0

(t, K)

2

.

Therefore, we have

E

__

t

0

(ln K)

2p

K

4

d

u

[

ˆ

P

u,t −u,K

, ]

_

(ln K)

2p

K

−4

E[(K −S

t

)

+2

].

Using the Lebesgue–Fubini theorem for a positive

integrand, we obtain

_

α

0

(ln K)

2p

K

−4

E[(K−S

t

)

+2

]dK E[[ ln S

t

[∨[ ln α[

2p

S

−1

t

]

With (4.10), we conclude that

_

α

0

E

_ _

t

0

(ln K)

2p

K

−4

d

u

[

ˆ

P

u,t −u,K

]

_

< ∞

By Lebesgue–Fubini, we obtain (4.11). Similarly, we

derive inequality (4.12). ¬.

Since X has independent increments and E[exp(2X

t

)] +

E[exp(−2X

t

)] < ∞, the Laplace transform of X

t

is deﬁned

for all [θ[ 2, t ∈ [0, T ] and satisﬁes the time-dependent

Levy–Khintchine formula for square-integrable processes:

E[exp(θ(X

t +x

−X

t

))] = exp

__

t +x

t

ψ

s

(θ) ds

_

,

ψ

s

(θ) =

1

2

σ

2

s

θ

2

+

_

+∞

−∞

(e

θz

−1 −θz) n

s

(dz).

Using the above formula, we show that the martingale X

for a regular sticky-delta model as in deﬁnition 2.2 is regular

in the following sense.

Deﬁnition 4.1. The martingale X is regular if there exists

λ 2:

sup

s∈(0,T )

_

σ

2

s

+

_

(−1,1)

c

exp(λ[x[)n

s

(dx)

_

< ∞, (4.13)

Thanks to (4.13), we derive for i 2:

_

+∞

−∞

[x[

i

n

s

(dx) <

i!

λ

i

_

(−1,1)

c

exp(λ[x[)n

s

(dx)+

_

1

−1

x

2

n

s

(dx)

Therefore for k, i 2, m

i

(t ) ≡

_

+∞

−∞

x

i

n

t

(dx) and

M

k

(t ) ≡ E

_

0<st

(X

s

)

k

_

=

_

t

0

m

k

(s) ds are uniformly

bounded in [0, T ].

In the case where the increments of X have stationary

distributions, we note that X is a Levy martingale and the

condition (4.13) is similar to the condition introduced by

Nualart and Schoutens (2000). With that restriction, we will

extend in section 6, the polynomial representation obtained by

Nualart and Schoutens for regular Levy martingales, to regular

martingales. With this representation property, we will derive

our quasi-completeness result in section 7. But ﬁrst we need

to deﬁne precisely our admissible trading strategies and what

we mean by quasi-completeness, as this type of completeness

is not standard.

5. Trading strategies, attainable claims

and quasi-completeness

In this section, we deﬁne the trading strategies that will be used

to replicate contingent claims in a regular sticky-delta model.

We ﬁrst deﬁne the static trading strategies, which are static

portfolios having a continuumof traded vanilla options. These

static trading strategies are traded instruments by assumption

(see section 2). As in the Black–Scholes theory, we then

deﬁne tradingstrategies as dynamic portfolios involvinga ﬁnite

number of traded instruments.

We highlight that in this paper, static portfolios with a

continuum of traded options, i.e. static trading strategies, are

assumedtobe tradedinstruments, as inCarr andMadan(1998).

We note that this assumption is equivalent to assuming that at

time t , all European claims, with maturity u ∈ (t, t + x

m

) and

payoffs f (S

u

), that can be decomposed in a continuum of call

and put option payoffs as in Breeden and Litzenberger (1978),

are traded instruments.

We deﬁne a static trading strategy λ to be a portfolio of

short-dated options with maturity t

1

and of the money market

account such that the portfolio holdings are constant over the

trading interval (t

0

, t

1

] ⊂ (t

0

, t

0

+ x

m

) and there are no ﬂows

coming in or out of the strategy up to time t

1

.

A static strategy is characterized by an initial date t

0

, an

end date t

1

∈ (t

0

, t

0

+ x

m

), an initial endowment C

0

∈ `

t

0

,

two locally bounded functions λ

C

(K) and λ

P

(K) deﬁned in

[α, +∞) and in (0, α] respectively, and two positive σ-ﬁnite

measures c

λ

(dK) and p

λ

(dK) deﬁned on the positive half line.

The static trading strategy λ = (t

0

, t

1

, λ

P

, λ

C

, p, c, α) is

a portfolio that has constant holdings in (t

0

, t

1

] and that is

instantiated at zero cost using the initial endowment at time t

0

to purchase λ

C

(K)c

λ

(dK) unit(s) of the call option with strike

K ∈ (α, +∞) and maturity t

1

and λ

P

(K)p

λ

(dK) unit(s) of the

put option with strike K ∈ (0, α) and maturity t

1

.

We assume that the functions λ

C

(K) and λ

P

(K) satisfy

the following conditions:

E

_ _

α

0

[λ

P

K

[

ˆ

P

0t

1

K

p

λ

(dK) +

_

+∞

α

[λ

C

K

[

ˆ

C

0t

1

K

c

λ

(dK)

_

< ∞,

(5.1)

E

_ _

α

0

_

t

1

t

0

λ

P

(K)

2

d

s

[

ˆ

P

s,t

1

−s,K

]p

λ

(dK)

_

< ∞, (5.2)

E

_ _

+∞

α

_

t

1

t

0

λ

C

(K)

2

d

s

[

ˆ

C

s,t

1

−s,K

]c

λ

(dK)

_

< ∞ (5.3)

35

P Balland QUANTI TATI VE FI NANCE

where we recall [X] = [X, X]. Using the Cauchy–Schwartz

inequality, we show as in the proof of lemma 4.1, that

equations (5.1)–(5.3) are implied by the single equation

E

_ _

α

S

t

1

∧α

(λ

P

K

K)

2

p

λ

(dK) +

_

S

t

1

∨α

α

(λ

C

K

S

t

1

)

2

c

λ

(dK)

_

< ∞.

We impose the holding functions to satisfy (5.2) and (5.3)

in order to apply the stochastic Fubini theorem as in Protter

(1995, p 160), so as to permute strike and time integrations.

As we will see, this will allow us to deﬁne dynamic portfolios

based on static trading strategies.

The value of the static trading strategy at time t ∈ (t

0

, t

1

]

is obtained by adding the values of its constituents:

V

t

(λ) =

_

α

0

λ

P

(K)P

t

(t

1

−t, K)p

λ

(dK)

+

_

+∞

α

λ

C

(K)C

t

(t

1

−t, K)c

λ

(dK) + C

0

B

t

/B

t

0

.

The above two integrals are guaranteed to exist thanks

to (5.1). Since the static portfolio does not involve any cost at

initiation, we derive for t in (t

0

, t

1

):

ˆ

V

t

(λ) =

_

α

0

λ

P

(K)

__

t

t

0

d

s

ˆ

P

s

(t

1

−s, K)

_

p

λ

(dK)

+

_

+∞

α

λ

C

(K)

__

t

t

0

d

s

ˆ

C

s

(t

1

−s, K)

_

c

λ

(dK).

Using (5.2) and (5.3) together with (4.6)–(4.9), we show

that we can permute strike and time integration, by application

of the stochastic Fubini theoremas formulatedinProtter (1995)

for martingales and in Lebedev (1995) for random measures:

ˆ

V

t

(λ)=

___

α

0

λ

P

K

H

P

t

1

K

p

λ

(dK) +

_

+∞

α

λ

C

K

H

C

t

1

K

c

λ

(dK)

_

•W

_

t

t

0

+

___

α

0

λ

P

K

P

t

1

K

p

λ

(dK) +

_

+∞

α

λ

C

K

C

t

1

K

c

λ

(dK)

_

∗ (N −n)

_

t

t

0

where we have used the notation [X]

b

a

= X

b

− X

a

. In short

and with abuse of notations, we simply write

ˆ

V

t

(λ) =

_

t

t

0

_

α

0

λ

P

(K)p

λ

(dK) d

s

ˆ

P(t

1

−s, K)

+

_

t

t

0

_

+∞

α

λ

C

(K)c

λ

(dK) d

s

ˆ

C(t

1

−s, K).

We set

ˆ

V

t

(λ) =

ˆ

V

(t ∨t

0

)∧t

1

(λ) for t ∈ [0, T ]. This

discounted value process is a square-integrable cadlag

martingale which is zero before t

0

and constant after t

1

.

These static strategies which are portfolios with a

continuum of traded options, are traded instruments by

assumption.

A trading strategy λ is deﬁned as a portfolio of n static

trading strategies and of the money market account. A trading

strategy is thus characterized by a ﬁnite sequence {

i

: 1

i n] of static trading strategies and by some predictable

processes {λ

i

t

: 1 i n] and by a progressively measurable

adapted process λ

B

t

such that

sup

t ∈(0,T )

E

__

n

i=1

λ

i

t

ˆ

V(

i

) + λ

B

t

_

2

_

< ∞, (5.4)

n

i,j=1

E

__

T

0

λ

i

s

λ

j

s

d[

ˆ

V(

i

),

ˆ

V(

j

)]

s

_

< ∞. (5.5)

At time t , the strategy λ is the portfolio consisting of λ

i

t

unit(s) of each of the static portfolios

i

and of λ

B

t

unit(s) of

the money market account.

The value of such a strategy is given at time t by the sum

of the values of its constituents:

V

t

(λ) =

n

i=1

λ

i

t

V

t

(

i

) + λ

B

t

B

t

.

Equation (5.4) guarantees that this process is a square-

integrable semimartingale. The gain cumulated up to time t

by the trading strategy is deﬁned as usual by

G

t

(λ) ≡

n

i=1

_

t

0

λ

i

s

dV

s

(

i

) +

_

t

0

λ

B

s

dB

s

.

Equation (5.5) guarantees the existence of the above

integrals. A trading strategy is self-ﬁnancing if and only if

the value process satisﬁes as usual

V

t

(λ) = V

0

(λ) + G

t

(λ).

Hence the discounted value process of a self-ﬁnancing

trading strategy is a square-integrable martingale that satisﬁes

ˆ

V

t

(λ) = V

0

(λ) +

n

i=1

_

t

0

λ

i

s

d

ˆ

V

s

(

i

). (5.6)

A self-ﬁnancing trading strategy is thus entirely

characterized by λ = (λ

i

t

,

i

) where λ

i

t

is a predictable process

satisfying (5.4) and (5.5). We denote by the space of all self-

ﬁnancing trading strategies. We deﬁne the following linear

subspace of L

2

(, `), V() = {V

t

(λ) : t ∈ [0, T ], λ ∈ ].

As explained in Jarrow and Madan (1999), an arbitrage

strategy is a self-ﬁnancing strategy λ such that

V

0

(λ) = 0, P(V

T

(λ) 0) = 1, P(V

T

(λ) > 0) > 0.

Proposition 5.1. Implied volatility models are arbitrage-free.

Proof. Suppose that λ is an arbitrage strategy then

E[1{V

T

(λ) < 0]] = 0 and thus, we have E[V

T

(λ) 1{V

T

(λ) <

0]] = 0. It follows that E[

ˆ

V

T

(λ)] = E[[

ˆ

V

T

(λ)[] > 0 =

ˆ

V

0

(λ).

This contradicts the fact that

ˆ

V

t

(λ) is a P-martingale. ¬.

Remark 5.1. This result is not surprising since we have

assumed the existence of at least one risk-neutral measure P.

We can now deﬁne attainability and attainability up to a

vanishing risk.

Deﬁnition 5.1. A claim ∈ L

2

(, `) with maturity t T is

attainable or can be replicated if there is a self-ﬁnancing

trading strategy λ such that = V

t

(λ), i.e. ∈ V().

A claim ∈ L

2

(, `) with maturity t T is attainable up

to a vanishing risk or can be replicated up to a vanishing risk

if there is a sequence of self-ﬁnancing strategies {λ

n

] such

that lim

n→∞

E[(−V

t

(λ

n

))

2

] = 0, i.e. ∈

¨

V().

36

QUANTI TATI VE FI NANCE Deterministic implied volatility models

A claim ∈ L

2

(, `) with maturity t is thus

attainable if there are some static trading strategies {φ

i

=

(t

0i

, t

1i

, φ

P

i

, φ

C

i

, p

i

, c

i

, α

i

) : 0 i n], some predictable

processes {λ

i

t

: 0 i n] satisfying (5.4) and (5.5) and a real

V

0

= E[P

0t

] which is the cost of replication, such that

P

0t

= V

0

+

n

i=0

_

t

1i

t

0i

_

α

i

0

λ

i

s

g

i

(K)p

i

(dK) d

s

ˆ

P

s

(t

1i

−s, K)

+

n

i=0

_

t

1i

t

0i

_

+∞

α

i

λ

i

s

f

i

(K)c

i

(dK) d

s

ˆ

C

s

(t

1i

−s, K).

We say that a claim ∈ L

2

(, `) with maturity t is

attainable at time s if there exists a self-ﬁnancing strategy λ

and C

s

∈ `

s

such that P

0t

=

ˆ

V

t

(λ) −

ˆ

V

s

(λ) + C

s

. Similarly,

we deﬁne attainable up to a vanishing risk, at time s.

With the above notations, we deﬁne quasi-completeness

as in Jarrow and Madan (1999) and in Bjork et al (1997).

Deﬁnition 5.2. An implied volatility model is complete up to

a vanishing risk or quasi-complete if any ∈ L

2

(, `) is

attainable up to a vanishing risk i.e. L

2

(, `) −

¨

V().

We now prove the following classic result to be used later.

Proposition 5.2. Let a ∈ (0, x

m

), b = t + a ∈ [0, T ] and let

f be a C

2

(0, +∞) function with f (S

b

) ∈ L

2

(, `) such that

there is 0 < α < ∞satisfying

E

__

α

S

b

∧α

f

//

(K)

2

K

2

dK +

_

S

b

∨α

α

f

//

(K)

2

S

2

b

dK

_

< ∞.

(5.7)

Then the claim with payoff f (S

b

) at time b can be replicated

at time t at a cost P

t b

E

t

[f (S

b

)].

