E4718 Spring 2008: Derman: Lecture 8:Local Volatility Models: Implications Page 1 of 19

Lecture 8: Local Volatility Models: Implications

• Practical calibration of local volatility models

Copyright Emanuel Derman 2008
• Implied trinomial trees

• Implications:

The deltas of standard options.

The values of exotic options: barriers, lookbacks, etc.

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8.1 Practical Calibration of Local Vol Models

In practice we are given implied volatilities Σ ( K i, T i ) over a range of discrete
strikes and expirations, and must calibrate a smooth local volatility function to
Copyright Emanuel Derman 2008
these discretely specified values. Earlier we mentioned that this is an ill-posed
problem, and finding methods to solve it are critically important to the practi-
cal use of local volatility models. To use Dupire’s equation, we need a smooth
implied volatility surface that is at least twice differentiable. We must therefore
create a smooth implied volatility surface.

The most straightforward way to do this is to write down a smooth parametric

form for the implied volatilities, and then compute the parameters that mini-
mize the distance between computed and observed standard options prices.
One can then calculate the local volatilities by taking the appropriate deriva-
tives of the implieds. One difficulty with this method is how to determine a
realistic form of the parametrization, particularly on the wings where prices are
hard to obtain. Wilmott’s book has one parametrization.There are a variety of
other papers on this topic, some of them mentioned in Chapter 4 of Fengler’s
book.

The method illustrated here will be semi parametric. The idea is to smooth the
variations in market implied volatilities by averaging the data in a series of
small contiguous and overlapping regions using a parametric smoothing func-
tion. One can again determine the resultant local volatilities from the theoreti-
cal relation between smooth differentiable implieds and their derivatives. Here
is an example.

n
Let { x i, y i } i=1 represent the discrete implied volatility data for a given expi-
ration, where x i is the moneyness, i.e. strike/spot for each option, and y i is the
corresponding implied volatility. The aim is to find a smoothed regression

yi = m ( xi ) + εi Eq.8.1

where m ( x ) is a smooth function with second derivatives. and ε i is the error.

We then estimate m ( x ) by writing

m(x) = ∑ wi, n ( x )yi Eq.8.2

i=1

where w i, n are n weight functions that sum to 1, and each w i, n peaks around
the corresponding moneyness x i so as to give higher weight to volatilities y i

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E4718 Spring 2008: Derman: Lecture 8:Local Volatility Models: Implications Page 3 of 19

closer to the moneyness x i that corresponds to a particular y i . Any argument x

n
in the function m ( x ) gets a contribution from all { x i, y i } i = 1, with the great-
est contribution coming from those x i closest to x .
Copyright Emanuel Derman 2008
As an example, we can choose

Kh ( x – xi )
w i, n ( x ) = ---------------------------------
n
- Eq.8.3

∑ Kh ( x – xi )
i=1

where K h ( u ) is a function that peaks around zero with a degree of peaking

determined by h . One example is the Gaussian with standard deviation h,

1 1 –u 2 ⁄ 2h 2
K h ( u ) = --- ----------e Eq.8.4
h 2π

a function which integrates to 1. Small h produces greater localization of the

smoothing, As h → 0 , all smoothing vanishes and the function is defined only
at the observed moneyness values. The greater the number of observed implied
volatilities n , the greater the density of information, and so the more informa-
tion there is in a small region around the moneyness x , and so one can choose
a smaller h and still obtain smoothing.

One can show that this Nadaraya-Watson estimator for m ( x ) converges to the
true regression function as h → 0 and n → ∞ with their product kept finite.
One can also show that minimizing the weighted squares of the differences
between the observed volatilities and the estimated volatilities, where the
weights are given by Equation 8.4, leads to the solution Equation 8.3. Fengler
discuss how to choose the K h ( u ) so as to minimize the bias between the true
regression and the smoothed estimator while avoiding the oversmoothing that
makes the estimator function follow every wiggle in the data.

