R∞ R∞ ∂2c

c(K) = e−rT K (x − K)fST (x)dx ⇒ ∂K ∂c

= −e−rT K fST (x)dx ⇒ ∂K 2
=
e−rT fST (K) where fST (x) = the density of ST in x.

Property 2.0.2:
Inqa forward risk neutral world, where dFt = σ(t, Ft )Ft dWt , we have σ(T, K) =
K
1
2 · ∂∂c/∂T (T,K)
2 c/∂x2 (T,K) .

Proof :
Let us denote φ(T, x) the state probability distribution of ST at point x.
∂2
We know the forward equation: ∂φ ∂t
= 12 ∂x 2 2
2 (σ (t, x)x φ) (F)
∂C
R ∞ ∂φ
Then ∂T
= K (x − K) ∂T (T, x)dx = (by using F equation)
1
R ∞ 2 2 00
2 KR
(σ x φ) (x − K)dx = (integrating by parts )
1 ∞ ∂2c
− 2 K (σ 2 x2 φ)0 · 1dx = = 12 σ 2 (T, K)K 2 φ(T, K) = 21 σ 2 (T, K)K 2 ∂x 2 (T, K)

From this we obtain the Dupire’s formula for local volatility expressed
entirely on terms of the market data C(., .).

Methodology of constructing a local volatility model

1. Assemble the data of quoted market prices C(Ti , Kj ) together with

the yield curve and the dividends to build r(t), q(t).
2. Interpolate and extrapolate these prices (or, more likely, the correspond-
ing the Black Scholes implied volatility) to produce a smooth curve C(.,.)
3. Calculate σ(T, FR ) from the above formula and then the corresponding
T
σ̃(T, S) = σ(T, F e− t rs ds )
4. The new price model is St given by dSt = µ(t, St )dt + σ(t, St )St dBt
5. Now we can calculate the prices of other options by finite differences,
Monte Carlo or analytical formulas using the new volatility term structure.

5.2 Option greeks under volatility smile

If V (S, σ(K/S, T )) is the value of a european derivative then we have the
following formulas:

∂σ
(1) ∆smile (K/S, T ) = ∆BS − ν BS · · K
∂(K/S) S 2
∂σ ∂2σ K2
(2) Γsmile (K/S, T ) = ΓBS −vannaBS · ∂(K/S) · SK2 +ν BS · ∂(K/S)2 · S 4 +ν
BS ∂σ
· ∂(K/S) ·

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