Proof. Following Carr and Madan (1998), we decompose the

payoff into four components

f (S

b

) =

_

α

0

(K −S

b

)

+

f

//

(K) dK

+

_

+∞

α

(S

b

−K)

+

f

//

(K) dK + f (α)

+f

/

(α)(S

b

−α) ≡ A + B + C + D. (5.8)

Thanks to our assumptions on f

//

, we derive by Cauchy–

Schwartz:

_

α

0

P

0bK

[f

//

(K)[dK +

_

+∞

α

C

0bK

[f

//

(K)[dK < ∞. (5.9)

[f

//

(K)[(K −S)

+

1{K < α] + [f

//

(K)[(S −K)

+

1{K > α] is

thus P{S

b

∈ dS]dK integrable on (0, +∞)

2

and the Fubini–

Lebesgue theoremimplies (Malliavin and Airault (1993, p 46))

P

t b

E

t

[A+B] =

_

α

0

f

//

(z)P

t

(a, z) dz+

_

+∞

α

f

//

(z)C

t

(a, z) dz.

Thanks to our assumption on f

//

, we conclude that the

claim A + B is square-integrable and attainable at t by the

static trading strategy (t, b, f

//

, f

//

, dK, dK, α):

P

t b

(A + B) = P

t b

E

t

[A + B] +

_

b

t

_

α

0

f

//

(z) dz d

s

ˆ

P

s

(b −s, z)

+

_

b

t

_

+∞

α

f

//

(z) dz d

s

ˆ

C

s

(b −s, z).

The third component is trivially replicated by taking

position in the money market account. The fourth component

is replicated by buying a call option and selling a put option

since it is the terminal value of a forward contract. ¬.

Corollary 5.1. The above result still holds if we replace in

(5.7) the squares by absolute values and replicated by

replicating up to a vanishing risk.

Proof. Consider the sequence of smooth functions f

n

deﬁned

by replacing in (5.8) f

//

(K) by f

//

(K)1{[f

//

(K)[ < n]. By

applying the Lebesgue dominated convergence theorem, we

obtain lim

n→∞

E[(f

n

−f )

2

] = 0.

By application of proposition 5.2 to f

n

(S

b

), we conclude

that f

n

(S

b

) is attainable and thus at time t , the claim f (S

b

) ∈

L

2

(, `) can be replicated up to a vanishing risk at a cost

P

t b

E

t

[f (S

b

)]. ¬.

Proposition 5.3. Let U

t

be a square-integrable martingale

such that the claim U

T

with maturity T is attainable and let

γ

t

be a predictable bounded process. Then the claim with

payoff at time a, Z

a

=

_

a

0

γ

t

dU

t

∈ L

2

(, `), can be

replicated at zero cost.

Proof. The claim with payoff U

T

/P

0T

is attained by a

self-ﬁnancing trading strategy λ = (λ

i

s

, φ

i

). We note that

ˆ

V

t

(λ) = E

t

[U

T

] = U

t

satisﬁes

U

t

= U

0

+

n

i=1

_

t

0

λ

i

s

d

ˆ

V

s

(φ

i

).

Since γ

t

is a predictable bounded process, (γ

s

λ

i

s

, φ

i

)

deﬁnes a self-ﬁnancing trading strategy and we have

_

a

0

γ

t

dU

t

=

n

i=1

_

a

0

γ

t

λ

i

t

d

ˆ

V

t

(φ

i

).

Therefore, the claim Z

a

with maturity a is attainable at

zero cost. ¬.

We conclude this section with a ﬁrst illustration of

how hedging in a sticky-delta model works in practice (see

remark 7.2).

Proposition 5.4. All call and put options with maturity in

[0, T ] are attainable.

Proof. Consider the long-dated call option with strike K > 0

and maturity t = kx

m

/2 + x in [0, T ] where k is an integer

and 0 < x x

m

/2. Given the set of dates {t

i

= (ix

m

/2) ∧ t :

1 i k + 1], we shall construct a sequence of static trading

strategies φ

i

having trading intervals (t

i

, t

i+1

] such that (1, φ

i

)

replicates the long-dated call option.

At time t

k

= kx

m

/2, the call option is a short-dated

option and thus can be replicated by purchasing the call option

itself. The discounted value process associated with this static

37

P Balland QUANTI TATI VE FI NANCE

strategy is

ˆ

V

u

=

ˆ

C

k

(t −u, K) for u ∈ [t

k

, t ]. Given the sticky-

delta assumption, we obtain

ˆ

V

t

k

= P

0t

E[(S

t

−K)

+

[S

t

k

] = P

0t

S

t

k

c(t −t

k

, K/S

t

k

),

where c(x, y) = E[(S

t

/S

t −x

−y)

+

] is a C

2

function which is

decreasing and convex with respect to the second argument.

The density of S

t

/S

t −x

is ∂

2

y

c(x, y) and y

2

∂

2

y

c(x, y) is

uniformly bounded in (0, +∞). We note that

ˆ

V ∈ L

2

(, `)

and ∂

2

S

t

k

ˆ

V

t

k

= K

2

∂

2

y

c(t

k

, K/S

t

k

)/S

3

t

k

0. We derive

E

__

1

S

k

∧1

∂

2

y

c(t

k

, K/S

k

)

2

K

6

/S

6

k

dK

_

< ∞,

E

__

S

k

∨1

1

∂

2

y

c(t

k

, K/S

k

)

2

K

4

/S

4

k

dK

_

< ∞.

We can thus apply proposition 5.2 and replicate the claim

ˆ

V

t

k

between time t

k−1

and t

k

using a static portfolio with

positive holdings in short-dated call and put options having

maturity t

k

, at a discounted cost

ˆ

V

t

k−1

= P

0t

E[(S

t

−K)

+

[S

t

k−1

] = P

0t

S

t

k−1

c(t −t

k−1

, K/S

t

k−1

).

By repeating the above argument, we obtain a set of static

trading strategy {φ

i

: 0 i k] with positive holdings such

that the self-ﬁnancing trading strategy (1, φ

i

) replicates the

long-dated call option at the following initial cost:

ˆ

V

0

= P

0t

E[(S

t

−K)

+

].

We obtain the result for the long-dated put options by put–

call parity. ¬.

In order to construct similar hedging strategies for square-

integrable claims, we need a representation property for X.

6. Representation property for regular

martingales with independent increments

Inthis sectionandinthe appendix, we extendthe representation

property obtained by Nualart and Schoutens (2000) for Levy

processes, to regular martingales with independent increments.

We adapt the notation and the approach taken by Nualart and

Schoutens to our purpose.

We deﬁne the Teugels martingales on [0, T ] as in Nualart

and Schoutens (2000):

Y

(1)

t

= X

t

,

Y

(k)

t

≡

0<st

(X

s

)

k

−

_

t

0

m

k

(s) ds, (k 2).

It is clear that these martingales are square-integrable

with independent increments and ﬁnite moments of all orders.

In the appendix and by [ ]-orthogonalization of the Teugels

martingales, we construct the following family of pairwise [ ]-

orthogonal martingales having independent increments:

H

(1)

t

= Y

(1)

t

,

H

(i)

t

=

_

t

0

dY

(i)

s

+ a

i,i−1

(s) dY

(i−1)

s

+ . . . + a

i,1

(s) dY

(1)

s

.

The deterministic functions a

ij

(s) are bounded in [0, T ]

and are such that the martingales H

(i)

t

are square-integrable

and pairwise strongly orthogonal.

We show in the appendix that the [ ]-orthogonal family

{H

(i)

: i 1] forms a complete basis of L

2

(, `). More

precisely, we have the following representation property.

Proposition 6.1. Let F ∈ L

2

(, `) then there are

predictable processes {φ

(i)

t

: i 1] such that

F = E[F] +

+∞

i=1

_

T

0

φ

(i)

s

dH

(i)

s

,

where {φ

(i)

t

: i 1] belongs to ⊕

+∞

i=1

L

2

H

(i)

.

Proof. See appendix. ¬.

Using this representation property, we prove in the next

section that in regular sticky-delta models, all square integrable

claims can be replicated up to a vanishing residual risk by

trading portfolios of vanilla options. We cannot typically

replicate, in the classic sense, contingent claims because the

family of martingales underlying the representation property

of proposition 6.1 has in general an inﬁnite dimension and thus

exact replication would be possible only if strategies based on

an inﬁnite number of traded instruments were admissible.

7. Quasi-completeness of regular

sticky-delta implied volatility models

In this section, we prove that all regular sticky-delta implied

volatility models are quasi-complete. But ﬁrst, we show that

the claims H

(i)

T

are attainable by application of Ito’s lemma to

polynomial functions. We deﬁne f

0b

≡ F

0b

/E[exp(X

b

)] and

observe that X

b

= ln(S

b

/f

0b

).

Lemma 7.1. Let i 2. The claim with payoff (X

b

)

i

at time b

is attainable at time a > b −x

m

using the static strategy:

X

i

b

= E

a

[(X

b

)

i

] +

_

b

a

_

f

0b

0

x

(i)

(K)K

−2

dKd

u

ˆ

P

u

(b −u, K)

+

_

b

a

_

+∞

f

0b

x

(i)

(K)K

−2

dK d

u

ˆ

C

u

(b −u, K),

x

(i)

(K) = {i(i −1)(ln{K/f

0b

])

i−2

−i(ln{K/f

0b

])

i−1

]/P

0b

.

Proof. Using equation (4.10) and proposition 5.2 with f (S) =

ln(S/f

0b

)

i

, we derive the result. ¬.

38

QUANTI TATI VE FI NANCE Deterministic implied volatility models

Proposition 7.1. For i 1 and b ∈ (a, a + x

m

), H

(i)

b

−H

(i)

a

satisﬁes

H

(i)

b

−H

(i)

a

=

_

b

a

_

f

0b

0

h

(i)

u

(K)K

−2

dKd

u

ˆ

P

u

(b −u, K)

+

_

b

a

_

+∞

f

0b

h

(i)

u

(K)K

−2

dK d

u

ˆ

C

u

(b −u, K)

+

_

b

a

g

(i)

u

d

u

ˆ

C

u

(b −u, f

0b

) −

_

b

a

g

(i)

u

d

u

ˆ

P

u

(b −u, f

0b

),

h

(i)

u

(K) =

0jki−1

h

jk

u,i

X

j

u−

(ln(K/f

0b

))

k

,

g

(i)

u

=

0ki−1

g

k

u,i

X

k

u−

.

The coefﬁcients h

jk

u,i

and g

k

u,i

are deterministic and uniformly

bounded on [0, T ]. For all i 1, the claim H

(i)

T

is attainable,

i.e. H

(i)

T

∈ V().

Proof. Y

(1)

t

= ln(S

t

/f

0t

) is a square-integrable martingale. By

proposition 5.2, we conclude that Y

(1)

b

is attainable using the

static trading strategy deﬁned by

P

0b

Y

(1)

t

= −

_

f

0b

0

ˆ

P

t

(b −t, K)K

−2

dK

−

_

+∞

f

0b

ˆ

C

t

(b −t, K)K

−2

dK

+(

ˆ

C

t

(b −t, f

0b

) −

ˆ

P

t

(b −t, f

0b

))/f

0b

.

This equation implies for t ∈ [a, b]

Y

(1)

t

−Y

(1)

a

=

_

t

a

_

f

0b

0

y

(1)

u

(K)K

−2

dK d

u

ˆ

P

u

(b −u, K)

+

_

t

a

_

+∞

f

0b

y

(1)

u

(K)K

−2

dK d

u

ˆ

C

u

(b −u, K)

+

_

t

a

f

(1)

u

d

u

ˆ

C

u

(b −u, f

0b

) −

_

t

a

f

(1)

u

d

u

ˆ

P

u

(b −u, f

0b

),

where y

(1)

u

(K) = −

1

P

0b

and f

(1)

u

=

1

P

0b

f

0b

.

With Ito’s formula for a real function f of class C

2

:

0<ut

{f (X

u

) −f

/

(X

u−

)X

u

] = f (X

t

) −f (X

0

)

−

_

t

0

f

/

(X

u−

) dX

u

−

1

2

_

t

0

f

//

(X

u−

)σ

2

u

du.

Taking f (x) = x

2

, we derive:

Y

(2)

b

= (X

b

)

2

−E[(X

b

)

2

] −2

_

b

0

X

u−

dY

(1)

u

.

Finally, the above equation and lemma 7.1 imply that

Y

(2)

b

−Y

(2)

a

is attainable:

Y

(2)

b

−Y

(2)

a

=

_

b

a

_

f

0b

0

y

(2)

u

(K)K

−2

dK d

u

ˆ

P

u

(b −u, K)

+

_

b

a

_

+∞

f

0b

y

(2)

u

(K)K

−2

dK d

u

ˆ

C

u

(b −u, K)

+

_

b

a

f

(2)

u

d

ˆ

C

u

(b −u, f

0b

) −

_

b

a

f

(2)

u

d

ˆ

P

u

(b −u, f

0b

)

y

(2)

u

(K) = 2{X

u−

−ln(K/f

0b

) + 1]/P

0b

f

(2)

u

= −2X

u

−

f

(1)

u

Similarly, we obtain by applying Ito’s lemma to

f (x) = x

3

:

0<ub

(X

u

)

3

−

_

b

0

m

3

(s) ds = (X

b

)

3

−E[(X

b

)

3

]

−3

_

b

0

X

u−

dY

(2)

u

−3

_

b

0

(X

2

u−

+ V

b

−V

u

+ M

(2)

b

−M

(2)

u

) dY

(1)

u

where V

t

=

_

t

0

σ

2

s

ds and M

(2)

t

=

_

t

0

m

2

(s) ds.

