Q U A N T I T A T I V E F I N A N C E V O L U M E 2 (2002) 61–69 RE S E A R C H PA P E R

INSTITUTE O F PHYSICS PUBLISHING quant.iop.org

Asymptotics and calibration of local

volatility models
H Berestycki1 , J Busca2 and I Florent3
1
CAMS, Ecole des Hautes Études en Sciences Sociales, 54 bd Raspail,
75270 Paris Cedex 06, France
2
Ceremade, Université Paris Dauphine, Pl. Maréchal de Lattre de Tassigny,
75775 Paris Cedex 16, France
3
HSBC-CCF, 103 av. des Champs-Elysées, 75419 Paris Cedex 08, France
E-mail: hb@ehess.fr, busca@ceremade.dauphine.fr and
igor.florent@ccf.com
Received 20 September 2001
Published 4 February 2002
Online at stacks.iop.org/Quant/2/61

Abstract
We derive a direct link between local and implied volatilities in the form of a
quasilinear degenerate parabolic partial differential equation. Using this
equation we establish closed-form asymptotic formulae for the implied
volatility near expiry as well as for deep in- and out-of-the-money options.
This in turn leads us to propose a new formulation near expiry of the
calibration problem for the local volatility model, which we show to be well
posed.

In the Black–Scholes–Merton model [4,24], it is assumed that
the price of a non-dividend paying stock St follows the log-
normal stochastic differential equation
dSt = St (µ dt + σ dWt ), (1)
where t is time, µ and σ are constants and Wt is a standard
Brownian motion. The parameter σ is called the volatility of
the stock St . It is well-known that the price C(St , t; K, T ) of a
European call option written on St with strike K and maturity
T satisfies the linear parabolic partial differential equation
σ2 2
Ct + S CSS + rSCS − rC = 0 in (0, +∞) × (0, T )
2
C(S, T ) = (S − K)+ ,
(2)
where r is the risk-free short-term interest rate. Such options
are commonly traded on markets, however σ is not directly
observable. Therefore it is common practice to start from the
observed prices and invert the closed-form solution to (2) in
order to find that constant σ —called implied volatility—for
which the solution to (2) agrees with the market price at today’s
value of the stock. It is widely observed that calls having
different strikes and otherwise identical have different implied
volatilities. This phenomenon, usually referred to as the smile
effect, clearly violates the Black–Scholes–Merton model, since
in this framework a constant σ is supposed to determine the
dynamics of the underlying stock St through (1) regardless of
options, strikes and maturities.
To overcome this difficulty, the model has to be extended.
One widely used approach is to consider that the volatility
also follows a stochastic diffusion process. Another case is
when the volatility σ is not a constant any more but rather a
(deterministic) function of the underlying asset and the time.
Actually this can be seen as a particular case of the previous
approach. These types of models are called local volatility
models. For them, the dynamics of the underlying asset is
governed by the stochastic differential equation
dSt = µSt dt + σ (St , t)St dWt . (3)
There are two problems which are relevant in practice. Firstly
one needs to compute accurately the implied volatilities of
option prices—the pricing problem. If one follows a traditional
approach (e.g. solve the PDE corresponding to each model
and then invert Black–Scholes formula), this is known to be

1469-7688/02/010061+09$30.00 © 2002 IOP Publishing Ltd PII: S1469-7688(02)32071-2 61

H Berestycki et al Q UANTITATIVE F I N A N C E

computationally difficult, especially near expiry or far from
the money.
Secondly, one wants to recover the value of the parameter
of the model from market data—the calibration problem. One
remarkable result, due to Dupire [13], states the following:
should the call options corresponding to all possible strikes
and maturities be priced on the market in a consistent manner,
the local volatility σ (S, t) would be uniquely determined by
the relation


CT + rKCK
(Dupire’s formula) σ (K, T ) = 2
K 2 CKK
where CK , CKK are the first- and second-order derivatives of
the call price with respect to its strike and CT the derivative
with respect to its maturity. For the reader’s convenience,
we present in the appendix a proof of this result using PDE
methods.
It turns out that in practice, this approach has two severe
shortcomings. Firstly, there is but a finite set of observations.
Hence some interpolation is needed in order to use (4). It is
nowadays generally acknowledged (see for instance [8, 26])
that it is by no means obvious to figure out how to interpolate
the data set in such a way that the radicand in (4) remains
positive and finite. Further, the result is overly sensitive to
the (arbitrary) choice of the interpolation—especially for short
maturities—this resulting in poor robustness of the method.
Secondly, a (related) difficulty lies in the intrinsic
indeterminacy of formula (4) in the regions {T − t  1},
{|ln(S0 /K)|
1}, {T − t
1}, where it assumes the form 00 .
This is the reason why several other approaches have
been proposed in the recent years. We shall not attempt
to give any comprehensive survey of this broad subject, but
for the implied volatility near expiry. Furthermore, using
this limit, we then show that some new formulation of the
calibration problem is well posed. Another use of the equation
allows us to give asymptotics of the implied volatility for deep
out-of-the-money options. Most of the results stated here have
been announced in [2].
In a broader perspective we also hope that this nonlinear
PDE approach will prove useful for the challenging problem of
calibrating the local volatility and understanding its qualitative

