Business Intelligence

Don't Stay Local - Extrapolation Analytics For Dupire's Local Volatility

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Executive Summary

A robust implementation of a Dupire type local volatility model is an important issue for every option trading floor. Typically, this (inverse) problem is solved in a two step procedure : a smooth parametrization of the implied volatility surface; computation of the local volatility based on the resulting call price surface. Point (i), and in particular how to extrapolate the implied volatility in extreme strike regimes not seen in the market, has been the subject of numerous articles, starting with Lee (Math. Finance, 2004). In the present paper, the authors give direct analytic insights into the asymptotic behavior of local volatility at extreme strikes.

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