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with current European option prices is known as the local volatility func- tion. It is unlikely that Dupire, Derman and Kani ever thought of local volatil-. So by construction, the local volatility model matches the market prices of all European options since the market exhibits a strike-dependent implied volatility. Local Volatility means that the value of the vol depends on time (and spot) The Dupire Local Vol is a “non-parametric” model which means that it does not.

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options – pricing using dupire local volatility model – Quantitative Finance Stack Exchange

By using our site, you acknowledge that you have read and understand our Cookie PolicyPrivacy Policyand our Terms of Service. I am reading about Dupire local volatility model and have a rough idea of the derivation.

But I can’t reconcile the local volatility surface to pricing using geometric brownian motion process. How does my model know that I changed my strike?

If I have a matrix of option prices by strikes and maturities then I should fit some 3D function to this data. I did the latter. If they have exactly the same diffusion, the probability density function will be the same and hence the realized volatility will be exactly the same for all options, but market data differentiate volatility between strike and option price.

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Local volatility

If I have realized volatility different than implied, there is no way I should get the same option prices as the market. Could you guys clarify? Ok guys, I think I understand it now. I performed MC simulation and got the correct numbers.

In fact the pdf will be tlhe same but it will allow to replicate implied vol surface. Thanks for the explanation, it was helpful. The idea behind this is as follows: The payoff of a European contingent claim only depends on the asset price at maturity.

Consequently any two models whose implied probability densities agree for the maturity of interest agree on the prices of all European contingent claims. So by construction, the local volatility model matches the market prices of all European contingent claims without the model dynamics depending on what strike or payoff function you are interested in.

Here is how I understand your first edit: You write that locap there is only one price process, there is one fixed implied standard deviation per maturity.

You then argue that consequently, we can’t replicate the prices of all European options since the market exhibits a strike-dependent implied volatility.

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While your statement is correct, your conclusion is not. By clicking “Post Your Answer”, eupire acknowledge that you have read our updated terms of serviceprivacy policy and cookie policyand that your continued use of the website is subject to these policies. Home Questions Tags Users Unanswered. I’m still not sure if I understand that correctly.

LocalVolatility 5, 3 13 Gordon – thanks I agree. I thought I could get away with it. LocalVolatility I added a comment to my original post.

Could you look at it? Sign up or volatilit in Sign up using Google. Sign up using Facebook. Sign up using Email and Password. Post as a guest Name. Email Required, but never shown. Post Your Answer Discard By clicking “Post Your Answer”, you acknowledge that you have read our updated terms of serviceprivacy policy and cookie policyand that your continued use of the website is subject to these policies.