properties.
We adopt throughout the paper the reduced variables
, x = ln(S/K) + rτ , τ = T − t, so that from (2) the transformed
(4) prices
v(x, τ ) = erτ C(S, T − τ ; K, T )/K
formally satisfy
vτ = 21 σ 2 (x, τ )(vxx − vx ) in T = R × (0, T )
(6)
x
v(x, 0) = (e − 1)+ ,
abusing somewhat the notation (see for instance [5]). We shall
assume that
σ ∈ BUC(T ), 0 < σ
σ (x, τ )
σ < ∞, (7)
BUC being the space of (globally) bounded uniformly
continuous functions and σ , σ are constants. In order to make
precise statements let us now specify the technical conditions
that we impose, and state some definitions of functional spaces
that we shall need.
2,1,p
We require that v ∈ C(T ) ∩ Wloc (),  =
R × (0, +∞), satisfy the equation in (6) pointwise almost
everywhere in  (strong solution). As is classical when
studying parabolic problems, we make use of the following
anisotropic Sobolev spaces:
 

rather focus on the results that are the closest to our point of
view. Let us mention in this respect the approach by Lagnado
and Osher [20], further extended by Jackson et al [18] and
Berestycki and Crépey [3] (see also [9]). The basic idea is to
introduce a regularized cost functional in the form
 
2
J (σ ) = ε |∇σ |2 + (C − C ∗ )(S0 , t0 ; Ki , Tj ) , (5)
i,j
W 2,1,p () = w |wxx |p + |wτ |p + |w|p < ∞
 (8)
W 2,0,∞ () = {w||w|∞ + |wxx |∞ < ∞}
endowed with their natural norms, together with their local
2,1,p
versions Wloc and Wloc 2,0,∞
.
Let us denote by u the solution to (6) corresponding to
σ ≡ 1, i.e. satisfying

where C ∗ are observed prices, to be minimized over an uτ = 21 (uxx − ux ) in 

appropriate functional space. Here ε represents the trade- x
(9)
u(x, 0) = (e − 1)+ .
off between accuracy and smoothness of the minimizer, this
follows the lines of Tychonov’s method [28]. The explicit solution to (9) is readily seen to be
Avellaneda et al [1] and Bodurtha and Jermakyan [5]    
x x 1√ x 1√
also propose other interesting minimization-like methods that u(x, τ ) = e N √ + τ −N √ − τ , (10)
τ 2 τ 2
we do not detail here. Let us mention finally the works by
Bouchouev and Isakov [6,7] who propose a different approach where  d
1 y2
based on a representation formula that results in an integral N (d) = √ e− 2 dy. (11)
equation for the local volatility. 2π −∞
The purpose of this paper is to propose a completely new Note that this is nothing but the celebrated Black–Scholes
point of view. We intend to show that there exists an explicit formula [4] written in our reduced variables.
link between the implied and the local volatilities, in the form The assumption (7) we made on σ turns out to ensure
of a quasilinear degenerate parabolic PDE. We then examine that the pricing problem in (6), which determines the price
several consequences that we can derive from this equation. of all European options, is well posed. Namely, we have the
Firstly, a particularly important one is an asymptotic formula following proposition.

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Q UANTITATIVE F I N A N C E Asymptotics and calibration of local volatility models

