is a market standard to quote prices as implied volatility, σimp (T, K), the local volatility formula

can be rewritten in terms of implied volatility and its derivatives:

v
u
u 2
σimp
∂σimp
+ 2σimp T ( ∂T + (r − q)K ∂K
∂σimp
)
σ(T, K) = u
u √
( ( )2 ) (13)
t ∂σimp 2 ∂σimp ∂ 2 σimp
1 + 2d1 K T ∂K + K T d1 d2 ∂K + σimp ∂K 2

Interpolation of the implied volatility surface is discussed in section 3, but first we will refor-
mulate equations 11 and 13 to eliminate r and q.
We define the moneyness, x = K/F (t, T ) and the fractional call price as
C(T, xF (t, T ))
Ĉ(T, x) ≡ (14)
P (t, T )F (t, T )
With these changes of variables, the forward PDE for the fractional call price is

∂ Ĉ 1 ∂ 2 Ĉ
= σ̂(T, x)2 x2 2 (15)
∂T 2 ∂x
and the local volatility is now a function of expiry and moneyness (denoted by the hat symbol).
The relationship between these two local volatility surfaces is trivially
σ(T, K) = σ̂(T, K/F (t, T )) σ̂(T, x) = σ(T, xF (t, T )) (16)
Equation 15 must be solved numerically4 , with initial condition Ĉ(0, x) = (1 − x)+ , lower
boundary condition Ĉ(T, 0) = 1 and upper boundary condition either Ĉ(0, xmax ) = 0 or
∂x |x=xmax = 0, for some xmax ≫ 1. After reversing the change of variables, this gives the call
∂ Ĉ

price across all expiries and strikes (within the set boundaries).
Just as in equation 13, we can rearrange equation 15 to give local volatility in terms of implied
volatility:
v
u
u 2
σ̂imp
∂ σ̂imp
+ 2σ̂imp T ∂T
σ̂(T, x) = u
u √ ∂ σ̂imp
( ( )2 ) (17)
t 2 ∂ σ̂imp ∂ 2 σ̂imp
1 + 2d1 x T ∂x + x T d1 d2 ∂x + σ̂imp ∂x2

The implied volatility, σ̂imp (T, x), is a function of expiry and moneyness, and
− ln(x) + 12 σ 2 τ √
d1 = √ d2 = d1 − σ τ τ =T −t (18)
σ τ
Again, it is trivial to convert between an implied volatility surface parameterised by strike to
one parameterised by moneyness.
Assuming we have obtained a smooth, interpolated, implied volatility surface from market
prices of options on a single underlying, we can then numerically or analytically take derivatives
to obtain the local volatility surface. Armed with this surface we numerically integrate (i.e.
solve) equation 15 once, read off the prices and compare with the market prices. Alternatively,
we can solve equation 6 once for each option. Either way the only discrepancy with the input
market option prices should be due to numerical error.
4 Except in the degenerate case where σ̂ is a function of time only, in which case the RMS volatility can be

plugged straight into the Black formula.