Electronic copy available at: http://ssrn.com/abstract=1493306 Electronic copy available at: http://ssrn.

com/abstract=1493306
CALIBRATION OF LOCAL STOCHASTIC VOLATILITY MODELS
TO MARKET SMILES:
A MONTE-CARLO APPROACH
SHORTER VERSION PUBLISHED IN RISK MAGAZINE, SEPTEMBER 2009.
PIERRE HENRY-LABORD
`
ERE
Abstract. In this paper, we introduce a new technique for calibrating local volatility extensions
of arbitrary multi-factor stochastic volatility models to market smiles. Although approximate,
this technique is both fast and accurate. The procedure is illustrated with the Bergomi variance
curve model and the 2-factor log-normal model.
Introduction
The development of exotic options depending on the dynamics of implied volatilities calls for
multi-factor stochastic volatility models (SVMs) such as the Bergomi variance curve model [3] and
2-factor log-normal SVM [8]. The former, based on the direct modeling of the joint dynamics of
the spot and the implied variance swap volatilities, allows both a perfect t to the VIX market [3]
and an easy MC simulation.
For some products, one would like to calibrate the vanilla smile as well. A common practice in
the Fx market is to embed an SVM within a local volatility model. The calibration of the local
volatility function can be achieved for old-fashioned one-factor SVMs (such as the Heston model)
using a two-dimensional PDE solver of the Fokker-Planck equation as explained in [13]. However,
calibration of multi-factor SVMs requires a three-or more-dimensional PDE solver and therefore
suers from the curse of dimensionality. In this paper, we provide a fast, accurate and easy-
to-implement approximate technique for calibrating the local volatility function of virtually any
multi-factor SVM. Our method relies on three steps: a smooth representation of the local volatility
associated to an SVM, a mapping of an LV-SVM to a simpler SVM and a Monte-Carlo simulation
of the variance process.
An efficient Monte-Carlo method
LV-SVM: A general framework. A local stochastic volatility model (LV-SVM) is dened by
the following SDE for the forward f
t
in the forward measure P
T
df
t
= f
t
(t, f
t
)a
t
(dZ
t
+
_
1
2
dW
t
) (1)
Z
t
and W
t
are two uncorrelated Brownian motions and a
t
is a Ito process. For the sake of simplicity,
we assume that there are no dividends at this stage. We will explain how to include (discrete)
Key words and phrases. Vanilla smile, Bergomis model, 2-factor log-normal model, Malliavins calculus, Mar-
kovian projection.
1
Electronic copy available at: http://ssrn.com/abstract=1493306 Electronic copy available at: http://ssrn.com/abstract=1493306
2 PIERRE HENRY-LABORD
`
ERE
dividends in our calibration procedure in the next section. In the examples we will be looking at,
a
t
will be driven by two independent Brownian motions Z
t
and

Z
t
(orthogonal to W
t
), typically
da
t
= b(a
t
, a
0
t
)dt +(a
t
, a
0
t
)dZ
t
+ (a
t
, a
0
t
)d

Z
t
(2)
with a
0
t
a second Ito process driven by

Z
t
. In order to be able to calibrate exactly the implied
volatility surface, we have decorated the volatility of the forward with a local volatility function
(t, f). In practice, we require (t, f) to be smooth and elliptic (i.e. there exists R

+
such that

1
(t, f) ) in order to ensure that the SDE (1) admits a unique weak solution.
By denition, the eective local volatility is [5]:

loc
(T, f)
2
(T, f)
2
E
P
T
[a
2
T
|f
T
= f] (3)
McKean non-linear SDE. The SDE (1) can be reframed into
df
t
= f
t