It follows that:

Y

(3)

b

−Y

(3)

a

=

_

b

a

_

f

0b

0

y

(3)

u

(K)K

−2

dK d

u

ˆ

P

u

(b −u, K)

+

_

b

a

_

+∞

f

0b

y

(3)

u

(K)K

−2

dK d

u

ˆ

C

u

(b −u, K)

+

_

b

a

f

(3)

u

d

ˆ

C

u

(b −u, f

0b

) −

_

b

a

f

(3)

u

d

ˆ

P

u

(b −u, f

0b

)

where y

(3)

u

(K) = Q

(2)

u

(X

u−

, ln(K/f

0b

)), f

(3)

u

= R

(2)

u

(X

u

−

)

and the polynomials Q

(k)

u

(X, Y) =

0ijk

q

ij

u,k

X

i

Y

j

and R

(k)

u

(X) =

0ik

r

i

u,k

X

i

have coefﬁcients that are

deterministic and uniformly bounded in [0, T ].

By induction, we extend the above formula to all Y

(k)

b

−

Y

(k)

a

. We recall that:

[H

(k)

]

b

a

=

_

b

a

dY

(k)

u

+ a

k,k−1

(u) dY

(k−1)

u

+ . . . + a

k,1

(u)dY

(1)

u

,

where the coefﬁcients are deterministic and bounded in [0, T ].

We ﬁnally obtain the promised expression for H

(k)

b

− H

(k)

a

by using the previous equation for Y

(k)

b

− Y

(k)

a

. By adding

the above decompositions obtained for a = t

l−1

, b = t

l

with

l = 1, . . . , [2T/x

m

] + 1, t

l

= (lx

m

/2) ∧ T , we obtain a self-

ﬁnancing trading strategy that replicates H

(k)

T

. ¬.

Finally, we have the following quasi-completeness result.

Theorem 7.1. Any square-integrable claim ∈ L

2

(, `)

with maturity T can be replicated up to a vanishing risk at a

cost P

0T

E[] by trading the underlying, the money-market

account and some portfolios of traded call and put options. A

regular sticky-delta model is quasi-complete or complete up

to a vanishing risk.

Proof. According to proposition 6.1, the random variable

∈ L

2

(, `) can be represented as follows:

= E[] +

+∞

i=1

_

T

0

ξ

(i)

s

dH

(i)

s

,

where ξ

(i)

t

is in L

2

H

(i)

.

We deﬁne

n

= E[] +

n

i=1

_

T

0

ξ

(i,n)

s

dH

(i)

s

∈ V()

with ξ

(i,n)

t

= ξ

(i)

y

1{[ξ

(i)

t

[ < n].

39

P Balland QUANTI TATI VE FI NANCE

Thanks to the strong orthogonality of H

(i)

t

, we obtain

E[(−

n

)

2

] E

__

−E[] −

n

i=1

_

T

0

ξ

(i)

s

dH

(i)

s

_

2

_

+E

_

+∞

i=1

_

T

0

{ξ

(i)

s

−ξ

(i,n)

s

]

2

d[H

(i)

, H

(i)

]

s

_

.

The ﬁrst sequence on the RHS converges to zero since

{ξ

(i)

t

: i 1] belongs to ⊕

+∞

j=1

L

2

H

(j)

. Observe next that:

lim

n→∞

(ξ

(i,n)

s

−ξ

(i)

s

)

2

= 0, (ξ

(i,n)

s

−ξ

(i)

s

)

2

4(ξ

(i)

s

)

2

.

By three applications of the dominated convergence

Lebesgue theorem, we derive

lim

n→∞

E

_

+∞

i=1

_

T

0

(ξ

(i)

s

−ξ

(i,n)

s

)

2

d[H

(i)

, H

(i)

]

s

_

= 0.

Finally, we have lim

n→∞

E[(−

n

)

2

] = 0. Each claim

n

is attainable by application of propositions 7.1 and 5.3 at a

cost P

0T

E[]. ¬.

Remark 7.1. The concept of quasi-completeness is due to

Jarrow and Madan (1999) and to Bjork et al (1997).

The next proposition shows that some square-integrable

claims can be replicated in the classical sense, by rolling a

portfolio of vanilla options.

Proposition 7.2. Consider a claim with square-integrable

payoff f (S

T

0

, . . . , S

T

n

) at time T

n

. We assume that this payoff

is such that S

T

i

.→ E[f (S

T

0

, . . . , S

T

n

)[`

T

i−1

∨ S

T

i

] satisﬁes,

after subtraction of a ﬁnite number of call and put payoffs,

equation (5.7) with b = T

i

. Then the claim can be replicated

by trading the underlying, the money-market account and

some portfolios of traded call and put options.

Proof. Consider a claim with maturity T

n

such as an Asian

option, a discrete barrier option, a Parisian option or a volatility

swap, that has a ﬁnite number of ﬁxing dates T

i

with 0 <

T

i

−T

i−1

< x

m

and a square-integrable payoff f (S

T

0

, . . . , S

T

n

)

as in proposition 7.2. At time T

n−1

, the payoff can be replicated

using a portfolio of call and put options, a forward contract and

a zero coupon bond as in proposition 5.2. The value V

T

n−1

of

the complex option at time T

n−1

, is thus

V

T

n−1

= P

T

n−1

,T

n−1

[℘

T

n−1

,T

n−1

f (S

T

0

, . . . , S

T

n−1

, •)](S

T

n−1

),

where the linear operator ℘

t x

is deﬁned by

[℘

t x

f ](S) ≡

_

+∞

0

f (I Sm

t x

)∂

2

I

C

BS

(xσ

t

(x, I)

2

, 1, I) dI.

The sticky-delta assumption implies that the operator

℘

T

n−1

,T

n−1

is deterministic and thus V

T

n−1

is a deterministic

function of S

T

0

, . . . , S

T

n−1

. At time T

n−2

, the complex option

can thus be replicated by the use of calls, puts, forwards and

zero coupon bonds with maturity T

n−1

. Finally, we derive by

induction that the complex option can be replicated at a cost

V

0

= P

0T

n

_

℘

0,T

0

n−1

i=0

℘

T

i

,T

i

_

(f )(S

0

) = P

0T

n

E[f ].

¬.

Remark 7.2. By modifying the above strategy, we obtain a

super-replication strategy for the complex option when there

are transaction costs on the implied volatility or when the

short-dated implied volatility smile is ‘uncertain’ but

bounded. Observe that the transition operators ℘

T

k

,T

k

are

nonlinear in this case.

The previous expectation can be estimated by using the

Monte Carlo method, a fast Fourier transform as in Carr and

Madan (1999) or by solving the integro-differential equation

∂

t

V + A

t

V = r

t

V where A

t

is the generator deﬁned by

A

t

= (∂

x

℘

t x

)

x=0

+ .

8. Regular geometric Levy models

We consider a regular sticky-delta implied volatility model

and we suppose that the per-delta implied volatility processes

are independent of time. Our previous analysis in section 4

shows that the increments of ln S

t

are independent and have a

stationary distribution under the probability measure P, i.e.

S

t

= F

0t

exp(L

t

−ln E[e

L

t

]),

where L is a regular P-Levy martingale (see Levy 1965).

We deﬁne a regular geometric Levy under P by:

S

t

= F

0t

exp(L

t

−ln E[e

L

t

]),

C

t

(x, K) = P

t x

E

t

[(S

t +x

−K)

+

],

P

t

(x, K) = P

t x

E

t

[(K −S

t +x

)

+

],

where x < x

m

and Lis an adapted regular P-Levy martingale.

Proposition 8.1. Regular geometric Levy models are

arbitrage-free and quasi-complete in the sense that all

square-integrable claims can be replicated up to a vanishing

risk by trading the underlying, the money-market account and

portfolios of short-dated call and put options.

Proof. By direct calculation, we show that regular geometric

Levy models are regular stationary sticky-delta implied

volatility models. Therefore, these models are arbitrage-free

and quasi-complete by application of theorem 7.1. ¬.

There is a long list of geometric Levy models proposed

as alternatives to the Black–Scholes model. We mention,

in particular, Mandelbrot (1963), Merton (1976), Madan and

Seneta (1990), the continuous-time formulation by Koponen

(1995) of the ‘truncated Levy ﬂight’ introduced by Mantegna

and Stanley (1994), Eberlein and Keller (1995), Barndorff-

Nielsen (1995), Bouchaud, Cont and Potters (1998), Bjork

et al (1997) and Schoutens (2001).

40

QUANTI TATI VE FI NANCE Deterministic implied volatility models

9. Characterization of sticky-strike

implied volatility models

As with sticky-delta models, we consider only regular sticky-

strike models. We denote v

t x

(K) ≡ x

t

(x, Km

t x

)

2

, the den-

sity of S

t

by p

t

and

t x

(S, K) ≡

BS

(x

t

(x, Km

t x

)

2

, S, K).

Lemma 9.1. For each t < T , there exists a positive, locally

bounded, P-integrable function h

t

such that:

lim

k→+∞

∂

x

v

t x

k

(S

t

) = h

t

(S

t

) P a.s.,

where x

k

is a sequence with limit zero.

Proof. First, we note by Jensen inequality:

E

t

[(S

t +x

/m

t x

−K)

+

] = E

t

[(S

t +x+y

/m

t,x+y

−K)

+

].

Hence v

t x

(K) is increasing with x. To simplify notation,

we assume that p

t

> 0 in (0, +∞). The case where p

t

vanishes

is treated similarly since we have P(p

t

(S

t

) = 0) = 0.

Using the Black–Scholes equation, we derive:

∂

x

E

t

[S

2

t +x

/F

2

t x

] =

_

+∞

0

∂

x

v

t x

(K)

t x

(S

t

, K)dK.

For

¨

I ⊂ (0, +∞), we deﬁne the increasing function:

H

It x

: z .→

_

I

∂

x

v

t x

(K)E[

t x

(S

t

, K) 1{S

t

< z]dK.

We observe that for any positive z:

H

It x

(z) E[sup

x

∂

x

E

t

[S

2

t +x

/F

2

t x

]].

Deﬁnition 2.2 implies that the increasing functions H

It x

are

uniformly bounded with respect to x and I. Helly’s theorem

implies that there is a sequence x

I,n

with limit zero and an

increasing function H

I,t

such that (see Doob 1994):

lim

n→+∞

H

It x

In

(z) = H

I,t

(z).

The increasing function H

I,t

satisﬁes for 0 a < b:

H

I,t

(b) −H

I,t

(a)

_

b

a

sup

x

∂

x

E[S

2

t +x

/F

2

t x

[S

t

]p

t

(S

t

)dS

t

.

The Radon–Nikodym theorem implies that there is a positive,

locally bounded, P-integrable function h

I,t

such that:

H

I,t

(b) −H

I,t

(a) =

_

b

a

h

I,t

(z)p

t

(z)dz (a, b > 0).

0 h

I,t

(z) sup

0<x<T −t

∂

x

E[S

2

t +x

/F

2

t x

[S

t

= z] P a.s.

Finally, we conclude that for any compact A ⊂ (0, +∞):

lim

n→+∞

_

I

∂

x

v

t x

I,n

E[

t x

I,n

(S

t

, K)1

A

(S

t

)]dK =

_

A

h

I,t

p

t

dz.

Since E[

t,x

I,n

1

A

]/p

t

converges uniformly to 1

A

on I:

lim

n→+∞

_

I

∂

x

v

t x

I,n

1

A

(K)p

t

(K)dK =

_

A

h

I,t

p

t

dz.

Hence ∂

x

v

t x

I,n

(S

t

) converges in probability to h

I,t

(S

t

) in I and

there exists x

I,σ(n)

with limit zero, such that (see Doob 1994):

lim

n→+∞

∂

x

v

t x

I,σ(n)

(S

t

) = h

I,t

(S

t

) (S

t

∈ I, P a.s.).

Application of Fatou’s theorem gives (see Doob 1994):

lim

n→+∞

_

I

E[

t x

I,n

(S

t

, K)1

A

(S

t

)] [∂

x

v

t x

I,n

−h

I,t

[dK = 0.

(9.1)

We deﬁne I

k

=

_

1

k+1

,

1

k

_

∪ [k, k + 1) and construct, as

previously, a family of positive P-integrable functions h

¨

I

k

,t

and sub-sequences x

σ

k

(n)

⊂ x

σ

k−1

(n)

converging to zero such

that:

lim

n→+∞

∂

x

v

t x

σ

k

(n)

(S

t

) = h

¨

I

k

,t

(S

t

) (k > 0, S

t

∈ I

k

, P a.s.).

Using the diagonal procedure, we deﬁne the sequence x

φ(n)

=

x

σ

n

(n)

with limit zero, and the positive, locally bounded, P-

integrable function:

h

t

(S) =

+∞

k=1

1

I

k

(S)h

¨

I

k

,t

(S) sup

x

∂

x

E[S

2

t +x

/F

2

t x

[S

t

= S].

Using equation (9.1), we obtain for any compact sets A, C:

lim

n→+∞

_

C

E[

t x

φ(n)

(S

t

, K)1

A

(S

t

)][∂

x

v

t x

φ(n)

−h

t

[dK = 0.

(9.2)

Since

k

I

k

= (0, +∞), we ﬁnally conclude that:

lim

n→+∞

∂

x

v

t x

φ(n)

(S

t

) = h

t

(S

t

) P a.s.

¬.

In fact, we have a stronger result.

Theorem 9.1. In a regular sticky-strike implied volatility

model, the per-strike implied volatility

t

(x, K) is

independent of K. Hence the Black–Scholes model is the only

arbitrage-free regular sticky-strike model.

Proof. The implied volatility model with zero-drift underlying

S

t

/m

0t

and implied volatility

t

(x, Km

0t

) is regular and

sticky-strike. Therefore, there is no loss of generality in

assuming zero drift i.e. m

0t

= 1.

For any bounded, Borel measurable function f , we have:

P

t x

E

P

t

[f (S

t +x

)] =

_

+∞

0

∂

2

K

C

t

(x, K)f (K)dK.

With our assumptions, the asset price process S

t

is a Markov

process entirely characterized by the transition function

℘

t x

(see Revuz and Yor 1991):

(

℘

t x

f )(S

t

) = E[f (S

t +x

)[S

t

].

41

P Balland QUANTI TATI VE FI NANCE

The transition function is Feller and it is thus associated with

an inﬁnitesimal generator

A

t

deﬁned on D

A

t

satisfying:

[

A

t

f ](S

t

) = lim

x↓0

∂

x

[

℘

t x

f ](S

t

).

