Constructing the Implied Volatility Surface: From Market Quotes to an Arbitrage-Free Fit
Why This Matters For vanilla options, the simple models are usually sufficient. A plain call or put can be priced off Black-Scholes directly; you often do not need to reach for local volatility or a stochastic volatility model. Those heavier models earn their place with exotics, where the payoff depends on how the smile behaves rather than just its level today. For a vanilla, you take the market’s implied volatility at the relevant strike and maturity and feed it into Black-Scholes. But that assumes a volatility surface already exists: before Black-Scholes can price anything, the surface it reads from has to be built, and building it is less straightforward than it appears. ...