From Implied Volatility to Local Volatility

Copyright Changwei Xiong 2010

November 2010
last update: July 26, 2013

TABLE OF CONTENTS

1.

Kolmogorov Forward and Backward Equations..................................................................................2

1.1.

The Markov Property ....................................................................................................................2

1.2.

One-dimensional Kolmogorov Backward Equation .....................................................................3

1.3.

One-dimensional Kolmogorov Forward Equation ........................................................................4

1.4.

Multi-dimensional Kolmogorov Forward Equation ......................................................................5

2.

Dupire Equation for Local Volatility ...................................................................................................8

3.

Application to Black-Scholes Implied Volatility ............................................................................... 11

4.

Equivalence of Local Volatility Formulas .........................................................................................16

REFERENCES ..........................................................................................................................................18

 Changwei Xiong 2010

http://www.cs.utah.edu/~cxiong/

This note at first derives the Kolmogorov forward and backward equations, and then summarizes
the Dupire equation for local volatilities and its application to Black-Scholes model [1].
1.

Kolmogorov Forward and Backward Equations

1.1.

The Markov Property

Consider a spot process following a stochastic differential equation (SDE)

= , + ,

(1)

, = ,

(2)

And let be a Borel-measurable function of variable only. Denote by

the expectation of , where is the solution of (1) with initial condition at time . Equation (2) can
also be written as

, =

(3)

Because

= ,

and

= ,

then for 0 , we must have

, = = = ,

(4)

(5)

is a martingale, based on Iterated Conditioning Expectation Theorem (i.e. If holds less information
than , then [[|]|] = [|]). Therefore the dynamics of the ,
=

1 2
+
+

2 2

,
2

= + ,
+
+ ,

must have a vanishing -term, that is

2

,
2

+ ,
+
=0

2 2

(6)

(7)

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This is the Feynman-Kac Theorem, which relates the SDE (1) to the partial differential equation (7).
If we consider another function
=

(8)

which involves a discount factor = 0

quantity

with a deterministic interest rate process , then the

, = = ,

(9)

in this case is a martingale. We then have

1 2
=
+
+

2 2

,
2

= +
+ ,
+

2 2

with a vanishing -term, which gives the following partial differential equation

1.2.

,
2

+ ,
+
=

2 2

(10)

(11)

One-dimensional Kolmogorov Backward Equation

For 0 , we define ,|, to be the transition probability density of the solution to

the SDE (1), i.e. if we solve the equation with the initial condition = , then the random variable
has a density ,|, in the variable at time . According to (2), we have
, = , = ,

(12)

where the notation , ,|, is used for brevity. The Feynman-Kac Theorem (7) defines that
2

,
2
, + ,
, +
= 0


2 2 ,
2 2
,
, ,
,

+ ,
+
= 0

2 2

(13)

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By the arbitrariness of and assuming , ,

2 2
,
, ,
,
+ ,
+
=0

2 2

and

2
2

are all continuous, we have

(14)

This is (in 1-D) the Kolmogorov Backward Equation. In this equation, the and are held constant, the
and are variables and are called backward variables.
1.3.

One-dimensional Kolmogorov Forward Equation

We begin with SDE (1) and use the same notation , for the transition density. Let be

the solution to the SDE with initial condition = . Firstly we derive the dynamics of
=

1 2

1 2 2

+
, +

,
2
2

2
,

Integrating on both sides of (15) from to , we have

1 2 2

, +

,
,
2

(15)

(16)

Taking expectation on both sides, we get

LHS = , = ,

RHS = ,

1 2 2

,
, +

2 2

= ,

(17)

=0

1
2 2
, + , 2 ,

Differentiating (17) with respect to on both sides, we get

1 , 2 2
,

= , + 2 ,

1 2
, , +

2 2 , ,

(18)

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If we assume and also assume the probability density , and its first derivative
a higher order rate than and

vanishes at

as , we then integrate by parts for the right hand side of (18),

once for the first integral and twice for the second

, ,

+
, , = , , =

=0

and

+
2
,
2 2
2
,

, ,
, ,
2

=0

(19)

2
2
,
,
2 ,
,
=

Plugging (19) into (18), we have

=0

2
,
, , , 1 2 ,

+

= 0
2

By the arbitrariness of , we conclude for any that

2
,
, , , 1 2 ,
+

=0
2

(20)

(21)

This is (in 1-D) the Kolmogorov Forward Equation (i.e. Fokker-Planck Equation). In this equation, the
and are held constant, the and are variables and are called forward variables.
1.4.