Let f ⊂ D

A

t

∩ C

2

with compact support . We obtain:

∂

x

[

℘

t x

f ](S

t

) =

_

∂

x

C

BS

(v

t x

(K), S

t

, K)f

//

(K)dK. (9.3)

The Black–Scholes function satisﬁes:

∂

V

C

BS

(V, F, K) =

1

2

F

2

BS

(V, F, K).

Hence, equation (9.3) can be written as follows:

∂

x

[

℘

t x

f ](S

t

) =

1

2

_

S

2

t

t x

(S

t

, K) ∂

x

v

t x

(K)f

//

(K)dK.

According to lemma 9.1, there is a positive, locally bounded

P-integrable function h

t

such that:

lim

n→∞

∂

x

v

t x

n

(S

t

) = h

t

(S

t

) P a.s.

By taking ﬁrst the expectation of equation (9.3) on a compact

C and then the limit as x

n

tends to zero, we obtain with (9.2):

_

C

[

A

t

f ](K)p

t

(K)dK =

1

2

_

C

h

t

(K)K

2

f

//

(K)p

t

(K)dK.

We ﬁnally obtain the following expression for the generator:

[

A

t

f ](S

t

) =

1

2

h

t

(S

t

)S

2

t

f

//

(S

t

) P a.s. (9.4)

The forward price V(t, S

t

) of a call option with maturity a and

strike K is a P-martingale. Therefore, V satisﬁes the backward

equation (see Revuz and Yor 1991):

∂

t

V(t, S

t

) + [

A

t

V](S

t

) = 0. (9.5)

On the other hand, V satisﬁes:

V(t, S

t

) = C

BS

((a −t )

t

(a −t, K)

2

, S

t

, K).

Since V has the same second-order derivatives with respect to

S as the Black–Scholes function, it follows that:

∂

t

V(t, S

t

) =

1

2

∂

t

[(a −t )

t

(a −t, K)

2

]S

2

∂

2

S

V(t, S

t

). (9.6)

Finally, equations (9.4)–(9.6) imply that we have for all

K, t, a ∈ (t, t + x

m

):

t

(a −t, K)

2

=

1

a −t

_

a

t

E[h

u

(S

u

)]du.

Hence, the implied volatility

t

(x, K) is independent of K

and the regular sticky-strike model coincides with the Black–

Scholes model! ¬.

Acknowledgments

I would like to thank L P Hughston, D B Madan, T Bjork,

W Schoutens, D Nualart, R Cont, an anonymous referee, the

participants of the EURANDOM seminar on Levy processes

(2001), the participants of the AMS Meeting (2001) and

my colleagues at Merrill Lynch for stimulating and fruitful

discussions.

Appendix. Representation property for

regular martingales

In this appendix, we extend the Schoutens–Nualart

representation property obtained for regular Levy martingales

to regular martingales with independent increments. We use

the notations of section6andwe followcloselythe presentation

of Nualart and Schoutens (2000).

We recall that two square-integrable martingales M and N

are said to be strongly orthogonal or [ ]-orthogonal if [M, N]

t

is a martingale (see Protter 1995).

Proposition A.1. There exists a family of pairwise strongly

orthogonal square-integrable martingales {H

(i)

: i 1].

Proof. We deﬁne the following inner product acting on the

space of real polynomials with time-dependent coefﬁcients in

L

2

(0, T ):

¸Q, R) =

_

T

0

_

+∞

−∞

Q(x, s)R(x, s)(x

2

n

s

(dx)−σ

2

s

δ(x)dx)ds.

By ¸)-orthogonalization of the total family {1{s < t ]x

i

:

i 0, t ∈ (0, T )], we ﬁnd a family of pairwise ¸)-orthogonal

polynomials {R

i

(x, s)] with bounded coefﬁcients such that:

R

i

(x, s) = a

i+1,1

(s) + a

i+1,2

(s)x + . . . + a

i+1,i

(s)x

i−1

+ x

i

,

¸R

i

, 1{s < t ]x

j

) = 0, (t < T, 1 j i −1).

The coefﬁcients of the above polynomial are bounded

because the measure n(s, dx) has ﬁnite moments of order

i 2, uniformly bounded in [0, T ].

Deﬁne Q

i+1

(x, s) ≡ x(R

i

(x, s) −a

i+1,1

(s)), a

i+1,i+1

≡ 1

and the following square integrable martingale:

H

(i+1)

t

≡

_

t

0

a

i+1,1

(s)dY

(1)

s

+ . . . + a

i+1,i+1

(s) dY

(i+1)

s

.

By direct calculation, we derive:

H

(i+1)

t

=

_

t

0

a

i+1,1

(s)dX

s

+

0<st

Q

i+1

(S

s

, s)

−

i+1

k=2

_

t

0

a

i+1,k

(s)m

k

(s)ds.

We note that the processes [Y

(k)

, Y

(j)

]

t

and [H

(i+1)

, Y

(j)

]

t

have independent increments. Furthermore, we have for

t ∈ [0, T ] and j = 1, . . . , i:

E[H

(i+1)

, Y

(j)

]

t

= E

__

t

0

i

k=1

a

i+1,k

(s) d[Y

(k)

, Y

(j)

]

s

_

= ¸R

i

(x, s), 1{s < t ]x

j−1

) = 0.

42

QUANTI TATI VE FI NANCE Deterministic implied volatility models

Therefore H

(i+1)

is strongly orthogonal to all Y

(j)

for

j = 1, . . . , i. The martingales H

(j)

are consequently pairwise

strongly orthogonal. ¬.

Remark A.1. We observe that if the polynomial R

i

is such

that ¸R

i

, R

i

) = 0 then the martingale H

(i+1)

satisﬁes

E[H

(i+1)

, H

(i+1)

]

T

= 0 and thus H

(i+1)

= 0 almost

everywhere. If the discontinuous component of the regular

martingale is the sum of a ﬁnite number of Poisson processes

with deterministic intensity then only a ﬁnite number of the

martingales H

(k)

will be non-zero.

We deﬁne the following families of L

2

(, `) variables:

t

1

...t

n

= {X

k

1

t

1

(X

t

2

−X

t

1

)

k

2

. . . (X

t

n

−X

t

n−1

)

k

n

: k

i

0],

= {X

k

1

t

1

. . . (X

t

n

−X

t

n−1

)

k

n

: 0 t

i

< t

i+1

T, k

i

0].

Lemma A.2. The family

t

1

...t

n

is total in the space

L

2

(, σ(X

t

1

, X

t

2

−X

t

1

, . . . , X

t

n

−X

t

n−1

)).

Proof. Let us prove the result for the family

t

. The case with

n non-overlapping independent increments is treated similarly.

Since X is regular, the linear hull

ˆ

t

of

t

is in L

2

(P{X

t

∈

dx]). The space C of functions in L

2

(P{X

t

∈ dx]) having

compact support is dense in L

2

(P{X

t

∈ dx]). Let F ∈ C

with support in [−a, a] and weakly orthogonal to

ˆ

t

, i.e.

E[(X

t

)

k

F(X

t

)] = 0, (k 0). For any real Z, we have:

+∞

k=0

[Z[

k

k!

E[[X

t

[

k

[F(X

t

)[] < E[F(X

t

)

2

]

1/2

exp([Za[).

By the dominated convergence theorem, we derive

E[exp(iZX

t

)F(X

t

)] = 0 for all Z and thus F(X

t

) = 0

(Malliavin and Airault (1994, p 110)). Therefore

ˆ

t

is dense

in C and thus in L

2

(P{X

t

∈ dx]). ¬.

Proposition A.2. The family is total in L

2

(, `).

Proof. A variable Z in L

2

(, `) can be approximated

arbitrarily closely by an element Y of L

2

(, σ(X

t

1

, X

t

2

−

X

t

1

, . . . , X

t

n

− X

t

n−1

)) for some sequence {t

i

]. Following

lemma A.2

t

1

...t

n

is total in L

2

(, σ(X

t

1

, . . . , X

t

n

− X

t

n−1

)).

Therefore, Y and thus Z can be approximated arbitrarily

closely by an element of

ˆ

. ¬.

We have the following representation property for

elements of .

Lemma A.3. For any integer k and any power-increment

(X

s

1

−X

s

0

)

k

, there is a sequence of predictable processes

{θ

(i)

s

0

s

1

k

(s) : i 1] such that:

(X

s

1

−X

s

0

)

k

= E[(X

s

1

−X

s

0

)

k

] +

+∞

i=1

_

s

1

s

0

θ

(i)

s

0

s

1

k

(s) dH

(i)

s

.

Proof. We prove the above equation by induction on k and by

application of Ito’s formula to power functions as in Nualart

and Schoutens (2000). ¬.

Proposition A.3. Let R ∈ ; then there are predictable

processes {

(i)

t

: i 1] such that:

R = E[R] +

+∞

i=1

_

T

0

(i)

s

dH

(i)

s

.

Proof. With lemma A.3, we derive that the product of non-

overlapping power-increments Y

kl

≡ ([X]

s

1

s

0

)

k

([X]

s

3

s

2

)

l

with

s

0

< s

1

s

2

< s

3

can be represented as follows:

Y

kl

= E[Y

kl

] +

+∞

i=1

_

T

0

(i)

s

dH

(i)

s

.

The process

(i)

s

is a predictable process deﬁned by:

(i)

s

= 1{s ∈ (s

2

, s

3

)]θ

(i)

s

2

s

3

l

(s)

+∞

j=1

_

s

1

s

0

θ

(j)

s

0

s

1

k

(u) dH

(j)

u

.

Hence, we have proved the result for the product of two

non-overlapping power-increments. By induction, we prove

the result for the product of an arbitrary number of non-

overlapping power-increments. ¬.

Since the linear space

ˆ

spanned by is dense in

L

2

(, `), we deduce the following representation property

of square-integrable variables.

Proposition 6.1. Let F ∈ L

2

(, `) then there is a family of

predictable processes {φ

(i)

t

: i 1] such that:

F = E[F] +

+∞

i=1

_

T

0

φ

(i)

s

dH

(i)

s

,

where φ

(i)

t

belongs to L

2

H

(i)

.

Proof. For a square-integrable adapted martingale m, we recall

that:

L

2

m

=

_

H ∈ :

_

T

0

H

s

dm

s

∈ L

2

(, `)

_

,

where is the predictable σ-algebra on [0, T ] . We need

to prove that:

L

2

(, `) =

+∞

i=1

L

2

H

(i)

,

+∞

i=1

L

2

H

(i)

≡

_

X ∈ L

2

(, `) : X=

+∞

i=1

φ

(i)

• H

(i)

, φ

(i)

∈ L

2

H

(i)

_

.

We observe that ⊕

+∞

i=1

L

2

H

(i)

is closed in L

2

(, `) since the

martingales H

(i)

are pairwise strongly orthogonal. Thanks to

proposition A.3, we have:

ˆ

⊂

+∞

i=1

L

2

H

(i)

⊂ L

2

(, `).

Since

¨

ˆ

= L

2

(, `) by proposition A.2, we derive the

result by closure of the above inclusion. ¬.

43

P Balland QUANTI TATI VE FI NANCE

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44

xm ) × (0. that a process St and a two-parameter family of implied volatility processes deﬁne an implied volatility model providing that this speciﬁcation is arbitrage-free. Pt (x. we characterize two recently proposed deterministic implied volatility models. T ]}. To illustrate further this point. in this sense. K). K) → Ct (x. the model will still need re-calibration every time S changes! These frequent re-calibrations cause the hedging strategies implied by the model to be ‘inefﬁcient’ as reported by Dumas et al (1998). We also assume that static portfolios consisting of a continuum of traded vanilla options are traded instruments as in Breeden and Litzenberger (1978) and Carr and Madan (1998). +∞) is of class C 1 (resp. complete. as in Schonbucher (1999) and in Cont and da Fonseca (2001). µ(s) ds ≡ mtx . K) from (0. K) = Ptx Et [(K − St+x )+ ]. Finally. We denote by Ftx the forward price at time t of receiving one unit of S at time t + x t. C 2 ) in the ﬁrst (resp. 32 . (f ∈ C0 ). the implied volatilities are however functions of S. however. T ] with traded assets at time t. We use the terminology of implied volatility models instead of option price models because implied volatilities rather than option prices are the ﬁnancial observable (see section 1). T ). This last dependence implies a greater stability of the corresponding hedging strategies. In this paper. 2. Hence. to be consistent with market smiles. It is important to stress. we show that the only arbitrage-free sticky-strike model is the Black–Scholes model. of one call and of one put option on S with maturity t + x ∈ (t. only short-dated options have liquid enough prices to be regarded as traded instruments. implied volatilities depend on t. Deﬁnition 2. consider the foreignexchange market. K). We denote by St > 0. It is clear. The market ﬁltration { t : t ∈ [0. leaving thus no control on this dynamic. such a model over-estimates. Local volatility models are. the volatility of volatility and the correlation of volatility with S and. The dynamic of the implied volatility surface is entirely speciﬁed once the model has been calibrated with the initial smile surface. In typical foreign exchange markets for example. We write C0 for the space of continuous functions vanishing at zero and inﬁnity. The option market and the implied volatility models We consider a continuous trading economy on a ﬁnite horizon [0. { t : t ∈ [0. K) ∈ (0. Ct (x.1. We assume that the map (x. Ct (x. Pt (x. = . St : (x. xm ) × [0. +∞) into (0. (ii) supx ∂x E[(St+x /Ftx )2 |St ] is locally bounded. only the vanilla options with maturity less than a couple of years have liquid prices. This restriction is fairly mild and met by most local volatility models. that these models need severe restrictions to be arbitrage-free. In a deterministic local volatility model such as the Dupire model. Schonbucher (1999) and Cont and da Fonseca (2001) for examples of stochastic implied volatility models. A family {Ct (x. However. The underlying S is typically traded more frequently than vanilla options and thus. K) > 0 and Pt (x. We now restrict our attention to two deterministic implied volatility models. second) variable for all t ∈ (0. we show that the underlying asset price is the exponential of a process with independent increments under the risk neutral measure and that any square-integrable claim can be replicated up to a vanishing risk by trading portfolios of vanilla options. P ) with a right-continuous. An implied volatility model is regular if (i) limx→0 E[f (St+x )|St = S] = f (S). In a stochastic local volatility model. These models are deﬁned by direct assumptions on the stochastic evolution of the smile surface from an initial surface. the cost of hedging is not accurately accounted for. T increasing ﬁltration with respect to which St and 1/St are cadlag quasi-left continuous square-integrable processes and sup{E[St2 + St−2 ] : 0 t T } < ∞. (iii) supt E[supx |∂x Et [(St+x /Ftx )±2 ]|] < ∞. We assume deterministic interest rates and we denote by Ptx the price at time t of a discount bond with maturity t + x and by Bt ≡ 1/P0t the money-market account. deﬁned by assuming that either the per-delta or the per-strike implied volatility surface has a deterministic evolution.2. We shall need the following technical restriction to ensure that S has bounded local characteristics. We assume that there exists a stochastic basis ( . t + xm ). however. where implied volatilities are quoted per delta. The need for smile models that are calibrated to an initial smile surface and that imply a ‘realistic’ evolution of implied volatility explains the recent interest in the so-called implied volatility models. We assume no transaction costs. In arbitrage-free stickydelta models. over a short time interval during which implied volatilities do not change. as a consequence. unsatisfactory. the money market account B. the local volatility σt and on the percentage-in-the-money St /K. Deﬁnition 2. +∞)} satisfying the above assumptions is called an implied volatility model. We refer to Derman and Kani (1998). a ﬁnancial asset S.P Balland Q UANTITATIVE F I N A N C E We assume that only short-dated vanilla options are traded assets because in typical option markets. Our deﬁnition of implied volatility models is based on option prices to ensure our implied volatility models are arbitrage-free. K) = Ptx Et [(St+x − K)+ ]. the implied volatilities do not change as frequently as S does. as previously explained. We assume that there exists a real bounded function µ(t) such that Ftx /St = exp t+x t It is important to understand that a complex option will be hedged efﬁciently using a smile model only if the model implies a dynamic of the smile that is sufﬁciently ‘realistic’ and ‘stationary’ for the model to not require frequent re-calibration. the call and the put options on S with strike K > 0 and maturity in (t. K) > 0 the price at time t of one unit of S. t + xm ) and with strike K > 0. T ]} is the ﬁltration generated by all primary traded asset prices.