Fengler’s Chapter 4 provides much more information on this method.

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8.2 Trinomial Trees with Constant Volatility

Trinomial trees provide another discrete representation of stock price move-
ment, analogous to binomial trees1. Their advantage is a greater flexibility in
the description of the implied stochastic process for the stock price in discrete
Copyright Emanuel Derman 2008
steps, so that one can avoid arbitrage violations more easily.

Both trinomial and binomial trees are simple discrete methods of solving the
partial differential equation for the options valuation model. An initial refer-
ence on trinomial trees is the paper by Derman, Kani and Chriss, Implied Tri-
nomial Trees of the Volatility Smile, Journal of Derivatives, 3(4) (1996) pp 7-
22; a version of this is on my web site, and the appendix of that paper has
describes the construction and calibration of trinomial trees. Some of the notes
below are taken from there. Other references are the book by Clewlow and
Strickland, and the book by Espen Haug. Rebonato’s book also has some mate-
rial on this.

Binomial and trinomial trees are merely special instances of more general
methods of solving partial differential equations, some of which may be much
more efficient. Wilmott has a thorough and more general discussion of these
methods.

We want to model the risk-neutral process

2
dS σ
------ = rdt + σdZ or d ln S = ⎛ r – ------⎞ dt + σdZ .
S ⎝ 2⎠

Figure 8.1 below illustrates a single time step in a trinomial tree.

The stock price at the beginning of the time step is S. During this time step the
stock price can move to one of three nodes: with probability p to the up node,
value Su; with probability q to the down node, value Sd; and with probability
1 – p – q to the middle node, value Sm. At the end of the time step, there are
five unknown parameters: the two probabilities p and q, and the three node
prices Su, Sm and Sd.

There are two conditions – on the mean and the variance of the process – that
must be satisfied in order for the tree to represent geometric Brownian motion
in the continuum limit. First, for a risk-neutral trinomial tree, as in the bino-
mial case, the expected value of the stock at the end of the period must be its
forward price F = Se ( r – δ )Δt , where δ is the dividend yield. Therefore:

1.Both trinomial and binomial trees approach the same continuous time theory as the number of periods
in each is allowed to grow without limit. Nevertheless, one kind of tree may sometimes be more conve-
nient than another when you are working in discrete time, before you reach the continuous limit.

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E4718 Spring 2008: Derman: Lecture 8:Local Volatility Models: Implications Page 5 of 19

FIGURE 8.1. In a single time step of a trinomial tree the stock price can
move to one of three possible future values, each with its respective
probability. The three transition probabilities sum to one.
Copyright Emanuel Derman 2008
o Su
p

1-p-q
S o o Sm
q

o Sd

pS u + qS d + ( 1 – p – q )S m = F Eq.8.5

Second, if the stock price volatility during this time period is σ , then the node
prices and transition probabilities must produce the appropriate variance, so
that

2 2
p ( S u – F ) 2 + q ( S d – F ) 2 + ( 1 – p – q ) ( S m – F ) 2 = S σ 2 Δt + O ( Δt ) Eq.8.6

2
where O ( Δt ) denotes terms of higher order than Δt which vanish more rap-
idly as we approach the continuum limit. Different discretizations of risk-neu-
tral trinomial trees have different higher order terms in Equation 8.6. They all
become negligible in the continuum limit.

Because there are two constraints on five parameters in the tree, one has much
more flexibility in building the tree. In contrast, in the binomial case, the mean
and variance conditions determined the location of the nodes and the risk-neu-
tral probability with no flexibility in avoiding arbitrage violations.

Figure 8.2 below illustrates two methods of combining binomial trees to pro-
duce a trinomial tree.

