Analytical approximation of the transition density in a local volatility model (Q432231)

In this work, a model driven by a multidimensional local diffusion (a Feller process which is also an inhomogeneous local diffusion) is studied, and an exact Taylor formula for implied volatility \(\sigma=\sigma(t,x; T,k)\) related to a call option with log-strike \(k\), maturity \(T\) and log-price \(x\) of the underlying asset at time \(t\) is proved. The obtained exact Taylor formula holds in a parabolic region of \((T,k)\) close to expiry and at-the-money, namely \(|x-k|\leq \lambda\sqrt{T-t}\) for an arbitrary \(\lambda>0\). The results are proved under mild conditions and apply to many popular models, including CEV, Heston and SABR, among others. Also, one can use them to study asymptotic behaviour of IV generated by VIX options where vertical limits (with \(T\to t+\) and \(k\) fixed) known in the literature are not sufficient. The main idea is to obtain sharp bounds on the difference between \(\sigma\) (resp. its derivatives \(\partial^q_T\partial^m_k \sigma\)) and a fully explicit approximation \(\bar{\sigma}\) (resp. its derivatives \(\partial^q_T\partial^m_k \bar{\sigma}\)) as \((T,k)\to(t,x)\) within the considered region. Here \(2q+m\leq N\) and \(N\) is the order of approximation. The approximation \(\bar{\sigma}\) was introduced and studied in an earlier paper by \textit{M. Lorig} et al. [Math. Finance 27, No. 3, 926--960 (2017; Zbl 1422.91713)].