Multi-dimensional Kolmogorov Forward Equation

To make it more general, lets consider the following multidimensional stochastic process

+
=

,
,
1

1 11

(22)

or without subscripts for brevity

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= +

(23)

Similarly, we derive the dynamics of , where : in this case is a scalar-valued function of

the vector variable

1
1

+

= + +
=

2
2
1 1

1 1

11

(24)

Where is the Jacobian (i.e. the same as gradient if is a scalar-valued function) and the Hessian

(here subscripts are used to denote indices of vector components)

=
1

and

2
1
=
2

Expanding the expression in (24), we have

=1

=1

=1

1

2

2

(25)

1
2
=
+
+

=
=1

=1 =1

=1

=1

=1

(26)

+
+

=1 =1

where = is the instantaneous variance-covariance of . Integrating on both sides of (26) from

to , we have

=1

=1

1
2

=
+
+

=1

=1 =1

Taking expectation on both sides of (27), we get

LHS = , = ,
and

(27)

(28)

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RHS =

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1
2

+
+ ,

=1
=1 =1
=1
=1

1
,
,
=
+


2

=1

=0

=1 =1

Differentiating (28) with respect to on both sides, we have

,|,

1
2

= ,
+ ,

=1

=1 =1

=1 =1

If we assume and also assume the probability density , and its first derivative
at a higher order rate than and

(29)

1
, +
,
2

=
=1

vanishes

as = 1, , , we can then integrate by parts for the

right hand side of (29), once for the first integral and twice for the second

,
+
, = , =

=0

and

,
2

, =
,

=0

,
2 ,
,|,

=
+

=0

Where

() = ()1 1 +1

(30)

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Plugging the results of (30) into (29), we have

,
,
2 ,
1

=
+

=1

=1 =1

(31)

,
, 1
,
+

= 0

2

=1

=1 =1

By the arbitrariness of , we conclude for any that

,
, 1
2 ,
+

=0

2

=1

(32)

=1 =1

This is the Multi-dimensional Kolmogorov Forward Equation (i.e. Fokker-Planck Equation) [2].
2.

Dupire Equation for Local Volatility

Assume that under the risk neutral measure the spot price of a stock with a deterministic

continuous dividend rate follows a geometric Brownian motion, where the drift = and
is the risk free rate

= + ,

(33)

Assuming a deterministic risk free rate, the vanilla European call option price can be expressed as a
function of maturity time and strike

, = ( )+ ,|, = ( ),|,

where =

(34)

is the continuously compounded discount factor and , |, is the transition

probability density function of the random spot = at time with initial condition = . Take the

first order partial derivative with respect to , note that the is in both the integrand and the integral
limit, to give

 Changwei Xiong 2010

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= ,|, ( ),|, = ,|,

We then derive the second derivative with respect to

2
= ,|,
2

(35)

(36)

which therefore gives the transition probability density function

,|, =

1 2
2

(37)

Equation (37) is also known as Breeden-Litzenberger formula. It is explained as the markets view of
the future stock price distribution density at time .
have

Taking the first derivative of the option price function (34) with respect to maturity time , we

,|,

=
( ),|, + ( )

,|,
= + ( )

(38)

Using the Kolmogorov Forward Equation (21)

2
2 ,|, ,|,
,|, 1 2 ,
=

2
2

(39)

we have

2 ,|, ,|,

1 2 ,
= + ( )

2
2

(40)

For the integral on the right hand side, we can apply the integration by parts formula

( )

,|,

(41)

( ) ,|, |
=
= ,|,
=0

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= ,|,

where ( ) ,|, |
= = 0, given that the probability density ,|, vanishes at a higher order
rate as . Similarly, we have

2
2 ,
2 ,|,
( )

2
2 2
,
2 ,|,
,|,
,

= ( )

(42)

=0

2
= ,
2 ,|,
2
= ,
2 ,|,

Plugging the equations (41) and (42) into (40), we have

1
2
= + ,
2 ,|, + ,|,

(43)

Noting that

,|, = ( ),|, + ,|,

(44)

therefore we have

2
= + ,
2 ,|, +

2

1 2 2 2

= + ,

2
2

1 2 2 2

= ,

2
2

Eventually we reach the Dupire Equation for the local volatility ,

10

(45)

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2
,

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+
+

=
1 2 2

2
2

(46)

Some applications require Dupire Equation to be expressed in terms of the undiscounted option
value
, =

,
= ( )+ ,|,

(47)

Following the same derivation procedure, we have

= ,|,

2
= ,|,
2

(48)

,|,
1 2 2 2

= ( )
= ,

2
2

Therefore, we have the Dupire Equation for , in terms of the ,

2
,

3.

=
1 2 2

2
2

(49)

Application to Black-Scholes Implied Volatility

It is a market standard to quote option prices as implied volatilities. The local volatility formula

(49) can then be rewritten in terms of implied volatilities and its derivatives. Lets first define the
forward price

= ( )

(50)

The undiscounted Black-Scholes option price is then given by

11

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,,, = (+ ) ( )
+ =

ln

,
+
2

and

ln

(51)

where , is the Black-Scholes implied volatility and () denotes the standard normal cumulative
density function.