Because trinomial trees are more general there are more ways to build them.
Figure 8.3 illustrates a trinomial tree for the ln S that’s chosen to be more sym-
metric. Because of the symmetry, we have to solve only for ε and q in order to
match the mean and variance of ln S ⁄ S 0 over time Δt. To make the tree even
2
σ
simpler, we choose m = ⎛ r – ------⎞ Δt so that the central node always coincides
⎝ 2⎠

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E4718 Spring 2008: Derman: Lecture 8:Local Volatility Models: Implications Page 6 of 19

FIGURE 8.2. Two equivalent methods for building constant volatility

trinomial trees with spacing Δτ. (a) Combining two steps of a CRR
binomial tree with a spacing of Δτ/2. (b) Combining two steps of a JR
binomial tree with spacing Δτ/2.
Copyright Emanuel Derman 2008
(a) Combining two steps of (b) Combining two steps of
a Cox-Ross-Rubinstein binomial tree a Jarrow-Rudd binomial tree

Su = Se σ 2Δt Su = Se ( r – σ 2 ⁄ 2 )Δt + σ 2 Δt

Sm = S
Sm = Se ( r – σ 2 ⁄ 2 )Δt
Sd = Se – σ 2Δt
2 ⁄ 2 )Δt – σ 2 Δt
2 Sd = Se ( r – σ
⎛ e rΔt ⁄ 2 – e – σ Δt ⁄ 2 ⎞
p = ⎜ ----------------------------------------------
-⎟
⎝ e σ Δt ⁄ 2 – e – σ Δt ⁄ 2⎠
p = 1/4
2
⎛ e σ Δt ⁄ 2 – e rΔt ⁄ 2 ⎞
q = ⎜ ----------------------------------------------
-⎟ q = 1/4
⎝ e σ Δt ⁄ 2 – e – σ Δt ⁄ 2⎠

Su
Su

S
p p Sm
Sm S
q q
Sd Sd

FIGURE 8.3. In a single time step of a trinomial tree the stock price can
move to one of three possible future values, each with its respective
probability. The three transition probabilities sum to one. We draw the log of
the stock price here.

ln(S/S0) o m+ε
(1-q)/2

q
0 o o m

(1-q)/2

o m-ε
Δt

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E4718 Spring 2008: Derman: Lecture 8:Local Volatility Models: Implications Page 7 of 19

with the expected value of ln S ⁄ S 0 and we also choose the probabilities to be

symmetric about the center.

The expected value of the log term is then exactly m, since the probabilities are
Copyright Emanuel Derman 2008
symmetric. To get the variance of returns right we must have

2 2
( 1 – q )ε ≈ σ Δt

or

Δt
ε = σ ------------ Eq.8.7
1–q

It’s often convenient to choose q = 2/3. Then the multiplicative factors for the
stock become
2
σ⎞
⎛ r – ----- Δt
⎝ 2⎠
M = e
σ 3Δt Eq.8.8
U = Me
– σ 3Δt
D = Me

This is accurate only to O(Δt), but in the limit as the spacing goes to zero,
higher order terms become negligible.

Figure 8.4 illustrates a risk-neutral trinomial tree with constant volatility.

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FIGURE 8.4. Example of a risk-neutral trinomial tree with constant volatility

Risk-neutral trinomial tree with constant volatility

r continuous 0.1 0.1 0.1 0.1 0.1 0.1
f 1.0101 1.0101 1.0101 1.0101 1.0101 1.0101
Copyright Emanuel Derman 2008
dt 0.1000 0.1000 0.1000 0.1000 0.1000 0.1000
sig 0.2000 0.2000 0.2000 0.2000 0.2000 0.2000
m 1.0080 1.0080 1.0080 1.0080 1.0080 1.0080 exp(r-sig^2/2)dt with prob 2/3
u 1.1247 1.1247 1.1247 1.1247 1.1247 1.1247 m*exp(sig*sqrt(3dt)) with prob 1/6
d 0.9034 0.9034 0.9034 0.9034 0.9034 0.9034 m*exp(-sig*sqrt(3dt)) with prob 1/6

