Extensions of Dupire Formula: Stochastic Interest Rates and Stochastic Local Volatility

DOI10.1137/21M1390906MaRDI QIDQ6159078zbMATH OpenOpenAlexFDO

Authors Orcan Ögetbil, Bernhard Hientzsch

Publication date 1 June 2023

Published in SIAM Journal on Financial Mathematics (Search for Journal in Brave)

Full work available at URL https://arxiv.org/abs/2005.05530

zbMATH Keywords

dupire equationlocal volatilitystochastic local volatilitystochastic rates

Mathematics Subject Classification ID

PDEs in connection with game theory, economics, social and behavioral sciences (35Q91) Derivative securities (option pricing, hedging, etc.) (91G20) Interest rates, asset pricing, etc. (stochastic models) (91G30)

Abstract: We derive generalizations of Dupire formula to the cases of general stochastic drift and/or stochastic local volatility. First, we handle a case in which the drift is given as difference of two stochastic short rates. Such a setting is natural in foreign exchange context where the short rates correspond to the short rates of the two currencies, equity single-currency context with stochastic dividend yield, or commodity context with stochastic convenience yield. We present the formula both in a call surface formulation as well as total implied variance formulation where the latter avoids calendar spread arbitrage by construction. We provide derivations for the case where both short rates are given as single factor processes and present the limits for a single stochastic rate or all deterministic short rates. The limits agree with published results. Then we derive a formulation that allows a more general stochastic drift and diffusion including one or more stochastic local volatility terms. In the general setting, our derivation allows the computation and calibration of the leverage function for stochastic local volatility models. Despite being implicit, the generalized Dupire formulae can be used numerically in a fixed-point iterative scheme.

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Cites work

• A forward equation for barrier options under the Brunick \& Shreve Markovian projection
• A theory of the term structure of interest rates
• Arbitrage-free smoothing of the implied volatility surface
• Arbitrage-free SVI volatility surfaces
• scientific article; zbMATH DE number 3059227 (Why is no real title available?)
• Jump-diffusion processes: volatility smile fitting and numerical methods for option pricing
• Markov interest rate models
• Mimicking the one-dimensional marginal distributions of processes having an Ito differential

Cited in

(5)

• Expectation of local times and the Dupire formula
• Stochastic flow approach to Dupire's formula
• Application of Itô processes and Schwartz distributions to local volatility for Margrabe options
• Calibration and option pricing with stochastic volatility and double exponential jumps
• Dupire-like identities for complex options

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