Now we make a few variable changes to map from (, ) plane to (, ) plane. It should be

noted that in (, ) plane, after the changes of variables, it is the and being orthogonal, the and
are no longer orthogonal. Firstly, we define the log-strike
= ln

(52)

then we can write the corresponding local volatility , and the Black-Scholes implied volatility , in
terms of variable , such that
, = , ,

, = ,

(53)

Finally we make another change of variable

2
= ,

(54)

where is the implied total variance. We define two new functions , and ,, in (, ) plane,
which are equivalent to , and ,,, , respectively, in (, ) plane
, = (, ) = ,
,,

(55)

= , , = ,,,

where by following the formula in Equation (51), we have

,, = [(+ ) ( )]

+ =
+
2

and

12

(56)

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The partial derivatives of , we have derived in (, ) plane can then be expressed by the

corresponding ones in the (, ) plane

, , , ,
,
=
+
=

, , ,
1 ,
=
+
=

=0

2 ,
,
1 ,
1 ,
=
=

2


2
=

(57)

1 ,
1 2 , 2 ,

2
2

1 2 , ,

2 2

Plugging the partial derivatives into the Equation (49), we have the Dupire Equation in terms of , in
the (, ) plane

2
, ,
2 , ,
=

+ ,

2
2

(58)

Now we derive the partial derivatives of in terms of the Black-Scholes option price ,, . In

the (, ) plane, we have

, ,, ,,
=
+

, ,, ,,
=
+

2 ,
,, ,,
=
+

(59)

2 ,, 2 ,, 2 ,,
2 2 ,, ,, 2
=
+
+
+
+
2

2
2
2 ,,
2 ,,
2 2 ,, ,, 2
=
+2
+
+
2

2
2
13

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Plugging the above equations into Equation (58), we have

2
,

+


= 2

2
2 2 2
+
2
+

2 2
2
2

(60)

Now, lets derive the first order partial derivatives of with respect to

(+ ) +
( )
=

+

= (+ )

(+ )

2 3

(+ )

2 3

(61)

where () is the standard normal density function and it is easy to prove that (+ ) = ( ). We

then derive the second order derivative

2
1
1
+
)
)
=

+
+
+
2

2
4 3
=

(+ )
2

1
z

2
2
2 3 4

(62)

1
2
1

+

2

2 2
8

The first order derivative with respect to is given by

= (+ )
( ) ( )

(+ )

( ) +

= ( )

(+ )

and the second order derivative is

14

(63)

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2
1
(+ )

)
)
)
=

(
+

(64)

=
+2

We then derive the cross derivative with respect to and

2
=

(+ )

(+ )

1
2
=
=
(+ )+

2
2

(65)

1

2

The first order derivative with respect to is computed as follows

= [(+ ) ( )]
=

(66)

Plugging all the previous derived derivatives into Equation (60), we have

2
,

+


= 2

2
2 2 2
+
2
+

2 2
2
2

2
,

2
,

1
2
2
1
+2
+2

+

2 +
2
8

2

2

2
+

2
2 +

1
2
1
2
1
2
+2

+
+

2 8
2

2
+

(67)

Eventually we have the local volatility formula for Black-Scholes implied volatility in terms of
variables , and

15

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=
2

1
1 2 1 2
1
+ 2
+

4 16
2 2
4

2
,

4.

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(68)

Equivalence of Local Volatility Formulas

Many literatures present the local volatility , as a function of , and , , that is

2
,

+ 2

2
2
1 + 2+
+ 2 + + 2

2
2 + 2

(69)

where + and are shown in Equation (51). The Equation (69) is actually identical to Equation (68)
and can be derived in a similar manner. Here the equivalence of the two equations is proved as follows.

Note that in the (, ) plane, the and are orthogonal while the and are no longer

orthogonal. The numerator in Equation (68) can be calculated as

( 2 )


=
= 2 + 2
+ = 2 + 2
+

= 2 + 2

Where,

+ 2

(70)

( )
=
=

This is identical to the numerator in Equation (69). For the denominator of Equation (68), we have
( 2 )

=
= 2
= 2

2

2
= 2 + +
=
2
2

2
2

2
= 2 +
+

where,

16

(71)

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( )
=
=

In addition, we have by definition

2

ln +

2 = +
+ =
2

ln

2 =
=
2

+ =

(72)

4 2 2
4

= 2

Therefore the denominator in Equation (68) can be written as

1

1
2
1
2 1 2

+

4 4 2 16
2 2

=1

2
2

1
2
1

2 2 2
2
2

4 4 2 16

+ 2

= 1 + 1

2
2

(73)

+ 2 + 2

2
2
4 2 2
2
= 1 + 2
+

+
+ 2
2
4

2
2
2
= 1 + 2+
+ + + 2

which is identical to the denominator in Equation (69). Therefore the two formulas (68) and (69) are
identical.

17

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REFERENCES
1.

Gatheral, J., The Volatility Surface: A Practitioners Guide, Wiley-Finance, 2006

2.

Clark, I., Foreign Exchange Option Pricing - A Practitioners Guide, Wiley-Finance, 2011, pp.82

18