stock 160.0279
142.2810 143.4238
126.5021 127.5182 128.5425
112.4732 113.3766 114.2872 115.2052
100.0000 100.8032 101.6129 102.4290 103.2518
90.3441 91.0697 91.8012 92.5386
81.6206 82.2761 82.9370
73.7394 74.3316
66.6192

pv of stock

142.2810
126.5021 127.5182
112.4732 113.3766 114.2872
100.0000 100.8032 101.6129 102.4290
90.3441 91.0697 91.8012
81.6206 82.2761
73.7394

strike
100.0000 60.0279
call option 43.2760 43.4238
28.4823 28.5132 28.5425 C = [ 1 / 6 ( u p ) + 2 / 3 ( m i d d l e ) + 1 / 6 ( d n ) ] / f
15.9075 15.5599 15.2822 15.2052
7.1968 6.5036 5.6828 4.6552 3.2518
1.6931 1.1223 0.5366 0.0000
0.0885 0.0000 0.0000
0.0000 0.0000
0.0000

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E4718 Spring 2008: Derman: Lecture 8:Local Volatility Models: Implications Page 9 of 19

8.3 Trinomial Trees with Local Volatility σ(S,t)

In dealing with binomial local volatility
trees, we discovered that for finite Δt cal- o Su
ibrating a binomial tree to a variable local p
Copyright Emanuel Derman 2008
volatility sometimes lead to negative
probabilities or violations of the no-arbi- 1-p-q
S o o Sm
trage principle. For trinomial trees, we
will show that the calibration to local vol- q
atilities can be done by adjusting the
probabilities after the stock price nodes
Δt o Sd
are chosen independently, thereby more
easily avoiding negative probabilities.

In the figure at right, the conditions to satisfy are

pS u + ( 1 – p – q )S m + qS d = F
2 2 2 2 2
Eq.8.9
p ( S u – F ) + ( 1 – p – q ) ( S m – F ) + q ( S d – F ) ≈ S σ Δt

To make life easier, we choose S m ≡ F , so the middle node always coincides

with the forward. Then the equations above simplifies to

pS u + qS d = ( p + q )F
2 2 2 2
Eq.8.10
p ( S u – F ) + q ( S d – F ) ≈ S σ Δt

Given the nodes Su and Sd, we can solve for p and q:

2 2
S σ Δt
p = ------------------------------------------
( Su – F ) ( Su – Sd )
Eq.8.11
2 2
S σ Δt
q = ------------------------------------------
( F – Sd ) ( Su – Sd )

We can therefore choose a grid of stock prices in the future that allows us to
determine p’s and q’s that lie strictly between 0 and 1 and still match the cor-
rect forward and variance.

Below are two examples of trees built with different grids and that lead to dif-
ferent probabilities p and q on the tree, but will nevertheless produce the same
options prices in the limit as Δt → 0 . We can first choose the grid and then
determine the probabilities. In the example below we choose stock prices that
lie on an initial grid formed simply by using a CRR stock price generators.

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E4718 Spring 2008: Derman: Lecture 8:Local Volatility Models: Implications Page 10 of 19

We choose U = exp ( σ g 2Δt ) and D = exp ( – σ g 2Δt ) , Note that volatility

σ g (the generator volatility) used to generate the grid is not the true local vol-
atility, but just some constant (convenient, fake, approximately representative
local) volatility used to generate the lattice of prices.
Copyright Emanuel Derman 2008
Here below is a risk-neutral trinomial tree with local volatility
σ ( S ) = 0.1 + ( S ⁄ 100 – 1 ) built on a lattice generated with a 15% CRR vola-
tility of prices.

