Extreme at-the-money skew in a local volatility model (Q2274223)

The paper deals with the pricing of European vanilla call options, when the underlying stochastic process, modelling the discounted price of an asset \((S_t)_{t\geq 0}\), follows in the risk neutral (pricing) measure a stochastic differential equation with discontinuous volatility \[ dS_t= S_t \sigma(S_t-R) dW_t, \] where \(\sigma(x)\) equals \(\sigma_-\) for negative \(x\) and \(\sigma_+ \) otherwise, \(\sigma_- \neq \sigma_+\). The author provides an analytical formula for the price of an option when the threshold \(R\) equals the initial value \(S_0\) or the strike \(K\). Next he compares his formulas with classical Black-Scholes one and study the implied volatility \(\sigma_{BS}\) as a function of the time to maturity \(t\) and moneyness \(k=\ln (K/S_0)\). Specifically the asymptotic of \(\sigma_{BS}(t,k)\) when \(t\) tends to 0. He shows that for \(S_0=R\) \[ \sqrt{t} \frac{\partial}{\partial k} \sigma_{BS}(t,0) \] has finite limit, when \(t\rightarrow 0^+\). This, as he claims, is ``remarkable close to what is observed'' in the stock market practice.