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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 ...


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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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For short maturity SPX option chain, the analytic form of the V-shape volatility smile has been fully worked out in my latest paper on SSRN. You can take a look.


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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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This is a result of Ledoit et al Lemma proof in Appendix of http://www.ledoit.net/9-98.pdf


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Local volatility trats volatility as a function of price (St) and time (t), considering volatility constant. It means that you are building a volatility surface depending on price and time. What you are doing is given a certain value of volatility, what will be the price in Xdays long, or viceversa. If you are dong market making with plain vanilla ...


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Instead of just considering a parallel shift of the whole volatility surface, you can decompose the surface into maturities/strikes domains, so called buckets and consider Vega buckets which are sensitivities wrt to bumps of each of these domains. The vol smile is often inter/extra-polated using a model calibrated to market prices, e.g. the SABR model or ...



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