Risk-neutral trinomial tree with constant volatility

r continuous 0
f 1.0000
dt 0.0100
local sig a+b(S/100 - a 0.1000 b 1.0000
For generation of initial lattice
vol generator
U
0.1500
1.0214 UD=M^2 to close tree
σ ( S ) = 0.1 + ( S ⁄ 100 – 1 )
D 0.9790 U = exp ( σ 2Δt ) = exp ( 0.15 0.02 ) = 1.0214
M 1.0000

stock state space 108.8557

106.5708 106.5708
104.3339 104.3339 104.3339

100.0000
102.1440
100.0000
102.1440
100.0000
102.1440
100.0000
102.1440
100.0000
Jarrow-Rudd generated lattice
97.9010 97.9010 97.9010 97.9010 with 15% volatility
95.8461 95.8461 95.8461
93.8343 93.8343
91.8647

p_up S^2*sig^2*dt/((S_u - F)(S_u - S_d)) 1-p-q

0.3019 0.3898
0.2259 0.2259 0.5434 0.5434
0.1621 0.1621 0.1621 0.6723 0.6723 0.6723
0.1099 0.1099 0.1099 0.1099 0.7778 0.7778 0.7778 0.7778
0.0686 0.0686 0.0686 0.8613 0.8613 0.8613
0.0376 0.0376 0.9241 0.9241
0.0162 0.9673

q_dn S^2*sig^2*dt/((F-S_d)(S_u - S_d))

0.3083
0.2307 0.2307
0.1656 0.1656 0.1656
0.1123 0.1123 0.1123 0.1123
0.0701 0.0701 0.0701
0.0384 0.0384
0.0165

strike
102.0000 6.8557
call option 4.5708 4.5708
2.4103 2.3339 2.3339

0.1955
0.8723
0.1273
0.7004
0.0645
0.4752
0.0158
0.1440
0.0000
discounted call value for strike 102
0.0054 0.0011 0.0000 0.0000
0.0000 0.0000 0.0000
0.0000 0.0000
0.0000

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Below is another risk-neutral trinomial tree built on 20% vol-generating lattice

with local volatility = 0.15 - 0.1(S/100 - 1) and time steps of one year, just as
an example. Of course, for accurate convergence to the continuous time limit,
one needs much smaller time steps.
Copyright Emanuel Derman 2008

Risk-neutral trinomial tree

r continuous 0.04879
f 1.0500
dt 1.0000
local sig a+b(S/100 - a 0.1500 b -0.1000
For generation of initial lattice

σ ( S ) = 0.15 – 0.1 ( S ⁄ 100 – 1 )

vol generator 0.2000
U 1.3932 UD=M^2 to close tree
D 0.7913
M 1.0500

stock state space 376.7949 104.999983

270.4449 283.9671
194.1121 203.8176 214.0085
139.3241 146.2903 153.6048 161.2850
100.0000 105.0000 110.2500 115.7624 121.5505 Jarrow-Rudd generated lattice
79.1320 83.0886
62.6188
87.2430
65.7497
91.6051
69.0371
with 20% volatility
49.5515 52.0290
39.2111

p_up S^2*sig^2*dt/((S_u - F)(S_u - S_d)) 1-p-q

0.0020 0.9953
0.0151 0.0103 0.9648 0.9760
0.0593 0.0521 0.0450 0.8620 0.8789 0.8953
0.1089 0.1018 0.0945 0.0872 0.7466 0.7632 0.7800 0.7971
0.1413 0.1348 0.1282 0.6712 0.6862 0.7017
0.1699 0.1643 0.6046 0.6177
0.1945 0.5475

q_dn S^2*sig^2*dt/((F-S_d)(S_u - S_d))

adjust probabilities
0.0027
0.0201 0.0137
0.0787 0.0691 0.0597
0.1445 0.1350 0.1254 0.1157
0.1875 0.1789 0.1701
0.2255 0.2180
0.2581

strike
102.0000 274.7949
call option 173.3020 181.9671
101.5950 106.6748 112.0085
51.4482 53.8486 56.4619 59.2850
20.5266 20.3209 20.0519 19.7653 19.5505 discounted call value for strike 102
5.3875 4.0986 2.3873 0.0000
0.3864 0.0000 0.0000 is 20.5266
0.0000 0.0000
0.0000

