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    Opengamma Local Vol - 003

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    Raj
    The document discusses two methods for determining forward rates and local volatility from option prices: 1) The forward rate F(t,T) can be determined as the expected future stock price ST under the T-forward measure, where the numeraire is the zero coupon bond P(t,T). Both F(t,T) and P(t,T) are observable. 2) Dupire's local volatility method uses the Fokker-Planck and Breeden-Litzenberger results to derive a PDE relating the call price C to local volatility σ(T,K). Solving this PDE forward in time gives call prices for all expiries and strikes. Rearranging

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    Opengamma Local Vol - 003

    Uploaded by

    Raj
    37 views1 page
    The document discusses two methods for determining forward rates and local volatility from option prices: 1) The forward rate F(t,T) can be determined as the expected future stock price ST under the T-forward measure, where the numeraire is the zero coupon bond P(t,T). Both F(t,T) and P(t,T) are observable. 2) Dupire's local volatility method uses the Fokker-Planck and Breeden-Litzenberger results to derive a PDE relating the call price C to local volatility σ(T,K). Solving this PDE forward in time gives call prices for all expiries and strikes. Rearranging

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    275742924-Opengamma-Local-Vol_003

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    The document discusses two methods for determining forward rates and local volatility from option prices: 1) The forward rate F(t,T) can be determined as the expected future stock price ST under the T-forward measure, where the numeraire is the zero coupon bond P(t,T). Both F(t,T) and P(t,T) are observable. 2) Dupire's local volatility method uses the Fokker-Planck and Breeden-Litzenberger results to derive a PDE relating the call price C to local volatility σ(T,K). Solving this PDE forward in time gives call prices for all expiries and strikes. Rearranging

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    37 views1 page

    Opengamma Local Vol - 003

    Uploaded by

    Raj
    The document discusses two methods for determining forward rates and local volatility from option prices: 1) The forward rate F(t,T) can be determined as the expected future stock price ST under the T-forward measure, where the numeraire is the zero coupon bond P(t,T). Both F(t,T) and P(t,T) are observable. 2) Dupire's local volatility method uses the Fokker-Planck and Breeden-Litzenberger results to derive a PDE relating the call price C to local volatility σ(T,K). Solving this PDE forward in time gives call prices for all expiries and strikes. Rearranging

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    The forward can be identified as

    F (t, T ) = ET [ST |Ft ] (7)

    where the expectation is under the T-forward measure - i.e. the numeraire is the zero coupon
    bond P (t, T ). The option price is Vt = P (t, T )V¯t , and both F (t, T ) and P (t, T ) are market
    observables (at time t for a range of T ) in many markets. By this transformation, any reference
    to the (generally) unobserved r and q is removed.

    2 Dupire Local Volatility


    Using the Fokker-Planck result that for a SDE

    dxt = a(t, xt )dt + b(t, xt )dWt (8)

    the transition probability, p(T, xT ) ≡ p(T, xT ; t, xt ),3 is governed by the PDE

    ∂p(T, x) ∂[a(T, x)p(T, x)] 1 ∂ 2 [b2 (T, x)p(T, x)]


    =− + (9)
    ∂t ∂x 2 ∂x2
    together with the Breeden-Litzenberger result that

    2
    ∂ C(t, S ; T, K)
    p(T, x; t, st ) = er(T −t)
    t
    (10)
    ∂K 2
    K=x

    where C(·) denotes a call option, leads to the forward PDE

    ∂C 1 ∂2C ∂C
    = σ 2 (K, T )K 2 − (r − q)K − qC (11)
    ∂T 2 ∂K 2 ∂K
    In this equation, the state variables are expiry, T , and strike, K. Numerically solving the PDE
    forward in time, T , with the initial condition is C(t, St ; t, K) = (St − K)+ , will give call prices for
    all expiries and strikes (within the chosen boundaries). Dupire [Dup94] rearranged this equation
    to:
    √
    ∂C
    + (r − q)K ∂K ∂C
    + qC
    σ(T, K) = 2 ∂T ∂ 2C (12)
    K 2 ∂K 2
    which, given a continuous, twice-differentiable in strike and once in time, surface of call options
    prices, will give a unique local volatility. A real market will only have a finite number of (liquid)
    option prices. Direct interpolation of market prices is difficult since calendar arbitrage (i.e.
    ∂2C
    ∂T + (r − q)K ∂K + qC < 0) and strike arbitrage (i.e. ∂K 2 < 0) must be avoided. Even if these
    ∂C ∂C

    conditions are met, finding local volatility this way is dangerous, not least because for OTM
    options, the derivatives will be with respect to very small prices (and thus in turn produce small,
    possibly inaccurate numbers), leading to a division of one very small number by another. Since it
    3 the probability of going from xt at time t to xT at time T ≥ t

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