Cutting Edge introduction: Continuity error

Some quants discarded the continuous time model when it got in the way of arbitrage-free pricing – but others see a chance to fix the traditional ideal. Laurie Carver introduces this month’s technical section

bridge-the-gap

Opinion was divided when Jesper Andreasen and Brian Huge – quants at Danske Bank in Copenhagen – unveiled a radical way to generate implied volatilities in two 2011 articles (Risk March 2011, pages 76–79, and Risk July 2011, pages 66–71). On the one hand, the new method promised arbitrage-free prices, but it did so by abandoning the continuous time model that is traditionally seen as the ideal.

Andreasen has been disarmingly blunt about this sacrifice. “I don’t care,” he told one audience member

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