Download This PaperHow to Make Dupire's Local Volatility Work with Jumps
7 Pages Posted: 28 Feb 2013
Date Written: February 22, 2013
Abstract
There are several (mathematical) reasons why Dupire's formula fails in the non-diffusion setting. And yet, in practice, ad-hoc preconditioning of the option data works reasonably well. In this note we attempt to explain why. In particular, we propose a regularization procedure of the option data so that Dupire's local vol diffusion process recreates the correct option prices, even in manifest presence of jumps.
Keywords: Local volatility, Fokker-Planck equation, Levy processes
JEL Classification: G13
Suggested Citation: Suggested Citation
Friz, Peter and Gerhold, Stefan and Yor, Marc, How to Make Dupire's Local Volatility Work with Jumps (February 22, 2013). Available at SSRN: https://ssrn.com/abstract=2224876 or http://dx.doi.org/10.2139/ssrn.2224876
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