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Here is one more risk-neutral trinomial tree built on a 13% vol-generating lat-
tice: stock prices are different, probabilities are different, but options prices are
about the same, and will be identical as Δt → 0
Risk-neutral trinomial tree
Copyright Emanuel Derman 2008
r continuous 0.04879
f 1.0500
dt 1.0000
local sig a+b(S/100 - a 0.1500 b -0.1000
For generation of initial lattice
vol generator 0.1300 σ ( S ) = 0.15 – 0.1 ( S ⁄ 100 – 1 )
U 1.2619 UD=M^2 to close tree
D 0.8737
M 1.0500

stock state space 253.5906 104.999983

200.9555 211.0032
159.2453 167.2075 175.5679
126.1924 132.5020 139.1271 146.0834 Jarrow-Rudd generated lattice
100.0000 105.0000 110.2500 115.7624 121.5505
87.3665 91.7349 96.3216 101.1376 with 13% volatility
76.3291 80.1456 84.1528
66.6861 70.0204
58.2614

p_up S^2*sig^2*dt/((S_u - F)(S_u - S_d)) 1-p-q

0.0292 0.9356
0.1001 0.0833 0.7796 0.8166
0.1863 0.1678 0.1494 0.5898 0.6306 0.6710
0.2735 0.2555 0.2374 0.2190 0.3979 0.4374 0.4774 0.5178
0.3215 0.3044 0.2870 0.2922 0.3297 0.3680
0.3666 0.3506 0.1929 0.2280
0.4084 0.1008

q_dn S^2*sig^2*dt/((F-S_d)(S_u - S_d)) adjust probabilities

0.0351
0.1203 0.1001
0.2239 0.2017 0.1796
0.3286 0.3071 0.2853 0.2632
0.3863 0.3659 0.3450
0.4406 0.4214
0.4908

strike
102.0000 151.5906
call option 103.8126 109.0032
66.7283 70.0647 73.5679

20.2896
38.4824
19.9541
40.0265
19.5063
41.9842
18.8357
44.0834
19.5505
discounted call value for strike
8.6451 7.1391 5.3443 0.0000 is 20.2896
1.8658 0.0000 0.0000
0.0000 0.0000
0.0000

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Finally, here is a trinomial tree built on a 5% volatility-generating lattice This

generating volatility is too small to properly match or represent the much larger
local volatilities generated by the formula, and so the nodes are not far enough
apart to give probabilities that lie between 0 and 1.This is an illustration of a
lattice that doesn’t work. But, because of the greater number of degrees of free-
Copyright Emanuel Derman 2008
dom in building trinomial trees, one can always find a lattice that doesn’t vio-
late the no-arbitrage principle.

Risk-neutral trinomial tree

r continuous 0.04879
f 1.0500
dt 1.0000
local sig a+b(S/100 - a 0.1500 b -0.1000
For generation of initial lattice

σ ( S ) = 0.15 – 0.1 ( S ⁄ 100 –

vol generator 0.0500
U 1.1269 UD=M^2 to close tree
D 0.9783
M 1.0500

stock state space 161.2850 104.999983

143.1184 150.2743
126.9980 133.3479 140.0153
112.6934 118.3281 124.2444 130.4566
100.0000 105.0000 110.2500 115.7624 121.5505 Jarrow-Rudd generated
97.8318 102.7234
95.7106
107.8595
100.4961
113.2525
105.5209 with 5% volatility
93.6354 98.3171
91.6051

p_up S^2*sig^2*dt/((S_u - F)(S_u - S_d)) 1-p-q

0.9991
1.3232 1.1901 -1.743
1.6489 1.5164 1.3831 -2.4186 -2.143
1.9679 1.8389 1.7081 1.5760 -3.0799 -2.8125 -2.541
2.0252 1.8971 1.7671 -3.1987 -2.933
2.0820 1.9549 -3.316
2.1384

q_dn S^2*sig^2*dt/((F-S_d)(S_u - S_d))

