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Now suppose we are given an absolute (normal) vol, and the user wants the equivalent log normal (Black) vol. For consistency, we need to invert 1.2a exactly. This should be done using a global Newton method. Let us re-write 1.2a as (1.5) where H( B ) = B f K log f /K 1 +

1 24

H( B ) = N ,

The problem is to nd B when the normal vol N is given. One should start with an initial guess of f K 2 log f /K 2 N 1 1 0.001 (1.6) B N 1 + 24 1 120 log f /K if f K fK K 1 f K 1 + 24 2 N B B if (1.7) K < 0.001 f K 1 + 1 log2 f /K

24

1 120

1 log2 f /K 2 + B

1 4 2 5760 B

Only one, or possibly two, Newton steps will be needed. In the Newton scheme, the derivative can be approximated by f K f K 0 0.001 H ( B ) = , if log f /K K f K 1 0 < 0.001 if H ( B ) = K fK (2.1a) where (2.1b) = user input CEV exponent, 0 1. dR = R

2. Converting CEV vols to absolute or Black volatilities. Another popular skew model is the CEV model:

2.1. Converting between CEV vol and normal vol. To convert the CEV vol into a normal (absolute) vol, one can use (2.2a) N = (1 )(f K) f 1 K 1 1 1+

2 1 22+ log2 f /K 120 2 1 (1) log2 f /K 12

(2 )2 24(f K)1

When f is very near K, or when is very near 1, one needs to replace the formula with one that doesnt have the singularity at = 1 or f = K. To cover both possibilities, we replace the above formula with (2.2b) N = (f K)/2 1+ 1+ 1+

2 1 24 log f /K (1)2 log2 f /K 24

1

2 1 22+ log2 f /K 120 2 1 (1) log2 f /K 12

(2 )2 24(f K)1

To convert the normal vol N into a CEV vol, we should again use a global Newton method, to solve (2.3a) Here, (2.3b) H() = (1 )(f K) f 1 K 1 1 1+

2 1 22+ log2 f /K 120 2 1 (1) log2 f /K 12

2 1 24 log f /K 2 (1) log2 f /K 24

(1)2 log2 f /K 24 2 1 24 log f /K

1 24

1+

(2 ) 2 N fK

As above, the derivative for Newtons method can be taken as (2.5a) (2.5b) H 0 () = (1 )(f K) , f 1 K 1

H 0 () = (f K)/2 .

2.2. Converting CEV vol to log normal vol. To convert the CEV vol to a log normal (Black) vol, one should rst translate it to the normal vol N , and then use the above routine to calculate the Black vol B from the normal vol N . Similarly, to convert the Black vol B to the CEV vol , one uses the above routines to rst translate it to a normal vol N , and then tranlate the normal to the Black vol.

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