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Chapter 1
Equation
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Local volatility model was invented around 1994 in [Dupire (1994)] for the
continuous case and [Derman and Kani (1994a)] for the discrete case in
response to the following problem.
In the celebrated Black-Scholes model, see e.g. [Hull (1997)], the dynam-
ics of the stock price is modeled as a Geometric Brownian motion process
with constant volatility parameter σ
dSt = µSt + σSt dWt , St = S0 . (1.1)
t=0
Here, St is the stock price at the time t, µ is the drift, Wt is the standard
Brownian motion. It can be shown that under the risk-neutral measure Q
the drift becomes µ = r − q, where r, q are the constant interest rate and
continuous dividends functions.
Next, we introduce a notion of the Black-Scholes implied volatility. In
financial mathematics, the implied volatility σBS of an option contract is
that value of the volatility of the underlying instrument which, when input
in an Black-Scholes option pricing model will return a theoretical value
equal to the current market price of the option. The implied volatility shows
what the market implies about the underlying stock volatility in the future.
For instance, the implied volatility is one of six inputs used in a simple
option pricing (Black-Scholes) model, but is the only one that is not directly
observable in the market. The standard way to determine it by knowing the
market price of the contract and the other five parameters, is solving for the
implied volatility by equating the model and market prices of the option
contract. There exist various reasons why traders prefer considering option
positions in term of the implied volatility, rather than the option price itself,
see e.g., [Natenberg (1994)].
The Black-Scholes implied volatility is a useful measure, as it is a market
practice instead of quoting the option premium in the relevant currency,
3
January 3, 2020 20:32 Fitting Local Volatility – 9in x 6in b3761-main page 4
the options are quoted in terms of the Black-Scholes implied volatility. Over
the years, option traders have developed an intuition in this quantity. How-
ever, it can be further generalized by using a similar concept, but replacing
the Black-Scholes framework with another one. For instance, in [Corcuera
et al. (2009)] this is done under a Lévy framework, and, therefore, based on
distributions that match more closely historical returns. Here we don’t con-
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prices of, say European Call and Put options written on this underlying with
the same expiration date T . Then one can compute the Black-Scholes im-
plied volatilities for these options which will be a function of strikes K, and
plot them against the strike price. Thus obtained line is called a volatility
smile if it slopes upward on either end, or volatility skew if it slopes upward
only on the left. The former behavior is typical for the stock options, while
the latter — for the index options.
The important observation is that the volatility smiles should never oc-
cur based on standard Black-Scholes option theory, which normally requires
a completely flat volatility curve. However, the first notable volatility smile
was apparently seen back to 1987 following the stock market crash. Since
that time the topic attracted a lot of attention in the financial industry. As
mentioned in [Derman et al. (2016)], “After the crash, and ever since, equity
index option markets have displayed a volatility smile, an anomaly in bla-
tant disagreement with the Black-Scholes-Merton model. Since then, quants
around the world have labored to extend the model to accommodate this
anomaly”. There exist various books on local and implied volatility with
main focus on modeling, description, understanding, etc. We mentioned
just few of them based on our own preferences, [Derman et al. (2016);
Gatheral (2006); Natenberg (1994); Bossu (2014)], but the reader can also
find numerous references therein.
The existence of the smile forced the quants to move from the simple
Black-Scholes model to more sophisticated ones that would be able to de-
scribe this pattern. The idea of the local volatility model as proposed in
[Dupire (1994); Derman and Kani (1994a)] was as follows. Assuming that
only minimal changes should be applied to the Black-Scholes model, they
proposed to replace the constant volatility σ with that which is a determin-
istic function of St and t. In other words, in this model instead of Eq.(1.31)
January 3, 2020 20:32 Fitting Local Volatility – 9in x 6in b3761-main page 5
we have
Thus, in this model the local volatility is a function of the stock level St
and time t (rather than the constant value) which might be sufficient to
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(2) If yes, that means that we can explain the observed smile by means of
a local volatility process for the stock. Is the explanation meaningful?
Does the stock actually evolve according to an observable local volatility
function? There are many different models that can match the implied
volatility surface, but achieving a match doesn’t mean that model is
“correct.”
(3) What does the local volatility model tell us about the hedge ratios of
vanilla options and the values of exotic options? How do the results
differ from those of the classic Black-Scholes model?
+
P (S, K, T − t) = D(t, T )EQ [(K − ST ) ],
Now the derivative under the integral in Eq.(1.7) can be substituted with
the right hands side of Eq.(1.5) taken at t = T which yields
Z ∞
∂C
+ r(T )C = D(t, T ) (ST − K) (1.7)
∂T K
1 ∂2 2 2
∂
· − [µ(T )ST p(S, ST , T − t)] + [σ ST p(S, ST , T − t)] dST
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∂ST 2 ∂σ 2
1
= D(t, T ) −µ(T )I1 + I2 ,
2
where the short notation I1 , I2 is introduced for the integrals in the second
line of Eq.(1.7). To evaluate these integrals we need two identities.
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h i∞ Z ∞
= (ST − K) ST p(S, ST , T − t) − ST p(S, ST , T − t)dST
K K
Z ∞
1 ∂C
=− ST p(S, ST , T − t)dST = K −C , (1.13)
K D(t, T ) ∂K
where in the last line the result in Eq.(1.10) is used, and also it is assumed
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that
lim (ST − K)ST p(S, ST , T − t) = 0.