adjust probabilities:
1.4202
1.0723
1.2773
ARBITRAGE
1.7697 1.6275 1.4845 VIOLATIONS
2.1121 1.9736 1.8333 1.6915
2.1736 2.0361 1.8965
2.2346 2.0981
2.2951

strike
102.0000 59.2850
call option 45.9755 48.2743
34.4810 36.2050 38.0153
24.5819 25.8110 27.1016 28.4566
-152.2057 43.7111 17.7329 18.6196 19.5505 discounted call valu
-34.8299 24.4765 10.7166 11.2525
2.6732 10.7124 3.5209 is -152.2057
7.1706 0.0000
0.0000
NONSENSE

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Thus, we have more flexibility in building trinomial trees; we can choose a lat-
tices of stock prices that don’t violate arbitrage, and then adjust the probabili-
ties to match the stochastic process, provided the lattice was reasonable. In
contrast, with binomial trees, we were forced to a definite lattice which some-
times violated the no-arbitrage conditions.
Copyright Emanuel Derman 2008
8.4 Deltas and Exotics in Local Volatility Models
8.4.1 Four rules of thumb for local volatilities in the small
slope at-the-money approximation:
Rule of Thumb 1: The Rule of 2: Local volatility varies with market level
about twice as rapidly as implied volatility varies with strike.

implied volatility
local volatility

vol

strike

Comment: In equity markets with negative skew, the implied volatility for all
strikes and maturities decrease as the market level increases.

Rule of Thumb 2: Relation between sensitivity of implied volatility to spot

and strike. The change in implied volatility of a given option for a change in
market level is about the same as the change in implied volatility for a change
in strike level.
index negative skew
level up
lower volatility
subtree
down higher volatility
subtree

current later time

Σ ( S, K ) ≈ σ 0 – β ( S + K ) + 2βS 0

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E4718 Spring 2008: Derman: Lecture 8:Local Volatility Models: Implications Page 15 of 19

Hedge ratios of standard options in the presence of (negative) skew are there-
fore smaller than Black-Scholes hedge ratios.

Rule of Thumb 3: The correct exposure Δ of an option is approximately

given by the chain rule formula
Copyright Emanuel Derman 2008
Δ = Δ BS + V BS × β Eq.8.12

For example, a one-year S&P option with a B-S hedge ratio of 60% probably
has a true hedge ratio of 50%, because volatility moves down as the market
moves up. Suppose S = 1000.

VBS = 400 dollars; β = -0.0002 vol point per strike pt.: V BS β ∼ 0.1

Black-Scholes tree implied tree

C'u
Cu
constant C
C volatility subtree
subtrees C'd
Cd
subtree

Rule 4. For short times to expiration, the inverse of the implied volatility for a
given strike is the harmonic average of the local volatilities across ln(S) from
spot to strike.

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E4718 Spring 2008: Derman: Lecture 8:Local Volatility Models: Implications Page 16 of 19

8.4.2 Theoretical Value of Barrier Options in Local Vol Models

In this section we illustrate the effect of local volatility models on exotic
options, taking barrier options as an example. Barrier options values are espe-
cially sensitive to the risk-neutral probability of index remaining in the region
Copyright Emanuel Derman 2008
between the strike and the barrier, and hence to the local volatility in this
region. strike and barrier, which depends on the skew:. Here we are going to
calculate their value in local volatility models and try to gain some intuition
about them.

Example 1: An Up-and-Out Call. with Strike 100 and Barrier 110

In the lecture on static hedging, we showed that you can approximately repli-
cate a down and out call by means of a long position in the call itself combined
with a short position in a put whose strike is (logarithmically) reflected through
the barrier. In a flat-volatility world, the value of both of these calls is deter-
mined by the constant Black-Scholes volatility. In a skewed world, however,
each call has an implied volatility which is approximately the average of the
local volatilities between spot and strike.

