Nonparametric and arbitrage-free construction of call surfaces using l1-recovery

Abstract

This paper is devoted to the application of an $l_1$ -minimisation technique to construct an arbitrage-free call-option surface. We propose a nononparametric approach to obtaining model-free call option surfaces that are perfectly consistent with market quotes and free of static arbitrage. The approach is inspired from the compressed-sensing framework that is used in signal processing to deal with under-sampled signals. We address the problem of fitting the call-option surface to sparse option data. To illustrate the methodology, we proceed to the construction of the whole call-price surface of the S\&P500 options, taking into account the arbitrage possibilities in the time direction. The resulting object is a surface free of both butterfly and calendar-spread arbitrage that matches the original market points. We then move on to an FX application, namely the HKD/USD call-option surface.