A new representation of the local volatility surface

Authors

Marianito R. Rodrigo, Instituto Tecnologico Autonomo de MexicoFollow
Rogemar S. Mamon, University of Western Ontario

RIS ID

50890

Publication Details

Rodrigo, M. R. & Mamon, R. S. (2008). A new representation of the local volatility surface. International Journal of Theoretical and Applied Finance, 11 (7), 691-703.

Abstract

In this paper, we address the problem of recovering the local volatility surface from option prices consistent with observed market data. We revisit the implied volatility problem and derive an explicit formula for the implied volatility together with bounds for the call price and its derivative with respect to the strike price. The analysis of the implied volatility problem leads to the development of an ansatz approach, which is employed to obtain a semi-explicit solution of Dupire’s forward equation. This solution, in turn, gives rise to a new expression for the volatility surface in terms of the price of a European call or put. We provide numerical simulations to demonstrate the robustness of our technique and its capability of accurately reproducing the volatility function.