Proposition 1 (existence). Under assumption (7), there (here and throughout the paper δ(x) is the Dirac mass at the
exists a unique solution v in the class origin), with σ satisfying (7). It is then proved that
2,1,p
Wloc () ∩ C() ∩ {w | ∃C, β > 0,  x 2
ds
∀(x, τ ) ∈  |w(x, τ )|
Ce βx 2
} −2τ ln v(x, τ ) →
0 σ (s)
for all 1 < p < ∞ to
as τ → 0. This corresponds to the Riemannian metric
vτ − 21 σ 2 (x, τ )(vxx − vx ) = 0 a.e. in associated with the inverse of the diffusion coefficient.
Denoting by U the fundamental solution of ∂t − 21 ∂x2 , namely
 = R × (0, +∞) (12)  x2 
U (x, τ ) = (2π τ )−1/2 exp − 2τ , we can rephrase the result
v(x, 0) = (ex − 1)+ . as follows. If φ is such that v(x, τ ) = U (x, τ φ(x, τ )2 ), noting
Furthermore, v satisfies that by (7) φ is bounded, we deduce that
0 < v(x, τ ) < ex v(x, τ )  (ex − 1)+  1
1 ds
→ (18)
vτ (x, τ ) > 0 in T . (13) φ(x, τ ) 0 σ (sx)
√ is that (x, τ ) → u(x, λτ )
A trivial yet crucial observation as τ → 0. Hence this problem gives rise to the same change of
(λ > 0) satisfies (12) with σ ≡ λ. This implies that if one metric as in theorem 1 (ii). However, it is not straightforward
defines ϕ  0 so that to derive from (18) the asymptotics in theorem 1 (ii), since we
v(x, τ ) = u(x, τ ϕ 2 (x, τ )) (14) are dealing with different initial conditions and composition
with a different function.
for all (x, τ ) ∈ , then ϕ is clearly the implied volatility of
the corresponding call option, in the sense described above. We also refer the reader to [14] for other large-deviation
That (14) uniquely determines ϕ(x, τ )  0 follows easily results.
from the fact that (ex − 1)+
v(x, τ ) < ex (see (13) above), We next establish asymptotics for deep in- and out-of-the-
u(x, 0) = (ex − 1)+ , limτ →∞ u(x, τ ) = ex (see (10)), together money options.
with uτ > 0 in .
Our main result gives the implied volatility as the unique Theorem 2. Suppose σ satisfies (7) and
solution to a well-posed degenerate quasilinear parabolic limx→+∞ σ (x, τ ) = σ+ (τ ) (respectively x → −∞, σ− (τ ))
problem. locally uniformly in τ , with σ± continuous. Then
  τ 1/2
Theorem 1. Under assumption (7) suppose that the implied 1
volatility ϕ is defined by (14) where v and u are solutions lim ϕ(x, τ ) = σ±2 (s) ds . (19)
x→±∞ τ 0
to (12) and (9) respectively. Then:
2,1,p
(i) The implied volatility ϕ lies in Wloc () for all We point out that theorem 1 (ii) and theorem 2 clarify in
1 < p < ∞ and satisfies particular the indeterminacy in Dupire’s formula in the regions
  {T − t  1} and {|ln(S0 /K)|
1} that we have mentioned
ϕx 2 earlier.
2τ ϕϕτ + ϕ − σ (x, τ ) 1 − x
2 2
ϕ It results from theorem 1 (ii) that ϕ can be extended up to
−σ 2 (x, τ )τ ϕϕxx + 41 σ 2 (x, τ )τ 2 ϕ 2 ϕx2 = 0 (15) τ = 0 as a continuous function. That the limit of ϕ(x, τ )
a.e. in . at τ = 0 exists at all is by no means obvious from (14).
(ii) In the limit τ → 0, the implied volatility is the harmonic As a matter of fact, the value of the limit is quite specific to
mean of the local volatility, namely the problem under consideration, as the following proposition
makes clear. Specifically, if the payoff function is strictly
 1
1 ds convex in the initial variable S, then the asymptotic behaviour
lim = , (16)
τ →0 ϕ(x, τ ) 0 σ (sx, 0) is dominated by the local volatility.
uniformly in x ∈ R. Proposition 2. If one replaces (ex − 1)+ in (9) by any smooth
2,1,p
(iii) Conversely, if ϕ̃ ∈ Wloc () (for some p > 1), satisfies function ζ (x) satisfying ζxx − ζx > 0, that is, ζSS > 0, then
(15) and (16) then ϕ̃ ≡ ϕ. limτ →0 ϕ(x, τ ) = σ (x, 0).
This result is actually much simpler than theorem 1. The main
Remark. The small time-to-maturity asymptotic in theorem 1 reason is that here uτ > 0 throughout T , so that the implicit
part (ii) has an interesting connection with a classical result function theorem applied to (14) gives bounds for ϕ together
by Varadhan [29], although it does not readily follow from it. with its derivatives near τ = 0. In other words, it is the very
In [29] the fundamental solution of the operator ∂t − 21 σ 2 (x)∂x2 , degeneracy of the original problem near τ = 0 that allows such
is considered, namely an ‘instantaneous averaging’ as that in (16) to take place.
vτ = 21 σ 2 (x)vxx A important feature of (16) is the following. Suppose that
(17) for x = 0 σ vanishes on some interval ω between 0 and x.
v(x, 0) = δ(x) Then ϕ(x, 0) = 0. This is consistent with the probabilistic

63
H Berestycki et al Q UANTITATIVE F I N A N C E

point of view. Indeed, in this limiting case the stock price 1. Proofs
process starting at x will never cross ω and so never reaches the
convexity region (x = 0). This feature was absent from other In the proof of theorem 1 we shall need the following series of
approximation formulae that were proposed, like weighted lemmas.
linear means (see for instance [10] ‘the poor man’s model’). Lemma 4 (maximum principle). Suppose a, b, c are
We refer to the book by Rebonato [26] for a very interesting globally bounded continuous coefficients defined in T , and
and detailed discussion on the qualitative properties of local assume that a(x, τ )  a > 0. Suppose that
and implied volatilities. 2,1,p
z ∈ Wloc (T ) ∩ C(T ) satisfies
The asymptotics in theorem 1 (ii) exhibits a linear relation
between the inverse of the local and implied volatilities. This zt − a(x, τ )zxx + b(x, τ )zx + c(x, τ )z  0 a.e. in T
leads us to propose a new regularization of the calibration
problem. Instead of (5) we introduce the following penalized lim z(x, τ )  0 in D (R)
τ →0
functional:
z(x, τ )  −Ceβ|x|
2
for some β, C > 0.
   2    2
1 1 1 (23)
J ε (σ ) = ε ∇ + − (x , τ ) , (20)
σ i,j
i j Then z  0 in T .
ϕ ϕ∗

