The Quadratic Local Variance Gamma Model: an arbitrage-free interpolation of class C3 for option prices

Abstract

This paper generalizes the local variance gamma model of Carr and Nadtochiy, to a piecewise quadratic local variance function. The formulation encompasses the piecewise linear Bachelier and piecewise linear Black local variance gamma models. The quadratic local variance function results in an arbitrage-free interpolation of class C3. The increased smoothness over the piecewise-constant and piecewise-linear representation allows to reduce the number of knots when interpolating raw market quotes, thus providing an interesting alternative to regularization while reducing the computational cost.