Analytical approximation of the transition density in a local volatility model (Q432231)
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English | Analytical approximation of the transition density in a local volatility model |
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Analytical approximation of the transition density in a local volatility model (English)
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3 July 2012
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The paper is mainly concerned with one-dimensional local volatility market models of the form \[ \text{d}S_t=\mu(t, S_t)\text{d} t+\sigma(t, S_t)S_t\text{d}W_t. \] Exploiting the analytical approximation of function \(\sigma\) the authors obtain an expansion of the transition density \(\Gamma(t, S_0; T, S)\) of \(S\) of the form \[ \Gamma(t, S_0; T, S)\approx \Gamma^0(t, S_0; T, S)+\sum_{n=1}^NJ_{S_0}^n\Gamma^0(t, S_0; T, S), \quad N\geq1, \] where the main term \(\Gamma^0(t, S_0; T, S)\) is the density in a suitable Black-Scholes model, while \(J_{S_0}^n\) is a differential operator containing derivatives w.r.t. \(S_0\). This is the expansion in terms of BS-Greeks. An iterative algorithm for the explicit expressions of the operators \(J_{S_0}^n\) is constructed. This algorithm is straightforward to implement by using a symbolic computation software. The analytical approximation formulae are tested with a Monte-Carlo simulation in the context of one-dimensional local volatility models (standard quadratic and CEV).
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local volatility
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analytical approximation
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heat kernel expansion
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Black-Scholes formula
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transition density
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