where ϕ ∗ are observed implied volatilities, to be minimized

Proof. This is a straightforward adaptation of (a particular
over a suitable functional space. We suspect that this
case of) theorem 9, chapter 2, section 4 in [15] to the strong
minimization problem is well posed, at least for short time-
solutions framework and to the distributional initial data. 
to-maturities τj . Indeed in this case J ε is close to a convex
functional. As a matter of fact we shall prove this property
in the limiting case, that is, τj ≡ τ → 0. Specifically, we 2,1,p
Lemma 5. For any ψ ∈ Wloc (T ) define
denote by ξ(x) = σ (x, 0)−1 the inverse of the local volatility w(x, τ ) = u(x, τ ψ 2 (x, τ )) where u is the solution to (9)
1
and ζ (x) = 0 ξ(sx) ds the inverse of the implied volatility in given by (10). The following relation holds:
the limit τ → 0. We can consider the functional in terms of ξ ,
ζ and write (abusing the notations) wτ − 21 σ 2 (x, τ )(wxx −wx ) = uτ (x, tψ 2 )F (x, τ, ψ, Dψ, D2 ψ)
 (24)
 2 a.e. in T , where
J ε (ξ ) = ε ξ 2 + ζ (xi ) − ζ ∗ (xi ) , (21)
 
i ψx 2
F (x, τ, ψ, Dψ, D ψ) = 2τ ψψτ + ψ − σ 1 − x
2 2 2
ψ
where ζ ∗ = ϕ1∗ .
We assume that these volatilities are consistent, i.e. that σ 2
−σ 2 τ ψψxx + τ 2 ψ 2 ψx2 . (25)
there exists σ0 (x, τ ) for which the solution to (12) with 4
σ (x) ≡ σ0 (x, 0) asymptotically replicates market prices, i.e.
such that limτ →0 ϕ(xi , τ ) = ϕ ∗ (xi ) ≡ ζ ∗ (xi ). It follows Proof. A straightforward computation gives
that J ε (ξ0 )|ε=0 = 0, with ξ0 = σ0−1 . This means that, 
by assumption, we have a solution to the exact asymptotic wτ − 2 σ (wxx − wx ) = uτ (x, τ ψ ) 2τ ψψτ + ψ 2
1 2 2

calibration problem. As a consequence, there are in fact 

infinitely many of them, as can easily be seen from the σ2
− 2 − 2τ ψψx + 2τ (ψx2 + ψψxx )
argument in the proof of theorem 3 below. The whole point 2
is to choose one of these solutions in a stable way. This is 
uxτ uτ τ
question that the following result addresses. + 4τ ψψx (x, τ ψ 2 ) + 4τ 2 ψ 2 ψx2 (x, τ ψ 2 ) . (26)
uτ uτ
Theorem 3. Besides, one easily derives from (10) the relations

(i) For all ε > 0 there exists a unique solution of the uxτ 1 x
(x, ξ ) = −
minimization problem uτ 2 ξ

inf J ε (ξ ), (22) uτ τ 1 x2 1
ξ ∈H 1 (R) (x, ξ ) = − + 2− .
uτ 2ξ 2ξ 8
denoted by ξ ε . Combining the above identities gives the result. 

(ii) When ε → 0, ξ ε converges uniformly in R to a solution ξ̂
of the exact asymptotic calibration problem, i.e. such that Lemma 5 applied to w ≡ v, hence to ψ ≡ ϕ, yields
 statement (i) in theorem 1.
1
An important tool in the subsequent argument is the fact
ζ̂ (xi , 0) ≡ ξ̂ (sxi ) ds = ζ ∗ (xi ).
0 that this problem satisfies a certain comparison principle that

