A Market Model of Stochastic Smiles: a conditional density approach

We introduce a new approach that allows to construct no-arbitrage market models of implied volatility surfaces. The need for developing such models has long been recognized. The framework presented here makes it possible to generate models of a joint evolution of an arbitrary number of option price processes together with the underlying price pro-cess. The key idea of the approach is to take a deterministic smile model as a backbone around which a stochastic smile model can be constructed without violating no-arbitrage constraints.