mkt
loc
(t, f)
_
E
P
T
[a
2
t
|f
t
= f]
a
t
(dZ
t
+
_
1
2
dB
t
) (4)
This becomes a nonlinear equation in the sense of McKean as the volatility (t, f
t
, a
t
, P
t
) depends
on the probability distribution P
t
of (f
t
, a
t
). An uniqueness and existence theorem for such a SDE
has been obtained by [17, 10] under a Lipschitz condition for the drift and volatility terms with
respect to the Monge-Kantorovich metric:
Theorem ([17, 10]). Let b : R
+
R
n
P
2
(R
n
) R
n
and : R
+
R
n
P
2
(R
n
) R
nd
be
Lipschitz continuous functions for the sum of canonical metric on R
n
and the Monge-Kantorovich
metric d on the set P
2
(R
n
) of probability measures with nite second order moments:
d(, ) = inf
P(R
k
,R
k
) with marginals and
__
R
n
R
n
|x y|
2
(dx, dy)
_1
2
Then the non-linear SDE
dX
t
= b(t, X
t
, P
t
) +(t, X
t
, P
t
)dW
t
, X
0
R
n
where P
s
denotes the probability distribution of X
s
admits an unique solution such that E(sup
tT
|X
t
|
p
) <
for all p 2.
The Monge-Kantorovich metric is related to the pricing of model-independent European multi-
asset option. Note that this Lipschitz condition is not satised by (4) and an uniqueness and
existence for such an equation is not at all obvious.
The right-hand side of (3) is dicult to compute numerically due to the conditional expectation.
In the following, we compute a smooth expression of the eective local volatility for arbitrary LV-
SVMs. While it is interesting that an exact solution exists to the problem of that rather singular
conditional expectation in the LV-SVM case (see appendix A), only the eective local volatility
for arbitrary SVMs (i.e. (T, f) 1) is used in the rest of the paper and is presented below.
Eective local volatility for arbitrary SVMs. In the particular case (t, f) = 1, the general
expression for the eective local volatility as given by equation (25) simplies to [11]

SV
loc
(T, f)
2
=
E
P
T
[a
2
T
e

K
2
2(1
2
)

T
0
a
2
s
ds

T
0
a
2
s
ds
]
E
P
T
[
e

K
2
2(1
2
)

T
0
a
2
s
ds

T
0
a
2
s
ds
]
(5)
CALIBRATION OF LOCAL STOCHASTIC VOLATILITY MODELS 3
with K ln
f
f0
+
1
2
_
T
0
a
2
s
ds
_
T
0
a
s
dZ
s
. Note that this expression only requires the simulation
of the stochastic volatility process a
t
. This expression were already derived in [12] as pointed out
by a referee. Expression (5) can be derived quickly by observing that conditional on the ltration
F
a
generated by the Brownian motions that drive a
t
, f
T
has a log-normal density
1
f

2V
e

(
ln
f
m
+
V
2
)
2
2V
with ln m = ln f
0
+
_
T
0
_
a
t
dZ
t

2
2
a
2
t
dt
_
and V = (1
2
)
_
T
0
a
2
s
ds [16]. However, in the general
case where (t, f) = 1, we do not know the conditional probability density explicitly and we must
rely on the Malliavin calculus as sketched in appendix A.
Next, we present an (approximate) mapping between an LV-SVM and a (simpler) SVM.
Mapping: Markovian projection. Let us dene a local martingale X
t
that is driven by sto-
chastic volatility only and rewrite the SDE of the full dynamics for f
t
under P
T
:
dX
t
= X
t
a
t
dN
t
(6)
df
t
= f
t
(t, f
t
)a
t
dN
t
(7)
where dN
t
dZ
t
+
_
1
2
dW
t
. By denition, we denote
SV
loc
(resp.
LVSV
loc
) the (eective)
local volatility associated to the SVM (resp. LV-SVM) dened by (6) (resp. (7)) and
mkt
loc
(T, f)
the Dupire local volatility that is calibrated using the market vanilla smile. We assume that our
LV-SVM is calibrated to the vanilla smile and therefore we require from [5] that

mkt
loc
(T, f)
2
= (T, f)
2
E
P
T
[a
2
T
|f
T
= f]
Similarly, we have by denition of
SV
loc
(, ):