64
Q UANTITATIVE F I N A N C E Asymptotics and calibration of local volatility models

we now state. For this purpose, let us denote by H the near τ = 0. This implies loss of a priori estimates for ϕ in
quasilinear operator this region. To circumvent this serious difficulty, the essential
  idea is to define suitable sub and supersolutions of (12) from
ψx 2
H [ψ] ≡ H (x, τ, ψ, Dψ, D ψ) = 1 − x
2
the formal limiting solution of (15) and prove that actual
ψ convergence takes place through the comparison principle.
+τ ψψxx − 41 τ 2 ψ 2 ψx2 , (27) For the sake of clarity we first treat the case that σ satisfies
and define I (0, T ) to be the class of those functions ψ ∈ the additional regularity assumption
C 2,1 () for which the ‘associated local volatility’
σ ∈ C 2,1 (T ) and σxx ∈ L∞ (T ). (35)
  2 1/2
τψ τ Let us define the formal limiting solution of (15) ϕ0 as the
σ [ψ](x, τ ) = (28)
H (x, τ, ψ, Dψ, D2 ψ) unique positive solution of F (x, 0, ϕ 0 , Dϕ 0 , D2 ϕ 0 ) = 0, i.e.

is well defined, continuous in T , and satisfies there  2

ϕ0
(ϕ ) − σ (x, 0) 1 − x x0
0 2 2
= 0. (36)
σ
σ [ψ](x, τ )
σ ; (29) ϕ
It is clearly given by
furthermore, we require the growth condition at zero
 1 −1
τ ψ 2 (x, τ ) → 0 as τ → 0. (30) ds
ϕ 0 (x) = . (37)
0 σ (sx, 0)
We have the following useful result.
We next define
Lemma 6 (comparison principle). Given ψ, ψ ∈ I (0, T ),
suppose that ϕ(x, τ ) = ϕ 0 (x)(1 + κτ ), (38)
σ [ψ](x, τ )
σ [ψ](x, τ ) (31)
and, respectively, ϕ(x, τ ) = ϕ 0 (x)(1 − κτ ) in T , for κ > 0,
for all (x, τ ) ∈ T = R × (0, T ). Then ψ
ψ there. T < 1/κ. Let us compute the associated local volatilities σ [ϕ],
Note that, due to the degeneracy of (25), it is not necessary to σ [ϕ] in the sense of lemma 6, see (28). A simple computation
prescribe any initial ordering condition on ψ, ψ. yields
 2
ϕ0
H [ϕ] = 1 − x x0 + τ ϕ 0 ϕxx
0
+ O(τ 2 ). (39)
Proof. Let us define u(x, τ ) = u(x, τ ψ 2 (x, τ )) and u(x, τ ) = ϕ
2
u(x, τ ψ (x, τ )) in T . By (5), (25) and (27), (29), (30), the It follows from here and (28) that
functions u, u satisfy
σ [ϕ](x, τ ) = σ (x, τ )
  
uτ − 1
2
σ [ψ]2 (x, τ )(uxx − ux ) = 0 in T 2 ϕxx
0
στ
(32) × 1 + τ 4κ − σ 0 − (x, 0) + O(τ 2 ), (40)
x
u(x, 0) = (e − 1)+ ϕ σ
where O = O(σ , σ , σ W 2,0,∞ ). Hence, taking first κ large
and enough and then δ small enough we have ϕ ∈ I (0, δ) with
uτ − 21 σ [ψ]2 (x, τ )(uxx − ux ) = 0 in T σ [ϕ]  σ in δ . Similarly, changing κ by −κ, one sees that
(33) ϕ ∈ I (0, δ) and σ [ϕ]
σ in δ . Clearly ϕ ∈ I (0, δ) as
u(x, 0) = (ex − 1)+ . well (note that (30) comes from the initial condition v(x, 0) =
(ex − 1)+ ), with σ [ϕ] ≡ σ , this resulting from uniqueness
The difference function w(x, τ ) = u(x, τ ) − u(x, τ ) then (see lemma 4). An application of the comparison principle
satisfies (lemma 6) then yields
wτ − σ1 [ψ]2 (x, τ )(wxx − wx ) ϕ(x, τ )
ϕ(x, τ )
ϕ(x, τ ) (41)

σ [ψ]2 for all (x, τ ) ∈ T . In particular, the desired result (ii) in
= − 1 uτ in T (34)
σ [ψ]2 theorem 1 holds, in the case (35) is met.
We finally remove assumption (35) by an approximation
w(x, 0) = 0.
procedure. Let us first observe that assumption (7) gives the
By (13) and (31), the right-hand side is non-negative. It then existence of a sequence σ ε satisfying σ ε ∈ C α,α/2 (δ/2 ) for
follows from the maximum principle (lemma 4) that w  0 in any α ∈ (0, 1), σ ε  σ , σ ε → σ uniformly in δ/2 . Indeed,
T . Since uτ > 0 this implies ψ
ψ in T . 
 take σ̃ (x, −τ ) = σ (x, τ ) for all τ  0 as an extension of σ and
define for any η > 0 ρ η (η to be chosen) a standard mollifier
(see (73)). Define then σ ε by
Proof of theorem 1 (ii). Note that the existence of the limit is
by no means obvious from (15) since this equation degenerates σ ε = ρ η ∗ (σ̃ + ε). (42)

