Local Volatility Calibration with the Markov Chain Approximation

Lo, Chia Chun and Skindilias, Konstantinos (2011) Local Volatility Calibration with the Markov Chain Approximation. Centre for EMEA Banking, Finance and Economics Working Paper Series, 2011 (29). pp. 1-11.

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Abstract

We propose a method for calibrating the local volatility surface that relaxes the computational complexity associated with many models and prices options consistently with the volatility skew. We achieve this under a continuous time semi-closed form solution based on the Markov chain approximation of Kushner (1990). The continuous time Markov chain setting can accommodate a diffusion or a jump-diffusion. We show that under both cases without the use of any regularisation we can accurately price out-of-sample options.

Item Type: Article
Uncontrolled Keywords: Centre for EMEA Banking, Finance and Economics Working Paper Series, Local Volatility, Inverse Problem, Markov chain approximation, Spline estimation
Subjects: 300 Social sciences > 330 Economics
Department: Guildhall School of Business and Law
Depositing User: David Pester
Date Deposited: 22 Apr 2015 08:06
Last Modified: 22 Apr 2015 08:06
URI: http://repository.londonmet.ac.uk/id/eprint/466

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