SV
loc
(T, X)
2
E
P
T
[a
2
T
|X
T
= X]
Proceeding as in the Markovian projection technique [15], we take the ratio of the equations above
and get

mkt
loc
(T, f)
2

SV
loc
(T, X)
2
= (T, f)
2
E
P
T
[a
2
T
|f
T
= f]
E
P
T
[a
2
T
|X
T
= X]
As shown in [15], if we assume that we are able to nd a smooth monotone mapping between f
t
and X
t
, X
t
= H(t, f
t
), we then get:

mkt
loc
(T, f) = (T, f)
SV
loc
(T, H(T, f)) (8)
as f
T
= f X
T
= X. Note that as stated in remark 6.5 in [15], H(, ) depends on the unknown
function (, ) and (8) should be treated as a non-linear functional equation for . However, we
are able to derive an exact solution to this functional equation. This is the purpose of the next
paragraph.
Let us now make this mapping explicit. Without any loss of generality, we take X
0
= f
0
. The
dynamics of X
t
is then given by
dX
t
= f
t

f
H(t, f
t
)(t, f
t
)a
t
dN
t
+
_

t
H(t, f
t
) +
1
2
f
2
t

2
f
H(t, f
t
)(t, f
t
)
2
a
2
t
_
dt (9)
and by assumption, this must equal
H(t, f
t
)a
t
dN
t
4 PIERRE HENRY-LABORD
`
ERE
Volatility term. Identifying the volatility terms, we deduce that
f
f
H(t, f)(t, f) = H(t, f) (10)
Integrating this rst-order ODE, we obtain as in [15]
ln
H(t, f)
(t)
=
_
f
f0
df

(t, f

)
(11)
with (t) an integration constant. From (10), equation (8) is equivalent to
f
f
ln H(T, f) =

SV
loc
(T, H(T, f))

mkt
loc
(T, f)
Finally, using (11) and integrating the equation above, we deduce our nal result
(T, f) =

mkt
loc
(T, f)

SV
loc
_
T,
1
T
_
_
f
f0
dx
x
mkt
loc
(T,x)
__ (12)
with

T
(x) =
_
x
(T)
dy
y
SV
loc
(T, y)
This (nice) formula involves the geodesic distance (i.e. the harmonic average) of the Dupire and
eective local volatilities (i.e.
mkt
loc
and
SV
loc
). As a sanity check, when the local volatility produced
by the SVM matches the market Dupire LV, the solution to the equation above is (t, f) = 1 as
expected. (Here (T) = f
0
see below.)
Drift term: Optimal choice of (). The drift term in (9) is
H(t, f
t
)
_

t
_
ln (t) +
_
f
f0
dy
y(t, y)
_
+
1
2
a
2
t
(1 (f
t
(t, f
t
))

)
_
(13)
where the prime means a derivative with respect to the forward f. The calibration method would
be exact if this drift term (13) were vanishing. Although it does not generally vanish, let us choose
the parameters (t) and E
P
T
[a
2
t
] in order to reduce it. When we replace f by f
0
and a
2
t
by its
conditional average E
P
T
[a
2
t
|f = f
0
] as suggested by Gyongys result, the drift becomes

t
ln (t) +
1
2

SV
loc
(t, f
0
)
2
(1 (t, f
0
) f
0
(t, f
0
)

)
We set (t) such that the above expression vanishes:
ln
(T)
f
0
=
1
2
_
T
0

SV
loc
(t, f
0
)
2
(1 (t, f
0
) f
0
(t, f
0
)

