Local Volatility Models - Ankirchner

Option Pricing
Chapter 12 - Local volatility models -

Stefan Ankirchner
University of Bonn
Stefan Ankirchner Option Pricing 1
Agenda
The volatility surface
Local volatility
Dupires formula
Practical note: how to calibrate the loc. volatility function
Further reading:
Chapter 1 in J. Gatheral: The volatility surface, 2006.
B. Dupire: Pricing with a smile. Risk 7, 1994.
Implied vola
Implied vola varies with
dierent strikes
dierent maturities
Recall the volatility smile:
Volatility surface
Volatility surface = graph of the the implied volatility as a
function of t2m and moneyness
Data: Exxon Mobile call prices, CBO on 5/12/2010.
Local volatility and transition densities
Proof of Dupires formula
Denition of local volatility
One way to make model prices consistent with market prices for
Plain Vanilla Options is to assume that the volatility is a function
of time and the underlying price:
dS
t
= rS
t
dt + S
t
(t, S
t
)dW
Q
t
. (1)
Denition: the mapping (t, x) (t, x) is called local volatility
function.
We will see that
European call / put prices uniquely determine the local
volatility function,
our pricing PDEs for American and exotic options remain
almost the same: only the constant vola has to be replaced
with the local volatility function.
Local volatility is determined by European Call Prices
Suppose that the market call prices C(T, K) are known for all
possible expiration dates T > 0 and strike prices K 0. Then the
local volatility function is given by
(T, K) =
_
2
C
T
+ rK
C
K
K
2

2
C
K
2
(2)
Equation (2) is called Dupires formula. For the proof we use the
transition density of the price process S
t
.
Transition probabilities
Let (0, x; T, y) be the probability density of S
T
at y conditional
to S
0
= x. This means that for any nice B R
P
0,x
(S
T
B) =
_
B
(0, x; T, y)dy.
Denition: (0, x; T, y) is called transition density of the process
S
t
.
Notation: In the following we x the initial condition (0, x) and
simply write (T, y) = (0, x; T, y).
Kolmogorov forward equation
Theorem (Kolmogorov forward equation)
Suppose that S
t
satises
dS
t
= rS
t
dt + S
t
(t, S
t
)dW
Q
t
, S
0
= x.
Then the transistion density (T, y) of S
t
satises the PDE
T
(T, y) =

y
(ry(T, y)) +
1
2
2
y
2
_
y
2
2
(T, y)(T, y)
_
.
Remark: The Kolmogorov forward equation is sometimes also
called Fokker-Planck equation.
Option prices
The price of a call option expiring at T and struck at K satises
C(T, K) = e
rT
E
Q
_
(S
T
K)
+
= e
rT
_
R
(y K)
+
(T, y)dy
= e
rT
_

K
(y K)(T, y)dy.
Partial derivatives
C(T, K) = e
rT
_

K
(y K)(T, y)dy
Observe that
T
C(T, K) = rC(T, K)+e
rT
_

K
(y K)

T
(T, y)dy (3)
K
C(T, K) = e
rT
_

K
(T, y)dy (4)
2
K
2
C(T, K) = e
rT
(T, K) (5)
Proof.
With the Kolmogorov forward equation we get
T
C(T, K)
= rC(T, K) + e
rT
_

K
(y K)

T
(T, y)dy
= rC(T, K) e
rT
_

K
(y K)
_

y
(ry(T, y))
1
2
2
y
2
_
y
2
2
(T, y)(T, y)
_
_
dy (6)
Proof of Dupires formula contd
Suppose that
A1) lim
y
(y K)

y
_
y
2
2
(T, y)(T, y)
_
= 0,
A2) lim
y
_
y
2
2
(T, y)(T, y)
_
= 0,
A3) lim
y
(y K)ry(T, y) = 0.
Then we can show
Dupires formula: (T, K) =
_
2
C
T
+rK
C
K
K
2

