Dupire Local Volatility by Fabrice Douglas Rouah.

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Dupire Local Volatility by Fabrice Douglas Rouah.

© All Rights Reserved

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The derivation of local volatility is outlined in many papers and textbooks

(such as the one by Jim Gatheral [1]), but in the derivations many steps are left

out. In this Note we provide two derivations of local volatility.

1. The derivation by Dupire [2] that uses the Fokker-Planck equation.

2. The derivation by Derman et al. [3] of local volatility as a conditional

expectation.

We also present the derivation of local volatility from Black-Scholes implied

volatility, outlined in [1]. We will derive the following three equations that

involve local volatility o = o(o

t

, t) or local variance

L

= o

2

.

1. The Dupire equation in its most general form (appears in [1] on page 9)

0C

0T

=

1

2

o

2

1

2

0

2

C

01

2

+ (r

T

T

)

_

C 1

0C

01

_

. (1)

2. The equation by Derman et al. [3] for local volatility as a conditional

expected value (appears with

T

= 0 in [3])

0C

0T

= 1(r

T

T

)

0C

01

T

C +

1

2

1

2

1

_

o

2

T

[o

T

= 1

0

2

C

01

2

. (2)

3. Local volatility as a function of Black-Scholes implied volatility, =

(1, T) (appears in [1]) expressed here as the local variance

L

L

=

@w

@T

_

1

y

w

@w

@y

+

1

2

@

2

w

@y

2

+

1

4

_

1

4

1

w

+

y

2

w

__

@w

@y

_

2

_. (3)

where n = (1, T)

2

T is the Black-Scholes total implied variance and j =

ln

K

F

T

where 1

T

= exp

_

_

T

0

j

t

dt

_

is the forward price with j

t

= r

t

t

(risk free

rate minus dividend yield). Alternatively, local volatility can also be expressed

in terms of as

2

+ 2T

_

@

@T

+ (r

T

T

) 1

@

@K

_

1 +

Ky

@

@K

_

2

+ 1T

_

@

@K

1

4

1T

_

@

@K

_

2

+ 1

@

2

@K

2

_

.

Solving for the local variance in Equation (1), we obtain

o

2

= o (1, T)

2

=

@C

@T

(r

T

T

)

_

C 1

@C

@K

_

1

2

1

2

@

2

C

@K

2

. (4)

1

If we set the risk-free rate r

T

and the dividend yield

T

each equal to zero,

Equations (1) and (2) can each be solved to yield the same equation involving

local volatility, namely

o

2

= o (1, T)

2

=

@C

@T

1

2

1

2

@

2

C

@K

2

. (5)

The local volatility is then

L

=

_

o

2

(1, T). In this Note the derivation of

these equations are all explained in detail.

1 Local Volatility Model for the Underlying

The underlying o

t

follows the process

do

t

= j

t

o

t

dt + o(o

t

, t)o

t

d\

t

(6)

= (r

t

t

) o

t

dt + o(o

t

, t)o

t

d\

t

.

We sometimes drop the subscript and write do = jodt + ood\ where o =

o(o

t

, t). We need the following preliminaries:

Discount factor 1(t, T) = exp

_

_

T

t

r

s

d:

_

.

Fokker-Planck equation. Denote by )(o

t

, t) the probability density func-

tion of the underlying price o

t

at time t. Then ) satises the equation

0)

0t

=

0

0o

[jo)(o, t)] +

1

2

0

2

0o

2

_

o

2

o

2

)(o, t)

. (7)

Time-t price of European call with strike 1, denoted C = C(o

t

, 1)

C = 1(t, T)1

_

(o

T

1)

+

(8)

= 1(t, T)1

_

(o

T

1)1

(S

T

>K)

= 1(t, T)

_

1

K

(o

T

1))(o, T)do.

where 1

(S

T

>K)

is the Heaviside function and where 1 [] = 1 [[T

t

]. In the

all the integrals in this Note, since the expectations are taken for the underlying

price at t = T it is understood that o = o

T

, )(o, T) = )(o

T

, T) and do = do

T

.

We sometimes omit the subscript for notational convenience.

2 Derivation of the General Dupire Equation (1)

2.1 Required Derivatives

We need the following derivatives of the call C(o

t

, t).

2

First derivative with respect to strike

0C

01

= 1(t, T)

_

1

K

0

01

(o

T

1))(o, T)do (9)

= 1(t, T)

_

1

K

)(o, T)do.