65
H Berestycki et al Q UANTITATIVE F I N A N C E

Now clearly
Proof of proposition 2. We apply identity (26) to w ≡ v
ε
−ω(η) + ε
σ − σ
ω(η) + ε (43) solution of (6), hence to ψ ≡ ϕ, the implied volatility. In this
case, uτ (x, 0) = 21 (uxx (x, 0) − ux (x, 0)) = 21 (ζxx − ζx ) > 0,
in δ/2 , if ω denotes a modulus of uniform continuity for σ so that the terms uuxττ and uuτττ in (26) remain bounded as τ → 0.
throughout δ . We can then choose η = η(ε) in such a way Furthermore, applying the implicit function theorem to (14),
that ω(η) < ε, so that σ ε  σ in δ/2 and σ ε → σ uniformly and using uτ  α > 0, we get that φ, φτ , φx , φxx remain
in δ/2 . bounded as τ → 0. Hence, sending τ to 0 in (26) clearly
Let us now define ϕ0ε (x) as the harmonic mean of σ ε (x, 0) yields φ(x, 0) = σ (x, 0).
i.e.
 1 −1
ε ds Proof of theorem 2. By an obvious symmetry in the argument,
ϕ0 (x) = ε
(44) we treat only the case x → +∞. As in the proof above, we
0 σ (sx, 0)
shall construct for a given T > 0 a sub- and supersolution
and, correspondingly, ϕ ε (x, τ ) = ϕ0ε (x)(1 + κτ ) together with ψ, ψ ∈ I (0, T ) that have the required behaviour at infinity. To
v ε (x, τ ) = u(x, τ ϕ ε (x, τ )2 ). this purpose, we shall need auxiliary functions whose relevant
Repeating the computations in the first step, we get that properties are summarized in the following lemmas. We refer
ϕ ε ∈ I (0, δ) and the reader to the appendix for the proof.
σ [ϕ ε ]  σ ε  σ (45)
Lemma 7. Given A > 0, η ∈ (0, 0.1), κ > 1/(1 − η), there
in δ by fixing κ = κ(ε) large enough, and δ = δ(ε) small
exists ψ ∈ C 2 (R) satisfying the following properties:
enough. Lemma 6 thus implies ϕ
ϕ ε in T . Similarly,
one constructs σε
σ , ϕε0 , ϕ ε = (1 − κτ ), and shows that (i) ψ ∈ W 2,∞ (R) with ψW 2,∞ independent of A
ϕ ε (x, τ )
ϕ(x, τ ) in δ . (ii) ψ(z)  1−η 1
= limξ →+∞ ψ(ξ ) ∀z ∈ R
Summing up, we get that for all ε > 0 there exists (iii) ψ(z)  2κ ∀z ∈ (−∞, A)
(κ, δ) = (κ, δ)(ε) such that zψ  (z) 1
(iv) ψ(z)
2 ∀z ∈ R
 1 −1 
ds zψ (z)  
(1 − κτ ) (v) ψ(z)
→ 0, ψ (z) → 0, ψ (z) → 0 as z → +∞.
0 σε (sx, 0)

ϕ(x, τ ) By assumption, σ (x, τ ) → σ+ (τ ) as x → +∞, uniformly
 1 −1 in τ ∈ (0, T ). Hence, given η ∈ (0, 0.1) there exists à such
ds

ε
(1 + κτ ) (46) that
0 σ (sx, 0)
σ+ (τ ) 
for all (x, τ ) ∈ R × (0, δ(ε)). This yields  1−η ∀(x, τ ) ∈ (Ã, +∞) × (0, T ). (49)
 1 −1 σ (x, τ )
ds

lim inf ϕ(x, τ ) Besides, using (7) we get κ > 1 for which
0 σε (sx, 0) τ →0

lim sup ϕ(x, τ ) 1 σ+ (τ )
τ →0

κ in R × (0, T ). (50)
 1 −1 κ σ (x, τ )
ds

(47) Let us define the quadratic mean limiting volatility
0 σ ε (sx, 0)
for all ε > 0, so that   τ 1/2
1
8+ (τ ) = σ+2 (s) ds (51)
 1 −1 τ 0
ds
lim ϕ(x, τ ) = . (48)
τ →0 0 σ (sx, 0) and, for ε > 0
That this limit is uniform in x ∈ R is easily seen through (46). ϕ(x, τ ) = 8+ (τ )ψ(εx), (52)