2
C
K
2
Proof.
Local volatility for pricing
Question: How to price American or exotic options that are not
actively traded?
Derive the local volatility function from standard European
options,
use the local vola function in the pricing PDE for the
American or exotic option considered,
and solve the PDE numerically.
Example: Pricing D&O call with a local volatility model
Assume that
dS
t
= rS
t
dt + S
t
(t, S
t
)dW
Q
t
, S
0
= x.
and that (t, x) has been calibrated from market prices of
standard calls or puts.
Let v(t, x) be the time t D&O call value under the assumption
that it has not been knocked out before t and that S
t
= x. Then
v(t, x) satises the Black-Scholes PDE
v
t
(t, x) + rxv
x
(t, x) +
1
2
2
(t, x)x
2
v
xx
(t, x) rv(t, x) = 0,
with boundary conditions
v(t, L) = 0, 0 t T,
v(T, x) = (x K)
+
, x > L.
time-space parameterization of the local vola function
Local vola from BS implied vola
How to nd the local vola function?
Dupires formula requires market prices for all strikes and
maturities!
In reality we have market prices for only a nite number of Plain
Vanilla Calls.
Idea: Parameterize the local vola function and choose the
parameters such that the model prices for European calls & puts
are as close as possible to the real market prices.
A simple time-space parameterization
A simple parameterization of the local vola function is given by
(t, y) = a
0
+ a
1
y + a
2
y
2
+ a
3
t + a
4
t
2
+ a
5
ty
Let
T
1
T
m
be the maturities of traded calls.
K
i ,1
, . . . , K
i ,n(i )
strikes of traded calls expiring at T
i
,
1 i m.
C(T
i
, K
i ,j
) = market price of the traded call with expiration
T
i
and strike K
i ,j
.
A simple time-space parameterization contd
Assume that the local vola function satises
(t, y) = a
0
+ a
1
y + a
2
y
2
+ a
3
t + a
4
t
2
+ a
5
ty.
For a given set of parameters (a
0
, . . . , a
5
) one can calculate the
model call prices
C
i ,j
= e
rT
i
_

K
i ,j
(y K
i ,j
)(0, x; T
i
, y)dy.
for all 1 i m and 1 j n(i ).
The quadratic distance to the market prices is given by
error(a
0
, a
1
, a
2
, a
3
, a
4
, a
5
) =
m
i =1
n(i )
j =1
(C(T
i
, K
i ,j
)

C
i ,j
)
2
A simple time-space parameterization contd
With a search algorithm one can nd (a
0
, . . . , a
5
) such that
error(a
0
, . . . , a
5
) min
(a
0
,...,a
5
)
error(a
0
, . . . , a
5
).
The local volatility function is then approximately given by
(t, y) = a
0
+ a
1
y + a
2
y
2
+ a
3
t + a
4
t
2
+ a
5
ty.
BS implied vola and local volatility
Notation:
BS
(T, K) = BS implied vola for a call with strike K
and exp. date T
Note that the market call price C(T, K) satises
C(T, K) = BS call(S
0
, K, T,
BS
(T, K), r ).
We will show that the local volatility function (T, K) is uniquely
determined by the BS implied volatility function
BS
(T, K).
Therefore: instead of parameterizing and calibrating the local vola
function directly, one can proceed as follows:
Parameterize the BS implied vola function
Calibrate the BS implied vola function to market prices
Calculate the local vola function from the calibrated BS
implied vola function.
Linking local vola and BS implied vola
Some new variables:
log moneyness y = log
_
K
e
rT
S
0
_
implied total variance w(T, y) = T
2
BS
(T, e
rT
S
0
e
y
)
Lemma
The local volatility function satises
2
(T, e
rT
S
0
e
y
) (7)
=
w
T
(T, y)
1
y
w
w
y
(T, y) +
1
2
2
w
y
2
(T, y) +
1
4
(
1
4

1
w
+
y
2
w
)(
w
y
)
2
(T, y)
Steps in the proof of Equation (7)
a) First write the BS call price as a function of log moneyness and
implied total variance
C
BS
(y, w) := BS call(S
0
, e
rT
S
0
e
y
, T,
_
w
T
, r ).
Observe that
C
BS
(y, w) = S
0
_
(
y
w
+
w
2
) e
y
(
y
w
2
)
_
The partial derivatives of C
BS
satisfy
2
C
BS
w
2
(y, w) =
2
C
BS
yw
(y, w) =
2
C
BS
y
2
(y, w)
C
BS
y
(y, w) =
b) Write the market call price as a function of T and log
moneyness:
C(T, y) := C(T, e
rT
S
0
e
y
).
Dupires formula implies
1
2
2
(T, e
rT
S
0
e
y
)(
C
y
2

C
y
)(T, y) =

C
T
(T, y). (8)
Proof of (8).
c) Observe that by denition we have
C(T, y) = C
BS
(y, w(y, T)).
With this one can rewrite Dupires formula in terms of C
BS
and
then derive (7).
Proof.
Objections to local volatility models
Local volatility models are criticized because:
bad statistical properties:
the local volatility functions change considerably over time.
E.g. parameters usually change from one week to the next
bad prediction properties
See Dumas, Fleming, Whaley. Implied Volatility Functions: Empirical
Tests. Journal of Finance, 6. 1998.
The local volatility model predicts the smile/skew to move in
the opposite direction as the underlying; in reality, both move
in the same direction.
See Hagan, Kumar, Lesniewski, Woodward. Managing Smile Risk.
Wilmott Magazine, 2002.
hedging based on volatility models is inconsistent
ad hoc model; no economic explanation of the local volatility
function

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