Extreme ATM skew in a local volatility model with discontinuity: joint density approach
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Publication:6437071
arXiv2305.10849MaRDI QIDQ6437071FDOQ6437071
Authors: Alexander Gairat, Vadim Shcherbakov 
Publication date: 18 May 2023
Abstract: This paper concerns a local volatility model in which volatility takes two possible values, and the specific value depends on whether the underlying price is above or below a given threshold value. The model is known, and a number of results have been obtained for it. In particular, a power law behaviour of the implied volatility skew has been established in the case when the threshold is taken at the money. This result as well as some others have been obtained by techniques based on the Laplace transform. The purpose of this paper is to demonstrate how to obtain similar results by another method. The proposed alternative approach is based on the natural relationship of the model with Skew Brownian motion and consists of the systematic use of the joint distribution of this stochastic process and some of its functionals.
Derivative securities (option pricing, hedging, etc.) (91G20) Brownian motion (60J65) Stochastic ordinary differential equations (aspects of stochastic analysis) (60H10) Financial applications of other theories (91G80)
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