F. 2 (V . √ √ 1 d = ln(F /K)/ V + 2 V . the forward value of this option is c(t. K) = ∂F C BS (V . K) = ∂F C BS (V . K) 2 At a given time t. 33 . The sticky-delta and the sticky-strike implied volatility models The Black–Scholes function is denoted C BS (V . xm ) × (0. we have proved that for any risk-neutral measure Q and any s t. xm ) × (0. I ) where I stands for the forward moneyness ratio. K) = 2 F 2 BS (V . (V . An implied volatility model is sticky-delta if the per-delta volatility process σt (x. It thus follows that ln St has independent increment in [0. F. xm ) × (0. K) is strictly increasing with respect to V . Ftx . K) with √ C BS (V . (4. (4. 1). We denote BS 4. F. F. 1. Ss and Q. ln St is square-integrable. K). x.1. xm ) × (0. This value is deterministic. K) in (0. Finally. I ) → σt (x. time-to-maturity x and notional 1/Ftx . This option pays at maturity the quantity (St+x − kFtx )+ /Ftx . At time t. (4. F. Hence at time s t. Finally. k) and thus independent of s.2): Pr Q {St+x < kFtx | on s} = 1 + ∂k c(t. F. I ) = C BS (xσt (x. +∞). we propose the following deﬁnition of sticky-delta and sticky-strike implied volatility models. K) = σt (x. k).4) The cumulative distribution of ln St+x − ln St conditional t. The per-delta implied volatility denoted σt (x.Q UANTITATIVE F I N A N C E Deterministic implied volatility models 3. 1/St are square-integrable. 0 < r − u < xm and u − t < xm . x. x. Since the function C BS (V . K) → t (x. we have Q Es [(St+x − kFtx )+ /Ftx ] = c(t. T ] for all (x. we conclude that t (x. F. I )2 . +∞). I ) ∈ (0. At time t. We observe that the Black–Scholes model is an implied volatility model deﬁned by σt (x. we deﬁne the following deterministic function: c(t. I ) are cadlag quasi-left continuous processes adapted to the market ﬁltration. s is thus independent of s Let u1 = ln Sr − ln Ss and u2 = ln Su − ln St with s < r < t < u < T . Consider a forward-start call option with ﬁxing date t and maturity t + x with x < xm . xm ) × (0. I ) and t (x. K) = σt (x. +∞). (4. (4. This result is extended by convolution to n arbitrary nonoverlapping increments of ln St in [0.2) Next. all risk-neutral probability measures are equal to the probability measure P on the σ -algebra T and the stochastic process ln St has independent increments under P .3) lim xσt (x. T ]. the implied volatility processes σt (x. T ] under any riskneutral measure. T ]. Characterization of the sticky-delta implied volatility models For a sticky-delta implied volatility model. T ] for all (x. K) = Ct (x.5) The variables u1 and u2 are thus independent and have the same joint distribution under any risk-neutral measure Q. For (x. BS We recall that 1 ∂V C BS (V . K) is deterministic on [0.1. K) = F N (d) − KN (d − V ). the volatility functions (x. An implied volatility model is sticky-strike if the per-strike volatility process t (x. We note that P is a risk-neutral measure. Let (x. this forward-start option is a regular call option on S with strike kFtx . I ) in (0. In a sticky-delta implied volatility model deﬁned on [0. F. Deﬁnition 3. Equation (4. we have E Q [eiαu1 +iβu2 ] = E Q [eiαu1 ] E Q [eiβu2 ].4) implies that for any risk-neutral measure Q. x. F. K). Ftx . we have the following result. Ftx I ) = Ct (x. Theorem 4. +∞). k). K) are of class C 1 in the ﬁrst variable and C 2 in the second variable in (0. Following Derman (1999) and Reiner (1999). x. Ftx I ). I ) is deterministic on [0. the market ﬁltration { t : 0 t T } coincides with the ﬁltration generated by S. I ) = t (x. k). 0 − 1 ∂k (St+x − kFtx )+ Ftx 1. BS 2 The per-strike implied volatility denoted unique positive solution of the equation Ptx C BS (x t (x. Proof.1) Since y 2 < 2(ey + e−y ) for all real y and St . +∞). K/Ftx ). K) 2 t (x. K). Deﬁnition 3. the cost of replicating this option is Ptx c(t. We can thus permute differentiation with respect to k and Q-expectation in (4. I ) ∈ (0. I ) and (x. is the unique positive solution of the equation Ptx C (xσt (x.2. I ) . K) is the . K). we note that = 0. I ). I )2 = lim x x↓0 x↓0 t (x.

(4. the martingale X has no ﬁxed points of discontinuity and can be decomposed as in Jacod and Shiryaev (1987. .P Balland Q UANTITATIVE F I N A N C E t 0 2 σu du < ∞. K)2 ds (4. this process will also be denoted [Z]t or [Zt ]. . Examples of processes with independent increments are Brownian motions. . It follows that H C (s. x 2 nu (dx) du < ∞. any sequence {Ti } ∈ [0.10) sup {E[St | ln St |i ] + E[St−1 | ln St |i ]} < ∞.9) 0: (4. x + dx). T ] × . 34 . We have proved that in a sticky-delta implied volatility model. Since S is assumed quasi-left continuous. K) are in L2 and W C (s. The Lebesgue– Fubini theorem for positive integrand (Malliavin and Airault 1994. With equation (4. Poisson processes. Levy processes and jump-diffusion processes. V (t. K)(x) N (dx u To ease notation. imply completeness of the model since the number of traded assets is inﬁnite (see Jarrow and Madan 1999). the stochastic integrals from a 0 to b are integrals on (a. du) − nu (dx) du}. measurable (see Protter 1995). . STn < Un }. b]. K) are squareintegrable. we conclude that for t in [0. there exists a cadlag square-integrable P -martingale X with P -independent increments such that St = S0 m0t exp(Xt )/E[exp(Xt )]. Since St and 1/St are assumed to be square-integrable. however. if ﬁnite.s−t.10).6) sK L2 = H ∈ W L2 = n ∈ ⊗B(R) : E :E 0 T 0 T 2 Hu du < ∞ . K) and recall that the quadratic variation of this process satisﬁes with equation (4.K ]u dK +∞ P (λK HutK )2 dK du +∞ 0 =E +E xN(dx × ds).7) (see Protter 1995) [V (t. p 77) Xt = (σ • W )t + (x ∗ (N − n))t . We refer to Protter (1995) for the construction of stochastic integrals with respect to cadlag square-integrable martingales.7) sK ˆ t = P0t Xt . 2 u (x) nu (dx) du < ∞ . Jensen inequality implies that the where X martingales P0t Ct (s − t. W is a Brownian motion. It follows that for all i t∈[0. We recall that the quadratic variation of a cadlag square-integrable martingale Z is an increasing cadlag adapted process deﬁned by [Z. ( ∗ (N − n))t = 0 t u (x){N (dx P ˆ Pt. Xt = (x ∗ N )t = 0<s t 0 t HsP (t. s + ds) × (x. we obtain that for all t in [0. Restricting our attention to regular sticky-delta models will ensure that X has ﬁnite moments and satisfy the representation property of Nualart and Schoutens. But ﬁrst. In this paper. P (s. Zu− dZu . Z]t = Zt2 − 2 t 0 We recall the following notation: (H • W )t = 0 t Hu dWu . K)2 + u 0 P 2 s (t. . we derive the following representation for the short-dated option prices: C ˆ Ct. we show by induction that for any integer n. p 32) implies that these probability measures coincide on σ (A) and thus on T . σ is a squareintegrable deterministic function. p 46) implies that the following Lebesgue integrals.T ] (4. A direct application of the monotone class theorem as in Jacod and Protter (1991. . Let Vu (t. T ] E 0<u t 2 Xu = t 0 +∞ −∞ 0 P 2 utK (x)) dK nu (dx) du . This will allow us to prove the quasi-completeness of regular sticky-delta models. . N is a Poisson measure independent of W with deterministic compensator n such that ns (dx) ds = E[N (dx × ds)] where N(dx × ds) is the number of non-zero jumps of X in (s. where is the predictable σ -algebra on [0. ω) < U1 . S(Tn . K). Finally. K) are in L2 with n By applying Ito’s formula (see Jacod and Shiryaev 1987) to St → E[(Ss − K)+ |St ]. Since ln St and thus Xt are square-integrable.8) + 0 × ds). . K). All risk-neutral probability measures Q coincide with P on the algebra A of cylindrical sets {ω ∈ : S(T1 . We note that the uniqueness of a risk-neutral measure does not. STn < Un } = P {ST1 < U1 . we prove the following lemma that will be useful in establishing our quasi-completeness result. T ]n and any real Ui : Q{ST1 < U1 . K) and P0t Pt (s − t.K = C0sK + (HsK • W )t + ( C ∗ (N − n))t (4. . K)]u = V0 (t. . K). (λK where Xt = Xt −Xt− is the jump of X at time t.s−t. we need some notation and some preliminary results. K) = P0u Pu (t − u. Let λ(K) be a square-integrable function. H P (s. satisfy E 0 +∞ 0 T 0 T 0 T λ(K)2 d[Vt. . T ] and all i 0 E[| ln St |i exp(| ln St |)] < i! E[St2 + St−2 ]. ω) < Un }. .K = P0sK + (HsK • W )t + ( P ∗ (N − n))t . that is the smallest σ -algebra making all adapted processes that are left continuous with right limits.