For an option with strike at 100 and barrier at 110, the reflected strike is
approximately at 120. Thus, in a local volatility model, the approximate value
of the Black-Scholes implied volatility for the up-and-out call is the average of
the local volatilities between 100 and 120.In the figure below, the local volatil-
ity varies between 0.1 and 0.07 in this range, with an average of a about 0.085.
The value of the down and out option in the local volatility model is about 1.1,
which corresponds to a Black-Scholes implied volatility of about 0.09, so this
intuition about averaging works reasonably.

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 E4718 Spring 2008: Derman: Lecture 8:Local Volatility Models: Implications Page 17 of 19

.
Copyright Emanuel Derman 2008
LOCAL VOLATILITY AS A FUNCTION OF SPOT




  
    


 
reflected strike
  "



 


strike
 



            

!
*+ ,!++ ++ 
 barrier
   +++  - 



+  '.+   
+/, #
       "
0 1 23$  $% $" $ 

&$  $ '$    $ 


VALUE OF UP-AND-OUT CALL AS A FUNCTION OF IMPLIED VOLATILITY
(  

The call value in the local volatility model has an implied BS volatility
which is about half the local volatility at strike and reflected strike,
 that is 1/2(0.1 + \0.7) = 0.85

     "'


  
  
  
 
 


) "

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E4718 Spring 2008: Derman: Lecture 8:Local Volatility Models: Implications Page 18 of 19

Example 1. An Up-and Out Call that has no Black-Scholes Implied Volatility

In some cases, the local volatilities can produce options values that cannot be
matched by any Black-Scholes implied volatility. No amount of intuition can
get you the exactly correct value. Consider the case below, with a spot and
Copyright Emanuel Derman 2008
strike at 100, and the barrier at 130, and the skew as shown in Figure 8.5.

FIGURE 8.5. A hypothetical volatility skew for options of any expiration.

We assume a constant riskless discount rate of 5% and a zero dividend
yield. The arrows show the strike (100) and barrier (130) level of the up-
and-out option under consideration.
25.00

20.00
implied volatility

15.00

10.00

5.00
0.00 50.00 100.00 150.00 200.00

strike (% of spot)

We can value the Up-and-Out Call by building an implied tree calibrated to this
skew. The resultant value of the barrier option in this local volatility model is
6.46. What Black-Scholes volatility does this call price correspond to?
No skew: Up-and-Out call value as a function of Black-Scholes
Implied Volatility

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E4718 Spring 2008: Derman: Lecture 8:Local Volatility Models: Implications Page 19 of 19

The maximum Black-Scholes value in a no-skew world is 6.00 corresponding

to a 9.5% implied volatility. This value is smaller than the “correct” value in
the local volatility model. There is NO Black-Scholes implied volatility which
gives the local-volatility “correct” option value.
Copyright Emanuel Derman 2008
The implied volatility that comes closest to it is about 10%. We can understand
this as follows.The slope of the skew is 1 vol pt. per 10 strike points. The rule
of 2 then indicates that the slope of the local volatilities will be about 1 vol pt.
per 5 strike points.

Now, we showed in the previous lecture that you can think of an up-and-out
option with strike 100 and barrier 130 as being replicated by an ordinary call
with strike 100 and a reflected call with strike 160. Therefore, the local volatil-
ity that is relevant to valuation ranges between spot prices 100 and 160 with a
slope of approximately 1 vol pt. per 5 strike points, that is from values of 15%
to 15 – ( 60 ⁄ 5 ) = 3% . The average local volatility in this range is about 9%,
which substantiates the approximate claim the implied volatility is the average
of the local volatilities between spot and strike.

Local volatility models have analogous effects on the values of other exotic
options, moving their values away from Black-Scholes values. Lookback calls
(that pay out the final value of the index less the minimum value of the index
between inception and expiration), for example, have higher deltas in a local
volatility model than they do in Black-Scholes.1

1. Derman, Kamal, Zou: The Local Volatility Surface.

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