The Heat-Kernel Most-Likely-Path Approximation
AbstractIn this article, we derive a new most-likely-path (MLP) approximation for implied volatility in terms of local volatility, based on time-integration of the lowest order term in the heat-kernel expansion. This new approximation formula turns out to be a natural extension of the well-known formula of Berestycki, Busca and Florent. Various other MLP approximations have been suggested in the literature involving different choices of most-likely-path; our work fixes a natural definition of the most-likely-path. We confirm the improved performance of our new approximation relative to existing approximations in an explicit computation using a realistic S&P500 local volatility function.
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Bibliographic InfoArticle provided by World Scientific Publishing Co. Pte. Ltd. in its journal International Journal of Theoretical and Applied Finance.
Volume (Year): 15 (2012)
Issue (Month): 01 ()
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Web page: http://www.worldscinet.com/ijtaf/ijtaf.shtml
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- Stefano De Marco & Peter Friz, 2013. "Varadhan's formula, conditioned diffusions, and local volatilities," Papers 1311.1545, arXiv.org.
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