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Local Volatility model

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Exercise on the Dupires Local Volatility Model

Claudio Cuevas Pazos

December 21, 2016

Introduction

The aim of this paper is to give a practical insight on Dupires Local Volatility Model, its formulation

and implementation.

Practical example

We begin assuming a parametrization for the Implied volatility of the form imp (k, t) = ( + t)(1 +

ak + bk 2 )1 , where , , a, b are constants defined in the real numbers.

Using this parametrization, compute the partial derivatives as follows:

(k, t)

= ( + t)(a + 2bk)

k

2 (k, t)

= 2b( + t)

k 2

(k, t)

= (1 + ak + bk 2 )

(1)

(2)

(3)

From the previous expressions, compute the local volatility using Dupires formula as follows:

2 (k, t) =

2

k2

C

t

2C

C 2

+ (1 + ak + bk 2 ) C

+ r(t)C

C(k,t)

C

+ 2 k

( + t)(a + 2bk) + (( + t)(a + 2bk))2 k

2 +

2

C

2b(

(4)

+ t)

where C is the option price using the Black & Scholes formula for European options (See Local Volatility Surface.doc

for more details regarding the computation of the option prices and the derivatives of the price w.r.t. ,

k,t).

In order to simulate the forward price Ft assuming local volatility, first define a partition t = t1 , t2 , . . . tn =

T for the time (usually ti = i Tn , i = 1, 2, . . . n). A first approach is to implement the Euler scheme for

the diffusion as follows:

Ft = (k, t)Ft Wt ,

(5)

p

Where Ft = Fti Fti1 and Wt = (ti ti1 )Z N (0, ti ti1 ). This method gives us an iterative

algorithm for computing Ft .

1 In

general, we will have a discrete set of points, hence, the partial derivatives (

computed numerically.

, dk , dk2 )

dt

must be

This method is fairly simple to implement, however, it has its complications regarding the discretization

error committed by the scheme (the Euler scheme converges strongly with order 12 to the solution of the

diffusion). We would need a really small partition to obtain a fair approximation, which will be traduced

to very expensive calculations for the computer.

To correct the previous scheme, we can obtain a better approximation for the diffusion called the Milstein

Scheme, which has the following form:

1

Ft = (k, t)Ft Wt + (k, t)2 ((Wt )2 t),

2

(6)

this method is an improvement of the Euler scheme as it converges strongly with order 1 to the solution

of the diffusion.

In order to compute the price of the option, we can take advantage of the Strong Law of Large Numbers

getting the following result:

n

lim erT

1 X FT

FT

(

k)+ = E[erT (

k)+ ] a.s.

n i=1 Ft

Ft

(7)

Hence, for a fairly big n, we can estimate the price of the derivative by:

n

Ct erT

1 X FT

(

k)+ .

n i=1 Ft

Using the Central Limit Theorem, it is easy to check that with a 95% of confidence that

#

"

n

n

X

X

FT

FT

rT 1

rT 1

+

+

(

(

Ct e

k) 1.96 , e

k) + 1.96 ,

n i=1 Ft

n i=1 Ft

n

n

(8)

(9)

in this case, 2 = E[erT ( FFTt k)2 ] c2t and it can be estimated from the sample.

Using this approach of the MonteCarlo Method, we can see that we may require lots of simulations in

order to obtain a precise price. To reduce the variance of the MonteCarlo method (hence, reducing

the number of iterations required for a certain precision), we use the Antithetic method for variance

reduction, which can be described as follows:

Suppose that from i.i.d. random variables X1 , ..., Xn one can easily obtain another sequence of i.i.d.

random variables Y1 , ..., Yn but so that Yi have the same distribution as Xi , but Xi and Yi are actually

dependent, and Zi = 21 (Xi + Yi ) are i.i.d. Then E[Xi ] = E[Yi ] = E[Zi ], and the variance of Zi is

V ar(Zi ) =

,

4

(10)

so if we can organise it so that cov(Xi , Yi ) < 0 then the variance of the sample will decrease.

p

In our particular diffusion, we know that Wt = Wti Wti1 = (ti ti1 )Z N (0, ti ti1 ), but

p

also (ti ti1 )Z N (0, ti ti1 ), then, for our case, we can follow the following algorithm for each

simulation (see [1] for further details):

1. Compute n pseudo random N (0, 1) numbers Z = (Z1 , Z2 , . . . Zn ).

2. Compute FT (Z)andFT (Z) using equation 5, and use Zi for each time ti .

3. Compute 21 (FT (Z) + FT (Z)

Notice that for given n we need to perform slightly less than twice as many operations as for the plain

MonteCarlo method. We need the variance to be reduced by factor at least 2 to gain something.

References

[1] Paul Glasserman. Monte Carlo methods in financial engineering, volume 53. Springer Science &

Business Media, 2003.

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