ST →∞
In other words, the first and the second moment of the density p(S, ST , T −t)
are finite.
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For I2 we obtain
Z ∞
∂2
I2 = (ST − K) 2 [σ 2 ST2 p(S, ST , T − t)]dST (1.14)
K ∂ST
∂ h 2 2 i∞
= (ST − K) σ ST p(S, ST , T − t)
∂ST K
Z ∞
∂
− [ST p(S, ST , T − t)]dST
K ∂S T
h i∞
= − σ 2 ST2 p(S, ST , T − t) = σ 2 K 2 p(S, K, T − t).
K
2 2
Here σ = σ(K, T ) , and it is assumed that
∂
lim (ST − K) [ST p(S, ST , T − t)] = 0.
ST →∞ ∂ST
Using the Breeden-Litzenberger we finally obtain
σ2 ∂2C
I2 = K2 . (1.15)
D(t, T ) ∂K 2
This equation can also be solved for the local variance σ 2 (K, T ) to obtain
∂C ∂C
+ [(r(T ) − q(T )]K ∂K + q(T )C
σ 2 (K, T ) = ∂T
1 2 ∂2C
. (1.18)
2 K ∂K 2
Using Itö’s lemma at time t = T , one can find that f (ST , t, T ) follows
the process
2
∂f ∂f 1 2 2 ∂ f ∂f
df = + µ(T )ST + σ(T ) ST dT + σ(T )ST dWT .
∂T ∂ST 2 ∂St2 ∂ST
(1.21)
The partial derivatives in this expression could be easily found using the
definition of f in Eq.(1.19):
∂f
= −r(T )D(t, T )(ST − K)+ , (1.22)
∂T (
∂f 1, x ≥ 0
= D(t, T )1ST >K , 1x =
∂ST 0, x < 0
∂2f
= D(t, T )δ(ST − K).
∂ST2
Substituting this into Eq.(1.21) yields
h
df = D(t, T ) − r(T )(ST − K)+ + µ(T )ST 1ST >K (1.23)
1 i
+ σ(T )2 ST2 δ(ST − K) dT + σ(T )ST 1ST >K dWT .
2
The first two terms in parentheses can be re-written as follows
−r(T )(ST − K)+ + µ(T )ST 1ST >K = 1ST >K [−r(T )(ST − K) + µ(T )ST ]
= r(T )K1ST >K − q(T )ST 1ST >K . (1.24)
January 3, 2020 20:32 Fitting Local Volatility – 9in x 6in b3761-main page 10
Since
D(t, T )EQ [ST 1ST >K ] = C + KD(t, T )EQ [1ST >K ],
and
∂C
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This means that the local variance is the risk-neutral expectation of the
instantaneous variance conditional on the final stock price ST being equal
to the strike price K.
In this Section we derive the identity that connects the local and Black-
Scholes implied variances. The identity was introduced in [Lipton (2002);
Gatheral (2006)] and reads
∂T w
σ 2 (T, K) = 2 , (1.30)
(∂y w)2 1 ∂y2 w
y∂y w 1
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1− − + +
2w 4 w 4 2
where y = log K/F , F = Se(r−q)T is the stock forward price, and w = σBS
2
T
is the total implied variance. In terms of these variables the Black-Scholes
formula for the future value of the Call option price becomes, [Gatheral
(2006)]
CBS (FT , y, w) = D(t, T )FT [N (d1 ) − ey N (d2 )] (1.31)
√ √
y w y w
= D(t, T )FT N − √ + − ey N − √ − ,
w 2 w 2
where N (x) is the normal CDF, and
σ2 √
ln FKT + BS T 1
d1 = √2 , d2 = d1 − σBS T . (1.32)
σBS T 2
The Dupire equation Eq.(1.17) can also be re-written in terms of the
new variables. It is easy to check that this yields
2
∂C 1 ∂ C ∂C
= σ2 − − qC. (1.33)
∂T 2 ∂y 2 ∂y
Computing derivatives of the Black-Scholes formula in Eq.(1.31), we
obtain
∂ 2 CBS y2
1 1 ∂CBS
= − − + − , (1.34)
∂w2 8 2w 2w2 ∂w
∂ 2 CBS
1 y ∂CBS
= − ,
∂w∂y 2 w ∂w
∂ 2 CBS ∂CBS ∂CBS
− =2 .
∂y 2 ∂y ∂w
January 3, 2020 20:32 Fitting Local Volatility – 9in x 6in b3761-main page 12
∂y 2 ∂y 2 ∂w∂y ∂y ∂w2 ∂y ∂w ∂y 2
∂C ∂CBS ∂CBS ∂w ∂CBS ∂w
= + = − qCBS .
∂T ∂T ∂w ∂T ∂w ∂T
Substituting these expressions into Eq.(1.33) yields
∂CBS ∂w 1 ∂CBS
= σ2 A, (1.36)
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∂w ∂T 2 ∂w
2
y2 ∂2w
∂w 1 1 ∂w
A=2− + − − + 2
+
∂y 8 2w 2w ∂y ∂y 2
1 ∂y ∂w
+2 − .
2 ∂w ∂y
Taking out a factor ∂C
∂w and simplifying, we finally obtain Eq.(1.30).
BS