Second derivative with respect to strike

0

2

C

01

2

= 1(t, T) [)(o, T)]

S=1

S=K

(10)

= 1(t, T))(1, T).

We have assumed that lim

S!1

)(o, T) = 0.

First derivative with respect to maturityuse the chain rule

0C

0T

=

0C

0T

1(t, T)

_

1

K

(o

T

1))(o, T)do + (11)

1(t, T)

_

1

K

(o

T

1)

0

0T

[)(o, T)] do.

Note that

@P

@T

= r

T

1(t, T) so we can write (11)

0C

0T

= r

T

C + 1(t, T)

_

1

K

(o

T

1)

0

0T

[)(o, T)] do. (12)

2.2 Main Equation

In Equation (12) substitute the Fokker-Planck equation (7) for

@f

@t

at t = T

0C

0T

+ r

T

C = 1(t, T)

_

1

K

(o

T

1) (13)

_

0

0o

[j

T

o)(o, T)] +

1

2

0

2

0o

2

_

o

2

o

2

)(o, T)

_

do.

This is the main equation we need because it is from this equation that the

Dupire local volatility is derived. In Equation (13) have two integrals to evaluate

1

1

= j

T

_

1

K

(o

T

1)

0

0o

[o)(o, T)] do, (14)

1

2

=

_

1

K

(o

T

1)

0

2

0o

2

_

o

2

o

2

)(o, T)

do.

Before evaluating these two integrals we need the following two identities.

3

2.3 Two Useful Identities

2.3.1 First Identity

From the call price Equation (8), we obtain

C

1(t, T)

=

_

1

K

(o

T

1))(o, T)do (15)

=

_

1

K

o

T

)(o, T)do 1

_

1

K

)(o, T)do.

From the expression for

@C

@K

in Equation (9) we obtain

_

1

K

)(o, T)do =

1

1(t, T)

0C

01

.

Substitute back into Equation (15) and re-arrange terms to obtain the rst

identity

_

1

K

o

T

)(o, T)do =

C

1(t, T)

1

1(t, T)

0C

01

. (16)

2.3.2 Second Identity

We use the expression for

@

2

C

@K

2

in Equation (10) to obtain the second identity

)(1, T) =

1

1(t, T)

0

2

C

01

2

. (17)

2.4 Evaluating the Integrals

We can now evaluate the integrals 1

1

and 1

2

dened in Equation (14).

2.4.1 First integral

Use integration by parts with n = o

T

1, n

0

= 1,

0

=

@

@S

[o)(o, T)] , =

o)(o, T)

1

1

= [j

T

(o

T

1)o

T

)(o, T)]

S=1

S=K

j

T

_

1

K

o)(o, T)do

= [0 0] j

T

_

1

K

o)(o, T)do.

We have assumed lim

S!1

(o 1)o)(o, T) = 0. Substitute the rst identity (16)

to obtain the rst integral 1

1

1

1

=

j

T

C

1(t, T)

+

j

T

1

1(t, T)

0C

01

. (18)

4

2.4.2 Second integral

Use integration by parts with n = o

T

1, n

0

= 1,

0

=

@

2

@S

2

_

o

2

o

2

)(o, T)

, =

@

@S

_

o

2

o

2

)(o, T)

1

2

=

_

(o

T

1)

0

0o

_

o

2

o

2

)(o, T)

_

_

S=1

S=K

_

1

K

0

0o

_

o

2

o

2

)(o, T)

do

= [0 0]

_

o

2

o

2

)(o, T)

S=1

S=K

= o

2

1

2

)(1, T)

where o

2

= o(1, T)

2

. We have assumed that lim

S!1

@

@S

_

o

2

o

2

)(o, T)

_

= 0.

Substitute the second identity (17) for )(1, T) to obtain the second integral 1

2

1

2

=

o

2

1

2

1(t, T)

0

2

C

01

2

. (19)

2.5 Obtaining the Dupire Equation

We can now evaluate the main Equation (13) which we write as

0C

0T

+ r

T

C = 1(t, T)

_

1

1

+

1

2

1

2

_

.