Part (iii) in theorem 1 (uniqueness) results from the where ψ is given in lemma 7, the values of η, κ > 0 being
maximum principle (lemma 4) applied to the difference defined as above, and A, ε to be fixed. A simple computation
function z(x, τ ) = u(x, τ ϕ̃ 2 (x, τ ))−u(x, τ ϕ 2 (x, τ )). Indeed, yields
by (16) z can be extended as a continuous function on T ,  
2
with z(x, 0) = 0. Furthermore, by lemma 5 this function ψ 
H [ϕ](x, τ ) = 1 − εx (εx) + τ 8+ ε 2 ψψ
satisfies zτ = 21 σ 2 (x, τ )(zxx − zx ) a.e. in T . Since clearly ψ
|z(x, τ )|
2ex , we can infer from the maximum principle 2 2
(lemma 4) that z ≡ 0, and thus ϕ̃ ≡ ϕ since uτ > 0. − 41 τ 2 ε 2 8+2 ψ ψ . (53)
Clearly by (iv) in lemma 7 we can choose ε =
Remark. Note that we retained from (16) only the fact that ε(ψW 2,∞ , T , 8+ ) > 0 independent of A such that
τ ϕ̃ 2 (x, τ ) → 0 as τ → 0. In this sense equation (15) has a
‘built-in’ initial condition, due to its degeneracy at τ = 0.
1
4

H [ϕ]
2 (54)

66
Q UANTITATIVE F I N A N C E Asymptotics and calibration of local volatility models

in T ; now by (v) in lemma 7 there is B > 0 for which for x  A and 41
H
2 in T . Now, by (50), (61), (ii),
x  B, τ ∈ (0, T ) imply H [ϕ](x, τ ) < 1−η1
. Setting (iii) in lemma 8, it follows that the local volatility associated
A = ε max(B, Ã), we see that (54) holds for all x and with ψ
 2 
1 τ 8+ (τ )ψ(εx)2 τ
H [ϕ](x, τ ) < (55) σ [ϕ](x, τ ) =
2
(64)
1−η H [ψ](x, τ )

for all z = εx  A, τ ∈ (0, T ). ψ(εx)2

= σ+2 (τ ) (65)
We next compute the local volatility associated with ϕ in H [ψ](x, τ )
the sense of proposition 6, that is satisfies
 2 
τ 8+ (τ )ψ(εx)2 τ σ [ϕ]
σ (x, τ ) (66)
σ [ϕ](x, τ ) =
2
(56)
H [ψ](x, τ ) for all (x, τ ) ∈ T . By applying our comparison principle
ψ(εx)2 (lemma 6) we get that ϕ
ϕ in T , and sending η → 0, that
= σ+2 (τ ) . (57) lim inf x→+∞ ϕ(x, τ )  8+ (τ ), hence the result.
H [ψ](x, τ )
Since ψ(εx)  (1−η)
1
for z = εx  A and ψ(εx)  2κ for
z ∈ (−∞, A), it follows from (49), (50), (54), (55) that Proof of theorem 3. That the infimum of J ε is achieved over
H 1 follows fairly directly from convexity. The uniqueness of
σ (x, τ )
σ [ϕ] (58) the minimizer follows from the Euler equation:

for all (x, τ ) ∈ R × (0, T ). By applying our comparison  2 1

−εξε + ζε (xi ) − ζi∗ 1(0,xi ) = 0. (67)
principle (lemma 6) we get that ϕ
ϕ in T . By (ii) in i
xi
lemma 7 and (52) we get
Indeed, if ξ and ξ̃ are two solutions to (67) (with corresponding
1 quantities ζ , ζ̃ respectively), multiplication by ξ − ξ̃ results in
lim sup ϕ(x, τ )
8+ (τ ), (59)
x→+∞ 1 − η 
 2   2
for all η ∈ (0, 0.1); this yields lim supx→+∞ ϕ(x, τ )
8+ (τ ). ε ξ − ξ̃ + ζ − ζ̃ = 0.
i
We finally claim that
Finally, it is not difficult to infer from (67) uniform H 1 bounds
lim inf ϕ(x, τ )  8+ (τ ). (60)
x→+∞ and to pass to the limit ε → 0. 

To this aim, we resort to an appropriate subsolution ϕ of the
problem. Since its construction is quite similar to that of ϕ,
the rest of the argument is only sketchy. Acknowledgments
Given η ∈ (0, 0.1), we have à for which This work is part of a research program at the Crédit
σ+ (τ )  Commercial de France (CCF, HSBC Group). We thank an

1+η ∀(x, τ ) ∈ (Ã, +∞) × (0, T ). (61) anonymous referee for his or her valuable comments and
σ (x, τ )
suggestions.
We shall make use of an auxiliary function defined in the
following lemma.
Appendix
Lemma 8. Given A > 0, η ∈ (0, 0.1), κ > 1/1 + η, there
exists ψ ∈ C 2 (R) satisfying the following properties: Sketch of the proof of (4). Let us sketch briefly the proof
∂2
(i) ψ ∈ W 2,∞ (R) with ψW 2,∞ independent of A of this well known result [13]. Since ∂K 2 (S − K)+ =
(ii) ψ(z)
1+η 1
= limξ →+∞ ψ(ξ ) ∀z ∈ R δ(S − K), δ being the Dirac mass at zero, G(S, t; K, T ) =
∂2
(iii) ψ(z)
2κ ∀z ∈ (−∞, A)
1 ∂K 2
C(S, t; K, T ) is the Green function for the operator L =
 ∂t + σ2 (S, t)S 2 ∂S2 + rS∂S − rC, i.e. satisfies the backward
2
zψ (z)
(iv) ψ(z)
21 ∀z ∈ R
parabolic equation
zψ  (z)
(v) → 0, ψ  (z) → 0, ψ  (z) → 0 as z → +∞.
ψ(z) Gt + LG = 0
(68)
We set G(S, T ; K, T ) = δ(S − K).
ϕ(x, τ ) = 8+ (τ )ψ(εx), (62)
It is then classical (see [15]) to infer from the Green identity
with the values of η, κ > 0 defined previously. A choice of ε
that G also satisfies the dual forward equation
and A similar to the above argument ensures that
GT = L∗ G
1 (69)
H [ϕ](x, τ )  (63)
1+η G(S, t; K, t) = δ(S − K),

