Setup for question: Consider a basket of $N$ stocks $\{S^1, S^2, \dots, S^N\}$. For fixed strike $K$, each stock in the basket, $S^i$, follows the SDE

$$dS_t^i = \mu^i(t) S_t^i dt + \sigma^i(K, t) S_t^i dW_t^i$$

where $W_t^i$ is a standard brownian motion, $\mu^i(t) = \dfrac{1}{t}\log\left(\dfrac{F^i(t)}{S^i_t}\right)$ and $\sigma^i(k, t)$ are the implied volatilities from standard call options in the market.

At time $T$, the SDE has the analytic solution

$$ \dfrac{S_T^i}{S_0^i} = e^{\left(\mu^i(T) -\frac{{\sigma^i(K, T)}^{2}}{2}\right)T+ \sigma^i(K, T) W_T^i }.$$

For ease of notation, put

$$\overline{S^i_t} := \dfrac{S_t^i}{S_0^i}$$ $$\overline{\mu^i(t)} :=\left(\mu^i(t) -\frac{{\sigma^i(K, t)}^{2}}{2}\right)t = \log\left(\dfrac{F^i(t)}{S^i_t}\right) -\frac{{\sigma^i(K, t)}^{2}}{2}t $$

Then $$ \overline{S^i_T} = e^{\overline{\mu^i(T)} )T+ \sigma^i(K, T) W_T^i }$$

My question: When I use real forward prices in the market and real volatility surfaces, I'm finding that $\overline{\mu^i(t)}$ is negative! Obviously, stock prices cannot be negative. So I'm not sure what I'm doing wrong! So basically, I find that $\log\left(\dfrac{F^i(t)}{S^i_t}\right) -\frac{{\sigma^i(K, t)}^{2}}{2}t < 0$ when I use real forward, stock and vol surfaces. What am I doing wrong?

  • $\begingroup$ Hmm. Shouldn’t you use risk neutral measure? And in a GBM the drift and volatility is constant. This is not the case for you. Why do you call it GBM? $\endgroup$ – Sanjay Aug 16 at 22:55

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