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The only problem I see with this approach, which remains completely valid from a theoretical perspective, is the embedded (and probably not accounted for) calibration risk: what if your LV surface does not allow you to correctly reproduce the observed vanilla option prices in the first place? In that case, you'll have lost information in the process and ...


2

It is valid to do that, but if your local volatility surface is calibrated to the same OTM options, then your price will converge to the same answer. A local volatility surface is mainly a way of treating path-dependent options consistently with the option volatility surface. Variance swaps are path dependent on the face of it, but as you note the math ...


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Since $S_T = S_0 + \sigma W_T$, \begin{align*} C &:= E\left((S_T-K)^+ \right)\\ &= E\left((S_0+\sigma W_T-K)^+ \right)\\ &=\int_{\frac{K-S_0}{\sigma \sqrt{T}}}^{\infty}(S_0+\sigma\sqrt{T} x-K) \frac{1}{\sqrt{2\pi}}e^{-\frac{x^2}{2}}dx\\ &=(S_0-K)\Phi\left(\frac{S_0-K}{\sigma \sqrt{T}}\right)+\frac{\sigma\sqrt{T}}{\sqrt{2\pi}}e^{-\frac{(S_0-K)...



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