67
H Berestycki et al Q UANTITATIVE F I N A N C E

where δ(x) being the Dirac mass at x = 0. It follows that zε  0 in

1   by the maximum principle (lemma 4). This implies in the
L∗ = ∂K2 2
K 2 σ 2 (K, T )· − r∂K (K·) − r. (70) limit vτ  0 in , hence v(x, τ )  v(x, 0) = (ex − 1)+ .

Integrating twice (69) with respect to K and integrating by

parts results in
Proof of lemma 7. Take
CT = K σ (K, T )CKK
1 2 2
− rKCK 
2  1
(71) 
 1 − η (1 + 4κ) if z
0
C(S, T ; K, T ) = (S − K)+ ,  
ψ(z) =
 1 1  z 

 1 + 4κN − ln if z > 0
so that 1−η 4κ A

  (77)
CT + rKCK where N is defined in (11). It is easily seen that ψ ∈ C 2 (R)
(Dupire’s formula) σ (K, T ) = 2 .
K 2 CKK and satisfies (i) and (ii). Then
 
(72) zψ (z)  z 

 1 1
= √ exp − ln2
ψ(z) (1 − η) 2π 4κ A
Proof of proposition 1. In the case σ is Hölder continuous, 1 1

√
.
namely σ ∈ C α,α/2 (T ) (0 < α < 1), it is theorem 12 (1 − η) 2π 2
chapter 1 section 7 in [15]. We shall construct the solution   z 
in the general case by an approximation procedure. Take a Further, noting that N − 4κ1 ln A
 1/2 for z
A
standard mollifier ρ ε (x, τ ), that is, a function satisfying yields (iii). 


ρ ε  0, ρ ε ∈ C0∞ , suppρ ε ⊂ Bε (0),

 (73) Proof of lemma 8. One may follow the lines of the argument
ρ ε = 1, ρ ε → δ(x, τ ). above, with

 1 1
Define σ̃ (x, −τ ) = σ (x, τ ) for all τ  0 and set for all ε > 0 
 if z
0
 1 + η 4κ

σ ε = ρ ε ∗ σ̃ . By (7) clearly σ ε ∈ C α,α/2 (T ) for all α ∈ (0, 1). 

 1    
1 −1
For each ε > 0 by theorem 12 chapter 1 section 7 in [15] 1
ψ(z) = 1− N 1−

 1 + η   4κ
there exists a unique solution to the approximate problem  4κ

  

 z 1
vτε − 21 (σ ε )2 (x, τ )(vxx
ε
− vxε ) = 0 in T  × ln + z0 (κ) + if z > 0,
(74) A 4κ
ε x
v (x, 0) = (e − 1)+   (78)
where z0 (κ) solves 1 − 4κ1 N (z0 (κ)) = 4κ1 . 

2,1,p
in the class Wloc (T ) ∩ {w|∃C, β > 0 ∀(x, τ ) ∈ T
|w(x, τ )|
Ceβ|x| }. (Note that, by classical Schauder
2

estimates [15], v ε together with its first time derivative and

second space derivative lie actually in a local Hölder space.)
Applying the maximum principle (lemma 4), we have
0
v ε (x, τ )
ex
in T . Since the σ ε are uniformly continuous, uniformly
in ε, by [30] and (75) we have uniform interior estimates
2,1,p
in Wloc (T ). To see this, note that (75) together with
the initial condition control the boundary terms. Hence v ε
converges locally uniformly to v, viscosity solution to the
2,1,p
limiting equation. By [30] again v ∈ Wloc (T ) and satisfies
the limiting equation pointwise a.e. (strong solution).
Now from (75) clearly 0
v(x, τ )
ex , which implies
0 < v(x, τ ) < ex by the strong maximum principle (see [15]).
Let us next take the notation zε = vτε and observe that it satisfies
1 ε 2 σε
zτε = ε
(σ ) (x, τ )(zxx − zε ) + 2 τε (x, τ )zε
2 σ
ε appliquées à la finance et aux jeux différentiels PhD
z (x, 0) = 1
2
(σ ε )2 (0, 0)δ(x),
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