Substitute for 1

1

from Equation (18) and for 1

2

from Equation (19)

0C

0T

+ r

T

C = j

T

C j

T

1

0C

01

+

1

2

o

2

1

2

0

2

C

01

2

Substitute for j

T

= r

T

T

(risk free rate minus dividend yield) to obtain the

Dupire equation (1)

0C

0T

=

1

2

o

2

1

2

0

2

C

01

2

+ (r

T

T

)

_

C 1

0C

01

_

.

Solve for o

2

= o(1, T)

2

to obtain the Dupire local variance in its general form

o(1, T)

2

=

@C

@T

+

T

C + (r

T

K

)1

@C

@K

1

2

1

2

@

2

C

@K

2

Dupire [2] assumes zero interest rates and zero dividend yield. Hence r

T

=

T

= 0 so that the underlying process is do

t

= o(o

t

, t)o

t

d\

t

. We obtain

o(1, T)

2

=

@C

@T

1

2

1

2

@

2

C

@K

2

.

which is Equation (5).

5

3 Derivation of Local Volatility as an Expected

Value, Equation (2)

We need the following preliminaries, all of which are easy to show

@

@S

(o 1)

+

= 1

(S>K)

@

@S

1

(S>K)

= c(o 1)

@

@K

(o 1)

+

= 1

(S>K)

@

@K

1

(S>K)

= c(o 1)

@C

@K

= 1(t, T)1

_

1

(S>K)

@

2

C

@K

2

= 1(t, T)1 [c(o 1)]

In the table, c() denotes the Dirac delta function. Now dene the function

)(o

T

, T) as

)(o

T

, T) = 1(t, T)(o

T

1)

+

.

Recall the process for o

t

is given by Equation (6). By Itos Lemma, ) follows

the process

d) =

_

0)

0T

+ j

T

o

T

0)

0o

T

+

1

2

o

2

T

o

T

0

2

)

0o

2

T

_

dT +

_

o

T

o

T

0)

0o

T

_

d\

T

. (20)

Now the partial derivatives are

0)

0T

= r

T

1(t, T)(o

T

1)

+

,

0)

0o

T

= 1(t, T)1

(S

T

>K)

,

0

2

)

0o

2

T

= 1(t, T)c (o

T

1) .

Substitute them into Equation (20)

d) = 1(t, T) (21)

_

r

T

(o

T

1)

+

+ j

T

o

T

1

(S

T

>K)

+

1

2

o

2

T

o

2

T

c(o

T

1)

_

dT

+1(t, T)

_

o

T

o

T

1

(S

T

>K)

d\

T

Consider the rst two terms of (21), which can be written as

r

T

(o

T

1)

+

+ j

T

o

T

1

(S

T

>K)

= r

T

(o

T

1)1

(S

T

>K)

+ j

T

o

T

1

(S

T

>K)

= r

T

11

(S

T

>K)

T

o

T

1

(S

T

>K)

.

When we take the expected value of Equation (21), the stochastic term drops

out since 1 [d\

T

] = 0. Hence we can write the expected value of (21) as

dC = 1 [d)] (22)

= 1(t, T)1

_

r

T

11

(S

T

>K)

T

o

T

1

(S

T

>K)

+

1

2

o

2

T

o

2

T

c(o

T

1)

_

dT

6

so that

dC

dT

= 1(t, T)1

_

r

T

11

(S

T

>K)

T

o

T

1

(S

T

>K)

+

1

2

o

2

T

o

2

T

c(o

T

1)

_

. (23)

Using the second line in Equation (8), we can write

1(t, T)1

_

o

T

1

(S

T

>K)

= C + 11(t, T)1

_

1

(S

T

>K)

dC

dT

= 11(t, T)r

T

1[1

(S

T

>K)

]

T

_

C + 11(t, T)1

_

1

(S

T

>K)

_

(24)

+

1

2

1(t, T)1

_

o

2

T

o

2

T

c(o

T

1)

= 1(r

T

T

)

0C

01

T

C +

1

2

1(t, T)1

_

o

2

T

o

2

T

c(o

T

1)

@C

@K

for 1(t, T)1[1

(S

T

>K)

]. The last term in the

last line of Equation (24) can be written

1

2

1(t, T)1

_

o

2

T

o

2

T

c(o

T

1)

=

1

2

1(t, T)1

_

o

2

T

o

2

T

[o

T

= 1

1[c(o

T

1)]

=

1

2

1(t, T)1

_

o

2

T

[o

T

= 1

1

2

1[c(o

T

1)]

=

1

2

1

_

o

2

T

[o

T

= 1

1

2

0

2

C

01

2

where we have substituted

@

2

C

@K

2

for 1(t, T)1[c(o

T

1)]. We obtain the nal

result, Equation (2)

0C

0T

= 1(r

T

T

)

0C

01

T

C +

1

2

1

2

1

_

o

2

T

[o

T

= 1

0

2

C

01

2

.

