Fokker-Plank:

The Langevin equation is a path-wise equation for a particle. 

Is driven by a particular realization of a noise term, a longer path. 

But for some problems this formulation is not the most convenient one and 
instead a probabilistic description of a system is preferred.

the Langevin equation and this transition leads to another famous differential equation. 
This time it's a partial differential equation or 
PDE known as the Fokker-Planck equation. 
In finance it's also sometimes called the forward Kolmogorov equation. 

It describes the probability for a particle or 

a system of particles or any other stochastic system to 
be in state x at time t given that it 
was at some other state x not at previous time t not. 

So in this equation where the time derivative of the probability density p of x, 
and in the right hand side we have two derivatives terms. 
The d term contains the derivatives for the potential u prime and 
the second diffusion term is 
a second derivative term that depends on the volatility function sigma of x. 

the Fokker-Planck equation is 

a second-order partial differential equation and it 
should be supplemented by boundary conditions, 
in addition to an initial condition. 
 The most interesting boundary is the boundary at zero. 
If the stock price touches this point it stops moving. 

Local Volatility in General

Exotic equity derivatives usually require a more sophisticated model than the BS model.
The most popular alternative model is a local volatility model (LocVol)

LocVol models try to stay close to the BS model by introducing more flexibility into the
volatility. 

LocVol model describes the instantaneous volatility of a stock, whereas BS is the

average of the instantaneous volatilities between spot and strike.

Instantaneous volatility is the volatility of an underlying at any given local point, which we
shall call the local volatility

There are many paths from spot to strike and, depending on which path is taken, they will
determine how volatile the underlying is during the life of the option. 
Black-Scholes Implied Volatility is
Underlying average volatility of all paths
between spot and strike.
Price

Strike

Spot

Expiry
http://www.frouah.com/finance%20notes/Dupire%20Local%20Volatility.pdf

The Derivation of Local Volatility is outlined in many papers and text books. But, there are various
ways we can derive local volatility which is outlined below.

1. The Dupire equation in its most general form that uses the Fokker-Planck equation:

Solving for local variance we obtain.

If we set the risk-free rate rT and the dividend yield qT each equal to zero.

2. The derivation by Derman of local volatility as a conditional expectation.

3. Local volatility as a function of Black-Scholes implied volatility,

The underlying St follows the process:

Discount Factor P(t,T):

Fokker-Planck equation Denote by f (St; t) the probability density function of the underlying price St
at time t. Then f satisfies the equation.

Time t Price of the European call with strike K, denoted C = C (St, K)

Glimpse of Derivation of Dupire Equation and where to use Fokker Plank:

First derivative with respect to strike:

Second derivative with respect to strike:

First derivative with respect to maturity using chain rule:

In above equation where we have partial derivative with respect to time which is function of spot
and time we will use Fokker plank equation.

Finally solving all the above derivation we come to conclusion for local volatility equation of the form
mentioned below.

http://sp-finance.e-monsite.com/medias/images/local-volatility-graph.png

http://www.columbia.edu/~mh2078/ContinuousFE/LocalStochasticJumps.pdf

http://www.frouah.com/finance%20notes/Dupire%20Local%20Volatility.pdf