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I am implementing my local volatility pricer using the finite difference method in MATLAB. I parametrise the implied volatility surface using the SSVI parametrisation (Gatheral & Jacquier), which allows me to obtain a pretty smooth local volatility surface:

enter image description here

I use Dupire's formula in terms of total implied variance $w(k,T)$, where $k=\log(K/F_{0,T})$ and interpSsviStineman is responsible for interpolating the ATMF total variance curve and return the implied total variance level for any arbitrary $k$ and $T$:

delta_k = 0.0001;
delta_t = 1e-6;
w_k_t = interpSsviStineman(k, t_, ssvi_param_);
w_k_tm = interpSsviStineman(k, t_-delta_t, ssvi_param_);
w_k_tp = interpSsviStineman(k, t_+delta_t, ssvi_param_);
dwdt = (w_k_tp-w_k_tm)/(2*delta_t);
w_km_t = interpSsviStineman(k-delta_k, t_, ssvi_param_);
w_kp_t = interpSsviStineman(k+delta_k, t_, ssvi_param_);
dwdk = (w_kp_t-w_km_t)/(2*delta_k);
d2wdk2 = (w_kp_t+w_km_t-2*w_k_t)/(delta_k^2);
[kg, ~] = ndgrid(k, t_);
local_var = dwdt./(1-kg./w_k_t.*dwdk+1/4*(-1/4-1./w_k_t+...
    kg.^2./w_k_t.^2).*(dwdk).^2 + 1/2*d2wdk2);
local_vol = sqrt(local_var);

To validate my implementation I am repricing the vanilla options that I used to calibrate the volatility surface in the first place. If my implementation were to be correct, I would expect to be able to back out the same implied volatilities used to generate the local volatility surface. This is not the case and I seem to be able to match only the prices of AMTF options while my implementation is overpricing the options in the wings:

enter image description here

I would be grateful for any suggestion that can point me to the mistake.

Cheers!

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    $\begingroup$ Can you show the code, please? $\endgroup$
    – Lisa Ann
    Jul 31, 2020 at 20:53
  • $\begingroup$ Does it work if you set the implied volatility surface flat 10%? How about flat 40%? $\endgroup$
    – Peter A
    Aug 1, 2020 at 8:20
  • $\begingroup$ Yes, both with flat 10% and 40% flat vol I am backing out the same IVs. $\endgroup$
    – ffbzona
    Aug 1, 2020 at 8:49
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    $\begingroup$ Your LV formula seems fine at first sight, maybe a problem in the PDE (which one are you solving) or the solver? Running a quick MC simulation should be enough to determine whether you have a problem in the PDE or the LV surface itself. Do exactly as you would in the BS case (e.g. Euler on log-returns) and just interpolate the instantaneous volatility from the local vol surface. Then price an OTM option and check the result. $\endgroup$
    – Quantuple
    Aug 3, 2020 at 7:09
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    $\begingroup$ Thanks a lot for the suggestion @Quantuple. The MC implementation shows indeed that I have a bug in the PDE solver. $\endgroup$
    – ffbzona
    Aug 3, 2020 at 20:13

1 Answer 1

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The bug I had in my PDE solver was that for approximating the option value at time $t$ in the backwards algorithm, I was sampling the local volatility for the time to expiry $t$ instead of $T-t$.

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