When r

T

=

T

= 0 we can re-arrange the result to obtain

1

_

o

2

T

[o

T

= 1

=

@C

@T

1

2

1

2

@

2

C

@K

2

which, again, is Equation (5). Hence when the dividend and interest rate are

both zero, the derivation of local volatility using Dupires approach and the

derivation using conditional expectation produce the same result.

4 Derivation of Local Volatility From Implied

Volatility, Equation (3)

To express local volatility in terms of implied volatility, we need the three deriv-

atives

@C

@T

,

@C

@K

, and

@

2

C

@K

2

that appear in Equation (1), but expressed in terms of

7

implied volatility. Following Gatheral [1] we dene the log-moneyness

j = ln

1

1

T

where 1

T

= o

0

exp

_

_

T

0

j

t

dt

_

is the forward price (j

t

= r

t

t

, risk free rate

minus dividend yield) and 1 is the strike price, and the "total" Black-Scholes

implied variance

n = (1, T)

2

T

where (1, T) is the implied volatility. The Black-Scholes call price can then

be written as

C

BS

(o

0

, 1, (1, T) , T) = C

BS

(o

0

, 1

T

c

y

, n, T) (25)

= 1

T

(d

1

) c

y

(d

2

)

where

d

1

=

ln

S0

K

+

_

T

0

(r

t

t

) dt +

w

2

_

n

= jn

1

2

+

1

2

n

1

2

(26)

and d

2

= d

1

_

n = jn

1

2

1

2

n

1

2

.

4.1 The Reparameterized Local Volatility Function

To express the local volatility Equation (1) in terms of j, we note that the

market call price is

C(o

0

, 1, T) = C(o

0

, 1

T

c

y

, T)

and we take derivatives. The rst derivative we need is, by the chain rule

0C

0j

=

0C

01

01

0j

=

0C

01

1. (27)

The second derivative we need is

0

2

C

0j

2

=

0

0j

_

0C

01

_

1 +

0C

01

01

0j

(28)

=

0

2

C

01

2

1

2

+

0C

0j

,

since by the chain rule

@A

@y

=

@A

@K

@K

@y

, so that

@

@y

_

@C

@K

_

=

@

2

C

@K

2

@K

@y

=

@

2

C

@K

2

1. The

third derivative we need is

0C

0T

=

0C

0T

+

0C

01

01

0T

(29)

=

0C

0T

+

0C

01

1j

T

=

0C

0T

+

0C

0j

j

T

8

since 1 = o

0

exp

_

_

T

0

j

t

dt + j

_

so that

@K

@T

= 1j

T

. Equation (28) implies

that

0

2

C

01

2

1

2

=

0

2

C

0j

2

0C

0j

.

Now we substitute into Equation (1), reproduced here for convenience

0C

0T

=

1

2

o

2

1

2

0

2

C

01

2

+ j

T

_

C 1

0C

01

_

0C

0T

0C

0j

j

T

=

1

2

o

2

_

0

2

C

0j

2

0C

0j

_

+ j

T

_

C

0C

0j

_

which simplies to

0C

0T

=

L

2

_

0

2

C

0j

2

0C

0j

_

+ j

T

C (30)

where

L

= o

2

(1, T) is the local variance. This is Equation (1.8) of Gatheral

[1].

4.2 Three Useful Identities

Before expression the local volatility Equation (1) in terms of implied volatility,

we rst derive three identities used by Gatheral [1] that help in this regard. We

use the fact that the derivatives of the standard normal cdf and pdf are, using

the chain rule,

0

(r) = :(r)r

0

and :

0

(r) = r:(r)r

0

. We also use the relation

:(d

1

) =

1

_

2

c

1

2

(d2+

p

w)

2

=

1

_

2

c

1

2

(d

2

2

+2d2

p

w+w)

= :(d

2

)c

d2

p

w

1

2

w

= :(d

2

)c

y

.

