Dupires Equation

Dupires Equation

In Derman-Kani: dS = dt + (S, t)dZ S And, in their paper, they show how to t the smile. What if we look at the continuous case? How do we know that, given a smile, there is a unique (S, t) that explains it? Dupires equation proves that the smile determines (S, T ).

Dupires Equation

A Markov Process is a process that satises: P(S(s) < a|S(t)t t0 < s) = P(S(s) < a|S(t0 )) So, after we consider the current information the past does not add anything additional. The process S(t) from Derman-Kani is a Markov Process.

Dupires Equation

It is a general fact of Markov Processes that its density p satisfy the Kolmogorov forward equation: p 1 2 ( 2 (S, t)S 2 p) (Sp) = r 2 T 2 S S As we know: C (S0 , K , T ) = e rT

max(s K , 0)p(s)ds
K

By using these two facts we can prove that: 2 (K , T ) = which is Dupires formula.
C C T + rK K 1 2 2C 2 K K 2

Dupires Equation

Sketch of proof: If we take derivatives wrt T in both sides of: C (S0 , K , T ) = e rT we obtain a term containing
p T .

max(s K , 0)p(s)ds
K

We can then use Kolmogorovs forward equation and replace that derivative with derivatives in S. Finally, integration by parts allows us to move the derivatives from S to K .

Dupires Equation

The importance of Dupires equation is that it implies that under: dS = dt + (S, t)dZ S the smile is uniquely determined. The bad news is that the way to compute the local volatility function involves taking derivatives, which is not a very unstable process and, on top of that, we do not even have a continuum of option prices.

Dupires Equation

A related result that can also be proved says that the square of the local volatility evaluated at (K , T ) is the expected value of the local variance at time T conditioned on the underlying to be at K at time T :

2 (K , T ) = E ( instantaneous variance at time T |ST = K )

Dupires Equation