are assumed to be traded instruments. the Laplace transform of Xt is deﬁned for all |θ | 2. ˆ ˆ ˆ du [Pu (t − u. we note that X is a Levy martingale and the condition (4. Since Pu (t − u. we derive inequality (4. we (4. +∞) and in (0. which are static portfolios having a continuum of traded vanilla options.t−u. we have E 0 t 5.K ]dK < ∞. M]. λC .K .t1 −s.13). K) is a P -martingale. M ≡ M/B for a cadlag process M. t ∈ [0. Since X has independent increments and E[exp(2Xt )] + E[exp(−2Xt )] < ∞.T ) σs2 + exp(λ|x|)ns (dx) < ∞.10). t1 (5. to regular martingales. 2: 1 −1 (4. A static strategy is characterized by an initial date t0 . static portfolios with a continuum of traded options.K ]pλ (dK) < ∞.13) (−1.12) ˆ (ln K)2p K −4 du [Pu. +∞) and maturity t1 and λP (K)pλ (dK) unit(s) of the put option with strike K ∈ (0.12). These static trading strategies are traded instruments by assumption (see section 2). As in the Black–Scholes theory. t1 . The martingale X is regular if there exists λ 2: sups∈(0. two locally bounded functions λC (K) and λP (K) deﬁned in [α. t1 ] and that is instantiated at zero cost using the initial endowment at time t0 to purchase λC (K)cλ (dK) unit(s) of the call option with strike K ∈ (α. T ]. c. all European claims. we obtain (4.t−u. p. we then deﬁne trading strategies as dynamic portfolios involving a ﬁnite number of traded instruments. T ] and satisﬁes the time-dependent Levy–Khintchine formula for square-integrable processes: E[exp(θ (Xt+x − Xt ))] = exp ψs (θ ) = 1 2 2 σ θ + 2 s +∞ −∞ t+x t ψs (θ ) ds .K ]dK < ∞. we show that the martingale X for a regular sticky-delta model as in deﬁnition 2.1)c exp(λ|x|)ns (dx)+ +∞ x ns (dx) 2 Therefore for k.t−u.K ]cλ (dK) < ∞ 35 .2 is regular in the following sense. With this representation property. an end date t1 ∈ (t0 .1. λP . We ﬁrst deﬁne the static trading strategies.t1 −s. For any integers p have E 0 α 0 +∞ α 0 t t Deterministic implied volatility models 0 and any real α > 0. an initial endowment C0 ∈ t0 . α] respectively. α) is a portfolio that has constant holdings in (t0 . t + xm ) and payoffs f (Su ). K)] = E[Pt (0+. we deﬁne the trading strategies that will be used to replicate contingent claims in a regular sticky-delta model. ] K4 (ln K)2p K −4 E[(K − St )+2 ]. t0 + xm ). we will extend in section 6.e. With that restriction. K)2 ] − P0 (t. K)2 . The static trading strategy λ = (t0 . Similarly.3) E +∞ α t0 ˆ λC (K)2 ds [Cs. But ﬁrst we need to deﬁne precisely our admissible trading strategies and what we mean by quasi-completeness. E 0 α ˆ λP (K)2 ds [Ps. the polynomial representation obtained by Nualart and Schoutens for regular Levy martingales. with maturity u ∈ (t. as this type of completeness is not standard. static trading strategies.11). (eθz − 1 − θ z) ns (dz). we derive for i +∞ −∞ ˆ |λP |P0t1 K pλ (dK) + K t1 t0 +∞ α ˆ |λC |C0t1 K cλ (dK) < ∞. Trading strategies. we observe that: E 0 t In the case where the increments of X have stationary distributions. i.Q UANTITATIVE F I N A N C E Lemma 4. E ˆ where [M] ≡ [M.1)c Thanks to (4.1.11) (4. i 2. are traded instruments. We assume that the functions λC (K) and λP (K) satisfy the following conditions: E 0 α (ln K)2p ˆ du [Pu. t1 ] ⊂ (t0 .K ] < ∞ By Lebesgue–Fubini. We highlight that in this paper. Using the above formula.t−u. attainable claims and quasi-completeness In this section. we conclude that α 0 E[| ln St |∨| ln α|2p St−1 ] E 0 t ˆ (ln K)2p K −4 du [Pu.13) is similar to the condition introduced by Nualart and Schoutens (2000). α) and maturity t1 .2) (5. ˆ Proof.1) i! |x| ns (dx) < i λ i (−1. we will derive our quasi-completeness result in section 7. ˆ (ln K)2p K −4 du [Cu. We note that this assumption is equivalent to assuming that at time t. Deﬁnition 4. we obtain α 0 (ln K)2p K −4 E[(K −St )+2 ]dK With (4. mi (t) ≡ −∞ x i nt (dx) and t k Mk (t) ≡ E 0<s t ( Xs ) = 0 mk (s) ds are uniformly bounded in [0. as in Carr and Madan (1998). t0 + xm ) and there are no ﬂows coming in or out of the strategy up to time t1 . Therefore. that can be decomposed in a continuum of call and put option payoffs as in Breeden and Litzenberger (1978). Using the Lebesgue–Fubini theorem for a positive integrand. We deﬁne a static trading strategy λ to be a portfolio of short-dated options with maturity t1 and of the money market account such that the portfolio holdings are constant over the trading interval (t0 . and two positive σ -ﬁnite measures cλ (dK) and pλ (dK) deﬁned on the positive half line. K (5.

As we will see. Using (5. A claim ∈ L2 ( .T ) sup E n i=1 ˆ λi V ( t B i ) + λt 2 < ∞. P (VT (λ) > 0) > 0. ) with maturity t T is attainable or can be replicated if there is a self-ﬁnancing trading strategy λ such that = Vt (λ). K). Hence the discounted value process of a self-ﬁnancing trading strategy is a square-integrable martingale that satisﬁes ˆ Vt (λ) = V0 (λ) + n i=1 0 t ˆ ds Ps (t1 − s. that equations (5. Suppose that λ is an arbitrage strategy then E[1{VT (λ) < 0}] = 0 and thus. A trading strategy is self-ﬁnancing if and only if the value process satisﬁes as usual Vt (λ) = V0 (λ) + Gt (λ).1). A trading strategy λ is deﬁned as a portfolio of n static trading strategies and of the money market account. T ]. i. V ( ˆ j )]s < ∞. p 160).5). K)pλ (dK) Equation (5. This discounted value process is a square-integrable cadlag martingale which is zero before t0 and constant after t1 .4) 36 . ˆt (λ) is a P -martingale.e. t1 ] is obtained by adding the values of its constituents: Vt (λ) = + α α 0 +∞ At time t. (5.4) guarantees that this process is a squareintegrable semimartingale. The value of the static trading strategy at time t ∈ (t0 .1. (5.e. t1 ): ˆ Vt (λ) = + α α 0 +∞ λP (K) t t0 t t0 Equation (5.1)–(5.6) λP HtPK pλ (dK) + K 1 +∞ +∞ α λC HtCK cλ (dK) •W K 1 ∗ (N − n) t t0 t t0 + 0 λP K P t1 K pλ (dK) + α λC K C t1 K cλ (dK) where we have used the notation [X]b = Xb − Xa . The value of such a strategy is given at time t by the sum of the values of its constituents: Vt (λ) = n i=1 λi Vt ( t i) + λ B Bt . the strategy λ is the portfolio consisting of λi t unit(s) of each of the static portfolios i and of λB unit(s) of t the money market account. A claim ∈ L2 ( . so as to permute strike and time integrations.1. ∈ V ( ). Implied volatility models are arbitrage-free. we have E[VT (λ) 1{VT (λ) < ˆ ˆ ˆ 0}] = 0. In short a and with abuse of notations.2) and (5. As explained in Jarrow and Madan (1999).3) in order to apply the stochastic Fubini theorem as in Protter (1995.2) and (5. i ) where λi is a predictable process t t satisfying (5. s The above two integrals are guaranteed to exist thanks to (5. this will allow us to deﬁne dynamic portfolios based on static trading strategies. The gain cumulated up to time t by the trading strategy is deﬁned as usual by Gt (λ) ≡ n i=1 0 t λC (K)Ct (t1 − t. ˆ λP (K)pλ (dK) ds P (t1 − s.3) are implied by the single equation E α St1 ∧α E 0 T ˆ λi λj d[V ( s s i ). Proof. an arbitrage strategy is a self-ﬁnancing strategy λ such that V0 (λ) = 0. by application of the stochastic Fubini theorem as formulated in Protter (1995) for martingales and in Lebedev (1995) for random measures: ˆ Vt (λ) = 0 α α ˆ λi d V s ( s i ). we show that we can permute strike and time integration. T ]. Proposition 5. we show as in the proof of lemma 4. K)cλ (dK) + C0 Bt /Bt0 . We impose the holding functions to satisfy (5. Since the static portfolio does not involve any cost at initiation.9).1. We deﬁne the following linear subspace of L2 ( .6)–(4.5) guarantees the existence of the above integrals. We denote by the space of all selfﬁnancing trading strategies. X]. This contradicts the fact that V Remark 5. Using the Cauchy–Schwartz inequality. These static strategies which are portfolios with a continuum of traded options. λ ∈ }. we simply write ˆ Vt (λ) = t t t0 α 0 +∞ α A self-ﬁnancing trading strategy is thus entirely characterized by λ = (λi .3) together with (4. ∈ V ( ). ) with maturity t T is attainable up to a vanishing risk or can be replicated up to a vanishing risk if there is a sequence of self-ﬁnancing strategies {λn } such ¯ that limn→∞ E[( − Vt (λn ))2 ] = 0. + t0 ˆ ˆ We set Vt (λ) = V(t∨t0 )∧t1 (λ) for t ∈ [0.4) and (5.P Balland Q UANTITATIVE F I N A N C E n i. This result is not surprising since we have assumed the existence of at least one risk-neutral measure P . are traded instruments by assumption. ). t λP (K)Pt (t1 − t. K) pλ (dK) λC (K) ˆ ds Cs (t1 − s.5) (λP K)2 pλ (dK) K St1 ∨α + α (λC St1 )2 cλ (dK) K < ∞.j =1 where we recall [X] = [X. (5. A trading strategy is thus characterized by a ﬁnite sequence { i : 1 i n} of static trading strategies and by some predictable processes {λi : 1 i n} and by a progressively measurable t adapted process λB such that t t∈(0. i. K) ˆ λC (K)cλ (dK) ds C(t1 − s. K) cλ (dK).1. V ( ) = {Vt (λ) : t ∈ [0. λi dVs ( s i) + 0 t λB dBs . Deﬁnition 5. We can now deﬁne attainability and attainability up to a vanishing risk. It follows that E[VT (λ)] = E[|VT (λ)|] > 0 = V0 (λ). P (VT (λ) 0) = 1. we derive for t in (t0 .

At time tk = kxm /2. The fourth component is replicated by buying a call option and selling a put option since it is the terminal value of a forward contract. We conclude this section with a ﬁrst illustration of how hedging in a sticky-delta model works in practice (see remark 7. T ] are attainable. we deﬁne quasi-completeness as in Jarrow and Madan (1999) and in Bjork et al (1997). s (K − Sb )+ f (K) dK Since γt is a predictable bounded process. we decompose the payoff into four components f (Sb ) = 0 +∞ α ˆ λi dVs (φi ). +∞) function with f (Sb ) ∈ L2 ( . s We say that a claim ∈ L2 ( . Proof. +∞)2 and the Fubini– Lebesgue theorem implies (Malliavin and Airault (1993. (5. dK. we conclude that fn (Sb ) is attainable and thus at time t. An implied volatility model is complete up to a vanishing risk or quasi-complete if any ∈ L2 ( . With the above notations. z). 37 . f . at time s. Following Carr and Madan (1998). ci . ) − V ( ). Given the set of dates {ti = (ixm /2) ∧ t : 1 i k + 1}.4. Deﬁnition 5. By application of proposition 5. (γs λi . Proposition 5. K). Similarly.3. The discounted value process associated with this static P0bK |f (K)|dK + +∞ α C0bK |f (K)|dK < ∞. ). Za = 0 γt dUt ∈ L2 ( . ) can be replicated up to a vanishing risk at a cost Ptb Et [f (Sb )]. b. can be replicated at zero cost. ) with maturity t is attainable at time s if there exists a self-ﬁnancing strategy λ ˆ ˆ and Cs ∈ s such that P0t = Vt (λ) − Vs (λ) + Cs . By applying the Lebesgue dominated convergence theorem. Proposition 5. Consider the long-dated call option with strike K > 0 and maturity t = kxm /2 + x in [0. φi ) replicates the long-dated call option. z) + t ˆ f (z) dz ds Cs (b − s. f . We now prove the following classic result to be used later. t +f (α)(Sb − α) ≡ A + B + C + D. φi ).5) and a real t V0 = E[P0t ] which is the cost of replication. All call and put options with maturity in [0. ti+1 ] such that (1. ) with maturity t is thus attainable if there are some static trading strategies {φi = (t0i . α): Ptb (A + B) = Ptb Et [A + B] + b +∞ α b t 0 α ˆ f (z) dz ds Ps (b − s. the claim f (Sb ) ∈ L2 ( . xm ). z) dz.8) f (K) by f (K)1{|f (K)| < n}. αi ) : 0 i n}. (5. Proof. (5. such that P0t = V0 + n n t1i t0i 0 αi i=0 t1i +∞ t0i αi Deterministic implied volatility models The third component is trivially replicated by taking position in the money market account.7) Then the claim with payoff f (Sb ) at time b can be replicated at time t at a cost Ptb Et [f (Sb )]. T ] where k is an integer and 0 < x xm /2. Let Ut be a square-integrable martingale such that the claim UT with maturity T is attainable and let γt be a predictable bounded process.Q UANTITATIVE F I N A N C E A claim ∈ L2 ( .1. K) s + i=0 ˆ λi fi (K)ci (dK) ds Cs (t1i − s. Proof. φiC . z) dz+ +∞ α f (z)Ct (a. L2 ( . ) is ¯ attainable up to a vanishing risk i. p 46)) Ptb Et [A+B] = 0 α f (z)Pt (a. pi . φiP . we shall construct a sequence of static trading strategies φi having trading intervals (ti . The claim with payoff UT /P0T is attained by a self-ﬁnancing trading strategy λ = (λi .2. Corollary 5. Let a ∈ (0. ) such that there is 0 < α < ∞ satisfying E α Sb ∧α f (K)2 K 2 dK + Sb ∨α α 2 f (K)2 Sb dK < ∞. the call option is a short-dated option and thus can be replicated by purchasing the call option itself.2). We note that s ˆ Vt (λ) = Et [UT ] = Ut satisﬁes Ut = U0 + n i=1 0 t ˆ λi gi (K)pi (dK) ds Ps (t1i − s.4) and (5.e.9) |f (K)|(K − S)+ 1{K < α} + |f (K)|(S − K)+ 1{K > α} is thus P {Sb ∈ dS}×dK integrable on (0. Proposition 5.2 to fn (Sb ). Thanks to our assumption on f . some predictable processes {λi : 0 i n} satisfying (5. we derive by Cauchy– Schwartz: α 0 Therefore.8) Thanks to our assumptions on f . b = t + a ∈ [0. we conclude that the claim A + B is square-integrable and attainable at t by the static trading strategy (t. T ] and let f be a C 2 (0. Proof. Consider the sequence of smooth functions fn deﬁned by replacing in (5. φi ) s deﬁnes a self-ﬁnancing trading strategy and we have a 0 + α (Sb − K)+ f (K) dK + f (α) γt dUt = n i=1 0 a ˆ γt λi dVt (φi ).2. we deﬁne attainable up to a vanishing risk. The above result still holds if we replace in (5. the claim Za with maturity a is attainable at zero cost. dK.7) the squares by absolute values and replicated by replicating up to a vanishing risk. t1i . we obtain limn→∞ E[(fn − f )2 ] = 0. Then the claim with a payoff at time a.