From Equation (25) the rst derivative with respect to n is

0C

BS

0n

= 1

T

[:(d

1

)d

1w

c

y

:(d

2

)d

2w

]

= 1

T

_

:(d

2

)c

y

_

d

2w

+

1

2

n

1

2

_

c

y

:(d

2

)d

2w

_

=

1

2

1

T

c

y

_

:(d

2

)n

1

2

_

9

where d

1w

is the rst derivative of d

1

with respect to n and similarly for d

2

.

The second derivative is

0

2

C

BS

0n

2

=

1

2

1

T

c

y

_

:(d

2

)d

2

d

2w

n

1

2

1

2

:(d

2

)n

3

2

_

(31)

=

1

2

1

T

c

y

:(d

2

)n

1

2

_

d

2

d

2w

1

2

n

1

_

=

0C

BS

0n

__

jn

1

2

+

1

2

n

1

2

__

1

2

jn

3

2

1

4

n

1

2

_

1

2

n

1

_

=

0C

BS

0n

_

1

8

1

2n

+

j

2

2n

2

_

.

This is the rst identity we need. The second identity we need is

0

2

C

BS

0n0j

=

1

2

1

T

n

1

2

0

0j

[c

y

:(d

2

)] (32)

=

1

2

1

T

n

1

2

[c

y

:(d

2

) c

y

:(d

2

)d

2

d

2y

]

=

0C

BS

0n

[1 d

2

d

2y

]

=

0C

BS

0n

_

1

2

j

n

_

where d

2y

= n

1

2

is the rst derivative of d

2

with respect to j. To obtain the

third identity, consider the derivative

0C

BS

0j

= 1

T

[:(d

1

)d

1y

c

y

(d

2

) c

y

:(d

2

)d

2y

]

= 1

T

c

y

[:(d

2

)d

1y

(d

2

) :(d

2

)d

2y

]

= 1

T

c

y

(d

2

).

The third identity we need is

0

2

C

BS

0j

2

= 1

T

[c

y

(d

2

) + c

y

:(d

2

)d

2y

] (33)

= 1

T

c

y

(d

2

) + 1

T

c

y

:(d

2

)n

1

2

=

0C

BS

0j

+ 2

0C

BS

0n

.

We are now ready for the main derivation of this section.

4.3 Local Volatility in Terms of Implied Volatility

We note that when the market price C(o

0

, 1, T) is equal to the Black-Scholes

price with the implied volatility (1, T) as the input to volatility

C(o

0

, 1, T) = C

BS

(o

0

, 1, (1, T), T). (34)

10

We can also reparameterize the Black-Scholes price in terms of the total implied

volatility n = (1, T)

2

T and 1 = 1

T

c

y

. Since n depends on 1 and 1 depends

on j, we have that n = n(j) and we can write

C(o

0

, 1, T) = C

BS

(o

0

, 1

T

c

y

, n(j), T). (35)

We need derivatives of the market call price C(o

0

, 1, T) in terms of the Black-

Scholes call price C

BS

(o

0

, 1

T

c

y

, n(j), T). From Equation (35), the rst deriv-

ative we need is

0C

0j

=

0C

BS

0j

+

0C

BS

0n

0n

0j

(36)

= a(n, j) + /(n, j)c(j).

It is easier to visualize the second derivative we need,

@

2

C

@y

2

, when we express the

partials in

@C

@y

as a, /, and c.

0

2

C

0j

2

=

0a

0j

+

0a

0n

0n

0j

+ /(n, j)

0c

0j

+

_

0/

0j

+

0/

0n

0n

0j

_

c(j) (37)

=

0

2

C

BS

0j

2

+

0

2

C

BS

0j0n

0n

0j

+

0C

BS

0n

0

2

n

0j

2

+

_

0

2

C

BS

0n0j

+

0

2

C

BS

0n

2

0n

0j

_

0n

0j

=

0

2

C

BS

0j

2

+ 2

0

2

C

BS

0j0n

0n

0j

+

0C

BS

0n

0

2

n

0j

2

+

0

2

C

BS

0n

2

_

0n

0j

_

2

.

The third derivative we need is

0C

0T

=

0C

BS

0T

+

0C

BS

0n

0n

0T

(38)

= j

T

C +

0C

BS

0n

0n

0T

.

