# Local Volatility Model Error

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

Cheers!

• Can you show the code, please? – Lisa Ann Jul 31 at 20:53
• Does it work if you set the implied volatility surface flat 10%? How about flat 40%? – Peter A Aug 1 at 8:20
• Yes, both with flat 10% and 40% flat vol I am backing out the same IVs. – ffbzona Aug 1 at 8:49
• 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. – Quantuple Aug 3 at 7:09
• Thanks a lot for the suggestion @Quantuple. The MC implementation shows indeed that I have a bug in the PDE solver. – ffbzona Aug 3 at 20:13

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 $$T-t$$.