) then there are predictable processes {φt(i) : i 1} such that +∞ E E 1 Sk ∧1 Sk ∨1 1 2 ∂y c( tk . we show that (i) the claims HT are attainable by application of Ito’s lemma to polynomial functions. + ai. ) 2 ˆ 2 2 3 and ∂St Vtk = K ∂y c( tk . +∞).1 (s) dYs(1) . . we derive the result. . F = E[F ] + i=1 0 T (i) φs dHs(i) . 38 . K/Sk ) K 2 6 6 /Sk dK < ∞. y) = E[(St /St−x − y)+ ] is a C 2 function which is decreasing and convex with respect to the second argument. By repeating the above argument. we obtain ˆ Vtk = P0t E[(St − K)+ |Stk ] = P0t Stk c(t − tk . But ﬁrst. we prove that all regular sticky-delta implied volatility models are quasi-complete. Let F ∈ L2 ( .1 has in general an inﬁnite dimension and thus exact replication would be possible only if strategies based on an inﬁnite number of traded instruments were admissible. to regular martingales with independent increments. More {H (i) : i precisely. 6. t]. Yt(k) ≡ ( X s )k − 0<s t 0 t 7. x (i) (K) = {i(i − 1)(ln{K/f0b })i−2 − i(ln{K/f0b })i−1 }/P0b . Representation property for regular martingales with independent increments In this section and in the appendix. We deﬁne f0b ≡ F0b /E[exp(Xb )] and observe that Xb = ln(Sb /f0b ). we construct the following family of pairwise [ ]orthogonal martingales having independent increments: Ht(1) = Yt(1) . where c(x. all square integrable claims can be replicated up to a vanishing residual risk by trading portfolios of vanilla options.2 with f (S) = ln(S/f0b )i . Using this representation property. We deﬁne the Teugels martingales on [0. ). See appendix. K). T ] and are such that the martingales Ht(i) are square-integrable and pairwise strongly orthogonal.2 and replicate the claim ˆ Vtk between time tk−1 and tk using a static portfolio with positive holdings in short-dated call and put options having maturity tk . Proof. K/Sk )2 K 4 /Sk dK < ∞. In the appendix and by [ ]-orthogonalization of the Teugels martingales. K) mk (s) ds. The deterministic functions aij (s) are bounded in [0. We obtain the result for the long-dated put options by put– call parity. Using equation (4. we obtain a set of static trading strategy {φi : 0 i k} with positive holdings such that the self-ﬁnancing trading strategy (1. K/Stk )/Stk 0. It is clear that these martingales are square-integrable with independent increments and ﬁnite moments of all orders. The claim with payoff (Xb )i at time b is attainable at time a > b − xm using the static strategy: i Xb = Ea [(Xb )i ] + b a 0 f0b ˆ x (i) (K)K −2 dKdu Pu (b − u. we have the following representation property. Given the stickydelta assumption. Proposition 6. We note that V ∈ L2 ( . K/Stk ). K) for u ∈ [tk .1. Let i 2. We can thus apply proposition 5.10) and proposition 5. We derive k dYs(i) + ai. i=1 H Proof. b +∞ f0b + a ˆ x (i) (K)K −2 dK du Cu (b − u. K/Stk−1 ). we extend the representation property obtained by Nualart and Schoutens (2000) for Levy processes. at a discounted cost ˆ Vtk−1 = P0t E[(St − K)+ |Stk−1 ] = P0t Stk−1 c(t − tk−1 . In order to construct similar hedging strategies for squareintegrable claims.i−1 (s) dYs(i−1) + . in the classic sense. We adapt the notation and the approach taken by Nualart and Schoutens to our purpose.1. φi ) replicates the long-dated call option at the following initial cost: ˆ V0 = P0t E[(St − K)+ ]. (k 2). where {φt(i) : i 1} belongs to ⊕+∞ L2 (i) . 2 2 The density of St /St−x is ∂y c(x. y) and y 2 ∂y c(x. We show in the appendix that the [ ]-orthogonal family 1} forms a complete basis of L2 ( . 2 4 ∂y c( tk . contingent claims because the family of martingales underlying the representation property of proposition 6.P Balland Q UANTITATIVE F I N A N C E Ht(i) = t 0 ˆ ˆ strategy is Vu = Ck (t − u. Lemma 7. y) is ˆ uniformly bounded in (0. T ] as in Nualart and Schoutens (2000): Yt(1) = Xt . we prove in the next section that in regular sticky-delta models. We cannot typically replicate. we need a representation property for X. Quasi-completeness of regular sticky-delta implied volatility models In this section.

. + a (i) ˆ gu du Cu (b − u. f0b ) + a (3) ˆ fu dCu (b − u. K) b a (3) ˆ fu dPu (b − u. − f (Xu− ) dXu − 1 2 2 f (Xu− )σu du. = 0 k i−1 k k gu. we obtain by applying Ito’s lemma to f (x) = x 3 : ( X u )3 − 0<u b 0 b 0 (2) Xu− dYu − 3 b 0 (2) 2 (2) (1) (Xu− + Vb − Vu + Mb − Mu ) dYu t 0 b ˆ h(i) (K)K −2 dKdu Pu (b − u. tl = (lxm /2) ∧ T . T ]. the claim HT is attainable. T ]. f0b ).k X Y i (k) i and Ru (X) = 0 i k ru.i are deterministic and uniformly (i) bounded on [0. . For all i 1. . f0b ). H We deﬁne n = E[ ] + (i) with ξt(i. (k) By induction. HT ∈ V ( ). + a (1) ˆ fu du Cu (b − u. K) b a (2) fu = E[ ] + i=1 0 T ξs(i) dHs(i) . + a ˆ dCu (b − u.i Xu− (ln(K/f0b ))k . 0b With Ito’s formula for a real function f of class C 2 : { f (Xu ) − f (Xu− ) Xu } = f (Xt ) − f (X0 ) 0<u t t 0 t 0 where the coefﬁcients are deterministic and bounded in [0. A regular sticky-delta model is quasi-complete or complete up to a vanishing risk. + ak. K) u −3 m3 (s) ds = (Xb )3 − E[(Xb )3 ] + a ˆ h(i) (K)K −2 dK du Cu (b − u. ) can be represented as follows: +∞ + a (2) ˆ yu (K)K −2 dK du Cu (b − u. ˆ Ct (b − t. K)K −2 dK ˆ ˆ +(Ct (b − t.1 imply that (2) (2) Yb − Ya is attainable: (2) (2) Yb − Ya = b +∞ f0b b (2) fu b f0b a 0 (2) ˆ yu (K)K −2 dK du Pu (b − u.e. f0b ) − (1) (1) where yu (K) = − P1 and fu = P0b1f0b . Finally. f0b ) − Pt (b − t. we obtain a self(k) ﬁnancing trading strategy that replicates HT . Taking f (x) = x 2 . the random variable ∈ L2 ( . a + xm ). we have the following quasi-completeness result. According to proposition 6. K) (k) Ya . (i) i.i and gu. f0b ) − Proof. T ]. f0b ) − h(i) (K) u (i) gu = 0 j k i−1 jk j hu.i Xu− . (k) (k) We ﬁnally obtain the promised expression for Hb − Ha (k) (k) by using the previous equation for Yb − Ya . b = tl with l = 1.2.1. Finally.Q UANTITATIVE F I N A N C E Proposition 7. ln(K/f0b )). K) u b a (i) ˆ gu du Pu (b − u. Hb − Ha Deterministic implied volatility models Similarly. [2T /xm ] + 1. By (1) proposition 5.k−1 (u) dYu + . Any square-integrable claim ∈ L2 ( . T n i=1 0 ξs(i. f0b ) − ˆ dPu (b − u. K) Proof. K)K −2 dK (3) (2) (3) (2) where yu (K) = Qu (Xu− . . + a (3) ˆ yu (K)K −2 dK du Cu (b − u. the above equation and lemma 7.n) = ξy 1{|ξt(i) | < n}. K) t a (1) ˆ fu du Pu (b − u. This equation implies for t ∈ [a. [H (k) ]b = a + a (1) ˆ yu (K)K −2 dK du Cu (b − u. fu = Ru (Xu− ) ij i j and the polynomials Q(k) (X.1 (u)dYu . By adding the above decompositions obtained for a = tl−1 . we extend the above formula to all Yb − We recall that: b a (k) (k−1) (1) dYu + ak.n) dHs(i) ∈ V ( ) 39 . K) k The coefﬁcients hu. For i satisﬁes (i) (i) Hb − H a = b +∞ f0b b b a 0 f0b (i) (i) 1 and b ∈ (a.k X have coefﬁcients that are deterministic and uniformly bounded in [0. f0b ))/f0b . . Yt(1) = ln(St /f0t ) is a square-integrable martingale. Y ) = u 0 i j k qu. Theorem 7. where Vt = 0 σs2 ds and Mt(2) = It follows that: (3) (3) Yb − Ya = b +∞ f0b b b a 0 f0b t m2 (s) ds.1. we conclude that Yb is attainable using the static trading strategy deﬁned by P0b Yt(1) = − − +∞ f0b f0b 0 ˆ Pt (b − t. jk (3) ˆ yu (K)K −2 dK du Pu (b − u. f0b ) (2) yu (K) = 2{Xu− − ln(K/f0b ) + 1}/P0b (2) (1) fu = −2Xu− fu where ξt(i) is in L2 (i) . we derive: (2) Yb = (Xb )2 − E[(Xb )2 ] − 2 b 0 (1) Xu− dYu . . the money-market account and some portfolios of traded call and put options. b] (1) Yt(1) − Ya = t +∞ f0b t t f0b a 0 (1) ˆ yu (K)K −2 dK du Pu (b − u. ) with maturity T can be replicated up to a vanishing risk at a cost P0T E[ ] by trading the underlying.1.

2. where the linear operator ℘tx is deﬁned by [℘tx f ](S) ≡ 0 +∞ 2 f (I × Smtx )∂I C BS (xσt (x. There is a long list of geometric Levy models proposed as alternatives to the Black–Scholes model.2. . the money-market account and some portfolios of traded call and put options. a fast Fourier transform as in Carr and Madan (1999) or by solving the integro-differential equation ∂t V + At V = rt V where At is the generator deﬁned by At = (∂x ℘tx )x=0+ . a forward contract and a zero coupon bond as in proposition 5. At time Tn−2 .P Balland Q UANTITATIVE F I N A N C E zero coupon bonds with maturity Tn−1 . The ﬁrst sequence on the RHS converges to zero since {ξt(i) : i 1} belongs to ⊕+∞ L2 (j ) . Mandelbrot (1963). . . . Therefore. We assume that this payoff is such that STi → E[f (ST0 . by rolling a portfolio of vanilla options.1. .n) }2 d[H (i) . Consider a claim with maturity Tn such as an Asian option. we show that regular geometric Levy models are regular stationary sticky-delta implied volatility models. Our previous analysis in section 4 shows that the increments of ln St are independent and have a stationary distribution under the probability measure P . STn−1 .1 and 5.n) )2 d[H .2. Observe next that: j =1 H n→∞ lim (ξs(i.2. Consider a claim with square-integrable payoff f (ST0 . we derive by induction that the complex option can be replicated at a cost V0 = P0Tn ℘0.e. STn )| Ti−1 ∨ STi ] satisﬁes. . . K) = Ptx Et [(St+x − K)+ ]. Pt (x. Tn−1 f (ST0 .1. STn ) at time Tn . we have limn→∞ E[( − n )2 ] = 0. we obtain a super-replication strategy for the complex option when there are transaction costs on the implied volatility or when the short-dated implied volatility smile is ‘uncertain’ but bounded. equation (5. 1. × [℘Tn−1 . lim E i=1 0 T (ξs(i) − ξs(i. •)](STn−1 ). Then the claim can be replicated by trading the underlying. The next proposition shows that some square-integrable claims can be replicated in the classical sense. Observe that the transition operators ℘Tk . . the continuous-time formulation by Koponen (1995) of the ‘truncated Levy ﬂight’ introduced by Mantegna and Stanley (1994). we obtain E[( − +E i=1 0 n) +∞ 2 ] T E − E[ ] − n i=1 0 T ξs(i) dHs(i) 2 ℘T i . Tn−1 is deterministic and thus VTn−1 is a deterministic function of ST0 . . {ξs(i) − ξs(i. St = F0t exp(Lt − ln E[eLt ]). The sticky-delta assumption implies that the operator ℘Tn−1 . where x < xm and L is an adapted regular P -Levy martingale. . Regular geometric Levy models We consider a regular sticky-delta implied volatility model and we suppose that the per-delta implied volatility processes are independent of time. Finally. .1. H ]s = 0.T0 n−1 i=0 Thanks to the strong orthogonality of Ht(i) . At time Tn−1 .n) − ξs(i) )2 = 0. Cont and Potters (1998). H (i) ]s . . The previous expectation can be estimated by using the Monte Carlo method. (ξs(i. The concept of quasi-completeness is due to Jarrow and Madan (1999) and to Bjork et al (1997). that has a ﬁnite number of ﬁxing dates Ti with 0 < Ti −Ti−1 < xm and a square-integrable payoff f (ST0 . . By modifying the above strategy. Tk are nonlinear in this case. (i) (i) Finally. Bjork et al (1997) and Schoutens (2001). Regular geometric Levy models are arbitrage-free and quasi-complete in the sense that all square-integrable claims can be replicated up to a vanishing risk by trading the underlying. STn ) as in proposition 7. By three applications of the dominated convergence Lebesgue theorem. Ct (x. these models are arbitrage-free and quasi-complete by application of theorem 7. . We mention. STn−1 . is thus VTn−1 = PTn−1 . . I )2 . Bouchaud. the complex option can thus be replicated by the use of calls. Proof. forwards and 40 . we derive +∞ n→∞ Remark 7. Madan and Seneta (1990). where L is a regular P -Levy martingale (see Levy 1965).7) with b = Ti . . a discrete barrier option. a Parisian option or a volatility swap. Proposition 8. We deﬁne a regular geometric Levy under P by: St = F0t exp(Lt − ln E[eLt ]). Each claim n is attainable by application of propositions 7. puts. Proposition 7. By direct calculation. . the payoff can be replicated using a portfolio of call and put options. Proof. Tn−1 8. . BarndorffNielsen (1995). Eberlein and Keller (1995).n) − ξs(i) )2 4(ξs(i) )2 . Remark 7. The value VTn−1 of the complex option at time Tn−1 . i. Merton (1976). I ) dI . . Ti (f )(S0 ) = P0Tn E[f ].3 at a cost P0T E[ ]. K) = Ptx Et [(K − St+x )+ ]. the money-market account and portfolios of short-dated call and put options. . after subtraction of a ﬁnite number of call and put payoffs. in particular.