Gatheral explains that the second equality follows because the only explicit

dependence of C

BS

on T is through the forward price 1

T

, even though C

BS

depends implicitly on T through j and n. The reparameterized Dupire equation

(30) is reproduced here for convenience

0C

0T

=

L

2

_

0

2

C

0j

2

0C

0j

_

+ j

T

C.

We substitute for

@C

@T

,

@

2

C

@y

2

, and

@C

@y

from Equations (38), (37), and (36) respec-

tively and cancel j

T

C from both sides to obtain

0C

BS

0n

0n

0T

=

L

2

_

0

2

C

BS

0j

2

+ 2

0

2

C

BS

0j0n

0n

0j

+

0C

BS

0n

0

2

n

0j

2

+

0

2

C

BS

0n

2

_

0n

0j

_

2

0C

BS

0j

+

0C

BS

0n

0n

0j

_

. (39)

11

Now substitute for

@

2

C

BS

@w

2

,

@

2

C

BS

@w@y

, and

@

2

C

BS

@y

2

from the identities in Equations

(31), (32), and (33) respectively, the idea being to end up with terms involving

@C

BS

@w

on the right hand side of Equation (39) that can be factored out.

0C

BS

0n

0n

0T

=

L

2

0C

BS

0n

_

2 + 2

_

1

2

j

n

_

0n

0j

+

_

1

8

1

2n

+

j

2

2n

__

0n

0j

_

2

+

0

2

n

0j

2

0n

0j

_

.

Remove the factor

@C

BS

@w

from both sides and simplify to obtain

0n

0T

=

L

_

1

j

n

0n

0j

+

1

2

0

2

n

0j

2

+

1

4

_

1

4

1

n

+

j

2

n

__

0n

0j

_

2

_

.

Solve for

L

to obtain the nal expression for the local volatility expressed in

terms of implied volatility n = (1, T)

2

T and the log-moneyness j = ln

K

F

T

L

=

@w

@T

_

1

y

w

@w

@y

+

1

2

@

2

w

@y

2

+

1

4

_

1

4

1

w

+

y

2

w

__

@w

@y

_

2

_.

4.4 Alternate Derivation

In this derivation we express the derivatives

@C

@K

,

@

2

C

@K

2

, and

@C

@T

in the Dupire

equation (1) in terms of j and n = n(j), but we substitute these derivatives

directly in Equation (1) rather than in (30). This means that we take derivatives

with respect to 1 and T, rather than with j and T. Recall that from Equation

(35), the market call price is equal to the Black-Scholes call price with implied

volatility as input

C(o

0

, 1, T) = C

BS

(o

0

, 1

T

c

y

, n(j), T).

Recall also that from Equation (25) the Black-Scholes call price reparameterized

in terms of j and n is

C

BS

(o

0

, 1

T

c

y

, n(j), T) = 1

T

(d

1

) c

y

(d

2

)

where d

1

is given in Equation (26), and where d

2

= d

1

_

n. The rst derivative

we need is

0C

01

=

0C

BS

0j

0j

01

+

0C

BS

0n

0n

01

(40)

=

1

1

0C

BS

0j

+

0C

BS

0n

0n

01

.

12

The second derivative is

0

2

C

01

2

=

1

1

2

0C

BS

0j

+

1

1

0

01

_

0C

BS

0j

_

. (41)

+

0

01

_

0C

BS

0n

_

0n

01

+

0C

BS

0n

0

2

n

01

2

Let =

@C

@y

for notational convenience. Then

@

@K

_

@C

@y

_

=

@A

@K

and

0

01

_

0C

BS

0j

_

=

0

01

(42)

=

0

0j

0j

01

+

0

0n

0n

01

=

0

2

C

BS

0j

2

1

1

+

0

2

C

BS

0j0n

0n

01

.

Similarly

0

01

_

0C

BS

0n

_

=

0

2

C

BS

0j0n

1

1

+

0

2

C

BS

0n

2

0n

01

. (43)

Substituting Equations (42) and (43) into Equation (41) produces

0

2

C

01

2

=

1

1

2

0C

BS

0j

+

1

1

_

0

2

C

BS

0j

2

1

1

+

0

2

C

BS

0j0n

0n

01

_

(44)

+

_

0

2

C

BS

0j0n

1

1

+

0

2

C

BS

0n

2

0n

01

_

0n

01

+

0C

BS

0n

0

2

n

01

2

=

1

1

2

_

0

2

C

BS

0j

2

0C

BS

0j

_

+

2

1

0

2

C

BS

0j0n

0n

01

+

0

2

C

BS

0n

2

_

0n

01

_

2

+

0C

BS

0n

0

2

n

01

2

.

