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Asymptotic Expansion for the Normal Implied Volatility in Local Volatility Models

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  • Viorel Costeanu
  • Dan Pirjol

Abstract

We study the dynamics of the normal implied volatility in a local volatility model, using a small-time expansion in powers of maturity T. At leading order in this expansion, the asymptotics of the normal implied volatility is similar, up to a different definition of the moneyness, to that of the log-normal volatility. This relation is preserved also to order O(T) in the small-time expansion, and differences with the log-normal case appear first at O(T^2). The results are illustrated on a few examples of local volatility models with analytical local volatility, finding generally good agreement with exact or numerical solutions. We point out that the asymptotic expansion can fail if applied naively for models with nonanalytical local volatility, for example which have discontinuous derivatives. Using perturbation theory methods, we show that the ATM normal implied volatility for such a model contains a term ~ \sqrt{T}, with a coefficient which is proportional with the jump of the derivative.

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  • Viorel Costeanu & Dan Pirjol, 2011. "Asymptotic Expansion for the Normal Implied Volatility in Local Volatility Models," Papers 1105.3359, arXiv.org.
    • Handle: RePEc:arx:papers:1105.3359
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    References listed on IDEAS

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    1. H. Berestycki & J. Busca & I. Florent, 2002. "Asymptotics and calibration of local volatility models," Quantitative Finance, Taylor & Francis Journals, vol. 2(1), pages 61-69.
    2. Patrick Hagan & Diana Woodward, 1999. "Equivalent Black volatilities," Applied Mathematical Finance, Taylor & Francis Journals, vol. 6(3), pages 147-157.
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    Cited by:

    1. Cyril Grunspan, 2011. "A Note on the Equivalence between the Normal and the Lognormal Implied Volatility : A Model Free Approach," Papers 1112.1782, arXiv.org.
    2. V. M. Belyaev, 2023. "Local Volatility in Interest Rate Models," Papers 2301.13595, arXiv.org, revised Oct 2024.

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