a family of positive P -integrable functions hI¯k . b > 0). we assume that pt > 0 in (0. Using the Black–Scholes equation. we note by Jensen inequality: Et [(St+x /mtx − K)+ ] = Et [(St+x+y /mt. the asset price process St is a Markov process entirely characterized by the transition function ℘ tx (see Revuz and Yor 1991): (℘ tx f )(St ) = E[f (St+x )|St ]. the density of St by pt and tx (S.σ (n) with limit zero. K) ht (S) = k=1 1Ik (S)hI¯k . Characterization of sticky-strike implied volatility models As with sticky-delta models. P integrable function: +∞ ¯ For I ⊂ (0.). P a. locally bounded.1. k ∪ [k. such that (see Doob 1994): n→+∞ lim ∂x vtxI. The implied volatility model with zero-drift underlying St /m0t and implied volatility t (x. +∞): n→+∞ I With our assumptions. For each t < T . we ﬁnally conclude that: n→+∞ Deﬁnition 2. Kmtx )2 . K) ≡ BS (x t (x.s. C: n→+∞ C We observe that for any positive z: HI tx (z) 2 2 E[sup ∂x Et [St+x /Ftx ]]. x lim E[ txφ(n) (St . K)1A (St )]|∂x vtxφ(n) − ht |dK = 0. m0t = 1.t and sub-sequences xσk (n) ⊂ xσk−1 (n) converging to zero such that: n→+∞ lim ∂x vtxσk (n) (St ) = hI¯k .t |dK = 0. lim ∂x vtxk (St ) = ht (St ) P a.σ (n) (St ) = hI. locally bounded. St ∈ Ik .xI.t (z)pt (z)dz = z] (a. x I × 1{St < z}dK. Using equation (9.t (a) = 0 hI. Km0t ) is regular and sticky-strike. n→+∞ I lim ∂x vtxI. K)dK.n − hI. K). P -integrable function hI.e. (9. P -integrable function ht such that: k→+∞ Since E[ t.2 implies that the increasing functions HI tx are uniformly bounded with respect to x and I . we deﬁne the sequence xφ(n) = xσn (n) with limit zero. Lemma 9. P a.1.n (St . Hence the Black–Scholes model is the only arbitrage-free regular sticky-strike model.t (S) 2 2 sup ∂x E[St+x /Ftx |St = S].n 1A (K)pt (K)dK = A Hence ∂x vtxI.2) Since k Ik = (0. there exists a positive. In a regular sticky-strike implied volatility model. and the positive.. K)f (K)dK. P a.t pt dz.s. a < b: The increasing function HI. K)1A (St )]dK = A hI. 0<x<T −t 2 2 ∂x E[St+x /Ftx |St Finally. we have a stronger result. we derive: 2 2 ∂x Et [St+x /Ftx ] = +∞ 0 lim E[ txI.Q UANTITATIVE F I N A N C E Deterministic implied volatility models 9.t (St ) (St ∈ I. Proof. Application of Fatou’s theorem gives (see Doob 1994): n→+∞ I where xk is a sequence with limit zero.t such that (see Doob 1994): n→+∞ lim ∂x vtxφ(n) (St ) = ht (St ) P a. We denote vtx (K) ≡ x t (x.t such that: HI.s. Theorem 9. the per-strike implied volatility t (x.t (z). Therefore. Proof.n 1A ]/pt converges uniformly to 1A on I : hI. +∞). Helly’s theorem implies that there is a sequence xI.n (St ) converges in probability to hI. Hence vtx (K) is increasing with x.t pt dz.x+y − K)+ ]. we have: Ptx EtP [f (St+x )] = +∞ 0 2 ∂K Ct (x. ∂x vtx (K) tx (St . For any bounded. Borel measurable function f . we obtain for any compact sets A.t satisﬁes for 0 HI.t (b) − HI. we conclude that for any compact A ⊂ (0.n E[ txI.1).n with limit zero and an increasing function HI. First.). K) is independent of K. we consider only regular stickystrike models.s.t (b) − HI. we deﬁne the increasing function: HI tx : z → ∂x vtx (K)E[ tx (St . To simplify notation. as previously. +∞). +∞). lim ∂x vtxI. (9.t (a) b a 2 2 sup ∂x E[St+x /Ftx |St ]pt (St )dSt . lim HI txI n (z) = HI.s. there is no loss of generality in assuming zero drift i. S.t (z) sup b a hI. x The Radon–Nikodym theorem implies that there is a positive. Using the diagonal procedure. In fact.t (St ) (k > 0. locally bounded. K)1A (St )] × |∂x vtxI. The case where pt vanishes is treated similarly since we have P (pt (St ) = 0) = 0.t (St ) in I and there exists xI.1) 1 1 We deﬁne Ik = k+1 . 41 . k + 1) and construct.n (St . Kmtx )2 .

K) = 2 F 2 BS Appendix. [At f ](St ) = lim ∂x [℘ tx f ](St ). 0 k=1 j −1 42 .4) By -orthogonalization of the total family {1{s < t}x i : i 0. St . K) × ∂x vtx (K)f (K)dK.3) can be written as follows: ∂x [℘ tx f ](St ) = 1 2 St2 tx (St . the implied volatility t (x. locally bounded P -integrable function ht such that: n→∞ lim ∂x vtxn (St ) = ht (St ) P a. .3) on a compact C and then the limit as xn tends to zero. s)} with bounded coefﬁcients such that: Ri (x. Therefore. T Bjork. s) ≡ x(Ri (x. uniformly bounded in [0. W Schoutens. we obtain with (9. R Cont. We note that the processes [Y (k) . we have for t ∈ [0. Hence. St ). an anonymous referee. s). K)f (K)dK.5) − t. a ∈ (t. dx) has ﬁnite moments of order i 2. s) = ai+1. V satisﬁes: V (t. St ) = 2 ∂t [(a − t) t (a 2 − t. equation (9.2): [At f ](K)pt (K)dK = 1 2 C C ht (K)K 2 f (K)pt (K)dK. s)R(x. i: E[H (i+1) .k (s)mk (s)ds.i+1 ≡ 1 and the following square integrable martingale: Ht(i+1) ≡ t 0 t 0 t 0 The forward price V (t. We use the notations of section 6 and we follow closely the presentation of Nualart and Schoutens (2000). x↓0 Let f ⊂ D At ∩ C 2 with compact support . s)(x 2 ns (dx)−σs2 δ(x)dx)ds. D Nualart. (9.1 (s)dYs(1) + . the participants of the AMS Meeting (2001) and my colleagues at Merrill Lynch for stimulating and fruitful discussions. F. T ): Q. Y (j ) ]t = E = Ri (x. The coefﬁcients of the above polynomial are bounded because the measure n(s. Proposition A. R = 0 T +∞ −∞ (V . We obtain: ∂x [℘ tx f ](St ) = ∂x C BS (vtx (K).P Balland Q UANTITATIVE F I N A N C E The transition function is Feller and it is thus associated with an inﬁnitesimal generator At deﬁned on D satisfying: At Acknowledgments I would like to thank L P Hughston. 1{s < t}x t i Hence. K). t ∈ (0. Y (j ) ]s = 0. K). t + xm ): 2 t (a − t.k (s) d[Y (k) . Ri .6) imply that we have for all K. On the other hand.1. s) − ai+1. . K) = ai+1. Since V has the same second-order derivatives with respect to S as the Black–Scholes function.i+1 (s) dYs(i+1) . Representation property for regular martingales In this appendix. F. + ai+1. T )}. K) is independent of K and the regular sticky-strike model coincides with the Black– Scholes model! ai+1. 1{s < t}x j = 0. 1 j i − 1). K)2 ]S 2 ∂S V (t. . St . We recall that two square-integrable martingales M and N are said to be strongly orthogonal or [ ]-orthogonal if [M.1. We ﬁnally obtain the following expression for the generator: 1 [At f ](St ) = 2 ht (St )St2 f (St ) P a.1 (s) + ai+1. K)2 .1 (s)).3) The Black–Scholes function satisﬁes: 1 ∂V C BS (V . (9. ai+1. + ai+1. Y (j ) ]t have independent increments. the participants of the EURANDOM seminar on Levy processes (2001). . There exists a family of pairwise strongly orthogonal square-integrable martingales {H (i) : i 1}. . s) Finally. T ] and j = 1. 1 a−t a t E[hu (Su )]du. (9. According to lemma 9. equations (9.4)–(9.s. Proof. Deﬁne Qi+1 (x. ai+1. T ]. t. V satisﬁes the backward equation (see Revuz and Yor 1991): ∂t V (t. N ]t is a martingale (see Protter 1995). it follows that: 1 ∂t V (t. Furthermore.1 (s)dXs + 0<s t Qi+1 ( Ss . St ) + [At V ](St ) = 0. . By taking ﬁrst the expectation of equation (9. St ) of a call option with maturity a and strike K is a P -martingale. Y (j ) ]t and [H (i+1) .6) By direct calculation. we extend the Schoutens–Nualart representation property obtained for regular Levy martingales to regular martingales with independent increments. (t < T . Q(x. there is a positive. D B Madan. . . We deﬁne the following inner product acting on the space of real polynomials with time-dependent coefﬁcients in L2 (0.s. we ﬁnd a family of pairwise -orthogonal polynomials {Ri (x. we derive: Ht(i+1) = − i+1 k=2 ai+1.i (s)x i−1 + x i . St ) = C BS ((a − t) t (a (9.2 (s)x + .

Remark A. (i) φs dHs(i) . . . The family t1 . E[(Xt )k F (Xt )] = 0. i.2. ). Let F ∈ C with support in [−a. We need to prove that: +∞ L2 ( . ). we recall that: L2 = H ∈ m T : 0 Hs dms ∈ L2 ( . (j ) Lemma A.3.tn is total in the space L2 ( . 0}. Y and thus Z can be approximated arbitrarily closely by an element of ˆ . Xtn − Xtn−1 )). We observe that if the polynomial Ri is such that Ri . ) : X = H i=1 φ (i) • H (i) . H Proof. . The family is total in L2 ( . We have the following representation property for elements of . ). . . a] and weakly orthogonal to ˆ t . The case with n non-overlapping independent increments is treated similarly. i. Proof. σ (Xt1 . φ (i) ∈ L2 (i) .1. we have: ˆ ⊂ +∞ i=1 L2 (i) ⊂ L2 ( . Proposition A. Ykl = E[Ykl ] + i=1 0 T (i) (i) s dHs .2. ) since the i=1 H martingales H (i) are pairwise strongly orthogonal. H (i+1) ]T = 0 and thus H (i+1) = 0 almost everywhere. Ri = 0 then the martingale H (i+1) satisﬁes E[H (i+1) . Proposition A. .. . the linear hull ˆ t of t is in L2 (P {Xt ∈ dx}).tn is total in L2 ( . where φt(i) belongs to L2 (i) . The martingales H (j ) are consequently pairwise strongly orthogonal. Since the linear space ˆ spanned by is dense in L2 ( .Q UANTITATIVE F I N A N C E Therefore H (i+1) is strongly orthogonal to all Y (j ) for j = 1. σ (Xt1 . If the discontinuous component of the regular martingale is the sum of a ﬁnite number of Poisson processes with deterministic intensity then only a ﬁnite number of the martingales H (k) will be non-zero. p 110)). Let us prove the result for the family t . For any integer k and any power-increment (Xs1 − Xs0 )k .2. T ] × . ) can be approximated arbitrarily closely by an element Y of L2 ( . ) variables: t1 . Therefore.tn Deterministic implied volatility models Proof.1. A variable Z in L2 ( . Proposition 6. H +∞ L2 (i) ≡ X ∈ L2 ( . Let R ∈ . For any real Z. we have: +∞ k=0 = 1{s ∈ (s2 .e. 0s ˆ Since ¯ = L2 ( . we derive E[exp(iZXt )F (Xt )] = 0 for all Z and thus F (Xt ) = 0 (Malliavin and Airault (1994. Thanks to proposition A. = {Xtk11 . . .. we derive that the product of nonoverlapping power-increments Ykl ≡ ([X]s1 )k ([X]s3 )l with s0 s2 s0 < s1 s2 < s3 can be represented as follows: +∞ = {Xtk11 (Xt2 − Xt1 )k2 . . With lemma A. we have proved the result for the product of two non-overlapping power-increments. We prove the above equation by induction on k and by application of Ito’s formula to power functions as in Nualart and Schoutens (2000). H We observe that ⊕+∞ L2 (i) is closed in L2 ( . Proof.3. The space C of functions in L2 (P {Xt ∈ dx}) having compact support is dense in L2 (P {Xt ∈ dx})... By induction. 43 . there is a sequence of predictable processes {θs(i)1 k (s) : i 1} such that: 0s (Xs1 − Xs0 )k = E[(Xs1 − Xs0 )k ] + +∞ i=1 s1 s0 where is the predictable σ -algebra on [0.3. ) . . . . . we prove the result for the product of an arbitrary number of nonoverlapping power-increments. ) = i=1 +∞ i=1 L2 (i) . Lemma A.3.. For a square-integrable adapted martingale m. .. (Xtn − Xtn−1 )kn : ki ti < ti+1 T . . . ) by proposition A.2 t1 . . Xt2 − Xt1 . we deduce the following representation property of square-integrable variables. Let F ∈ L2 ( . s3 )}θs(i)3 l (s) 2s Hence. H θs(i)1 k (s) dHs(i) . then there are predictable processes { t(i) : i 1} such that: +∞ R = E[R] + i=1 0 T (i) s dHs(i) . Xtn − Xtn−1 )). (k 0). Since X is regular. Proof. . Following lemma A. σ (Xt1 . We deﬁne the following families of L2 ( . Xtn − Xtn−1 )) for some sequence {ti }. Therefore ˆ t is dense in C and thus in L2 (P {Xt ∈ dx}). Xt2 − Xt1 . (Xtn − Xtn−1 )kn : 0 The process (i) s (i) s is a predictable process deﬁned by: +∞ j =1 s1 s0 (j θs0 s1 k (u) dHu ) . . we derive the result by closure of the above inclusion. ki 0}. ) then there is a family of predictable processes {φt(i) : i 1} such that: +∞ |Z|k E[|Xt |k |F (Xt )|] < E[F (Xt )2 ]1/2 exp(|Z a|). k! F = E[F ] + i=1 0 T By the dominated convergence theorem.

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