The third derivative we need is

0C

0T

=

0C

BS

0T

+

0C

BS

0j

0j

0T

+

0C

BS

0n

0n

0T

(45)

= j

T

C

BS

+

0C

BS

0j

j

T

+

0C

BS

0n

0n

0T

,

again using the fact that

@C

BS

@T

depends explicitly on T only through 1

T

. Now

substitute for

@C

@K

,

@

2

C

@K

2

, and

@C

@T

from Equations (40), (44), and (45) respectively

into Equation (4) for Dupire local variance, reproduced here for convenience.

o

2

=

@C

@T

j

T

_

C

BS

1

@C

@K

1

2

1

2

@

2

C

@K

2

.

13

We obtain, after applying the three useful identities in Section 4.2,

o

2

=

j

T

C

BS

+

@C

BS

@y

j

T

+

@C

BS

@w

@w

@T

j

T

_

C

BS

1

_

1

K

@C

BS

@y

+

@C

BS

@w

@w

@K

__

1

2

1

2

_

1

K

2

_

@

2

C

BS

@y

2

@C

BS

@y

_

+

2

K

@

2

C

BS

@y@w

@w

@K

+

@

2

C

BS

@w

2

_

@w

@K

_

2

+

@C

BS

@w

@

2

w

@K

2

_.

Applying the three useful identities in Section 4.2 allows the term

@C

BS

@w

to be

factored out of the numerator and denominator. The last equation becomes

o

2

=

_

@w

@T

+ j

T

1

@w

@K

1

2

1

2

_

2

K

2

+

2

K

_

1

2

y

w

_

@w

@K

+

_

1

8

1

2w

+

y

2

2w

2

_

_

@w

@K

_

2

+

@

2

w

@K

2

_. (46)

Equation (46) can be simplied by considering deriving the partial derivatives

of the Black-Scholes total implied variance, n = (1, T)

2

T. We have

@w

@T

=

2T

@

@T

+

2

,

@w

@K

= 2T

@

@K

, and

@

2

w

@K

2

= 2T

_

_

@

@K

_

2

+

@

2

@K

2

_

. Substitute into

Equation (46). The numerator in Equation (46) becomes

2

+ 2T

_

0

0T

+ j

T

1

0

01

_

(47)

and the denominator becomes

1 + 21T

_

1

2

j

n

_

0

01

+ 21

2

2

T

2

_

1

8

1

2n

+

j

2

2n

2

__

0

01

_

2

+1

2

T

_

_

0

01

_

2

+

0

2

01

2

_

.

Replacing n with

2

T everywhere in the denominator produces

1 + 21T

_

1

2

j

2

T

_

0

01

+ 21

2

2

T

2

_

1

8

1

2

2

T

+

j

2

2

4

T

2

__

0

01

_

2

+1

2

T

_

_

0

01

_

2

+

0

2

01

2

_

= 1 + 1T

0

01

21j

0

01

1

2

2

T

2

4

_

0

01

_

2

+

1

2

j

2

2

_

0

01

_

2

+1

2

T

0

2

01

2

=

_

1

1j

0

01

_

2

+

_

1 2

1j

0

01

+

_

1j

0

01

_

2

_

. (48)

Substituting the numerator in (47) and the denominator in (48) back to Equa-

tion (46), we obtain

2

+ 2T

_

@

@T

+ j

T

1

@

@K

_

_

1 +

Ky

@

@K

_

2

+ 1T

_

@

@K

1

4

1T

_

@

@K

_

2

+ 1

@

2

@K

2

_

14

See also the dissertation by van der Kamp [4] for additional details of this

alternate derivation.

References

[1] Gatheral, J. (2006). The Volatility Surface: A Practitioners Guide. New

York, NY: John Wiley & Sons.

[2] Dupire, B. (1994). "Pricing With a Smile." Risk 7, pp. 18-20.

[3] Derman, E., Kani, I., and M. Kamal (1996). "Trading and Hedging Local

Volatility." Goldman Sachs Quantitative Strategies Research Notes.

[4] van der Kamp, Roel (2009). "Local Volatility Modelling." M.Sc. disserta-

tion, University of Twente, The Netherlands.

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