Arbitrage-Free Call Option Surface Construction Using Regression Splines (Preprint)

Abstract

In this work, we suggest a novel quadratic programming-based algorithm to generate an arbitrage-free call option surface. Our approach relies on a regression spline-based implementation of the framework proposed by Orosi (2011) who presents a multi-parameter extension of the models of Figlewski (2002) and Henderson, Hobson, and Kluge (2007). Moreover, the empirical performance of the proposed method is evaluated using S&P 500 Index call options. Our results indicate that the proposed method provides a more precise fit to observed option prices than other alternative methodologies. NOTE: This is a preprint. The published version has been extensively revised.