) dt (14)
Furthermore, we impose that the underlying SVM is matched as closely as possible to the market
implied volatility surface. We set the term structure E
P
T
[a
2
t
] in order to exactly match the variance
swap term structure VS
mkt
T
:
E
P
T
[a
2
T
] =
T
_
T.VS
mkt
T
_
This choice is easy to implement if the variance swap term-structure can be computed analytically
(although this quantity can also be computed by MC as we need to simulate the volatility process
in our calibration procedure anyway). This is the case for the examples we look at: the 2-factor
log-normal and Bergomi SVMs.
The nal procedure can be summarised as follows:
CALIBRATION OF LOCAL STOCHASTIC VOLATILITY MODELS 5
Calibration of the local volatility: Final recipe.
(1) Calibrate the volatility function
mkt
loc
(T, f) to the market vanilla smile using the classical
Dupire formula [4].
(2) Simulate the stochastic volatility process {a
t
()} and compute the local volatility
SV
loc
on
a space-time grid using formula (5).
(3) Using relationship (12), calculate the local volatility function (T, f) by setting rst (T) =
f
0
. Repeat this step by using (14) for the computation of () using the (t, f
0
) and

(t, f
0
)
found in the previous step. In our experience, further repetition of this step is not necessary
for achieving convergence.
Note that in the second step, the dynamics of a
t
do not involve local volatility function (t, f))
and that formula (5) is very smooth (in particular not involving any scary Heaviside functions) and
does not require many Monte-Carlo paths to convergence. In practice, we use N = 2
11
paths. The
numerical integrations in the third step are performed using a quadrature method on the interval
[0, 1], and the numerical inversion
1
T
uses a Brent algorithm. The calibration method does not
involve any optimization routine.
As an extension of our algorithm, we sketch in appendix B a new method based on the exact
expression for the eective local volatility associated to an LV-SVM (see appendix A). As illustrated
in this paper, our initial guess is very accurate and therefore we do need to use this iterative
procedure. In the next section, we explain how to include dividends in this framework without any
additional approximation.
Including discrete dividends
Exact mapping. We assume that the spot process S
t
jumps down by the dividend amount
D(t

i
, S

ti
) paid at time t
i
and that between dividend dates {t
i
}
i
it follows an LV-SVM
dS
t
= (r(t)S
t
D
t
) dt +S
t
(t, S
t
)a
t
dN
t
(15)
with D
t
=

i=1
D(t

i
, S

ti
)(t t
i
). Furthermore, we assume that dividends are part cash, part
yield:
D(t, S) = (t)S
0
+(t)S
t
as is commonly used by practitioners [9]. If we set
S
t
= A(t)S
0
+B(t)f
t
(16)
with coecients A(t) and B(t) given by
B(t) = B
0
P
1
0t

i: t>t

i
_
1 (t

i
)
_
(17)
A(t) = P
1
0t

i: t>t

i
_
1 (t

i
)
_
_
_
_A
0

k: t>t

k
(t
k
)P
0t
k

j: t
k
>t

j
_
1 (t

j
)
_
1
_
_
_ (18)
then the Ito process f
t
becomes a local martingale
df
t
= f
t
(t, f
t
)a
t
dN
t
with
(t, S) =
_
t,
S A(t)S
0
B(t)
__
S A(t)S
0
S
_
(19)
6 PIERRE HENRY-LABORD
`
ERE
A(t) and B(t) depend on two arbitrary integration constants A
0
, B
0
that will be set below. Here
P
0t
= e

t
0
r(s)ds
is the discount factor at time t. By working with the variable f
t
, we have removed
the dividends and can apply the results from the rst section. Taking now dividends into account,
formula (12) is replaced by
(T, S) =

mkt
loc
(T, S)

SV
loc
_
T,
1
T
_
_
S
(B(T)+A(T))S0
dx
x
mkt
loc
(T,x)
__
To complete our project, we outline how to calibrate the (market) Dupire local volatility
mkt
loc
(T, S)
when there are dividends.
Exact calibration of the Dupire local volatility with dividends. Using our previous map-
ping (16) between the processes S
t
and f
t
, we are able to write the price of a call option with strike
K and maturity T written on f
t
as a function of market prices of vanilla options on S
t
through:
C
f
(f
0
, K, T) = B(T)
1
C
mkt
(S
0
, A(T)S
0
+B(T)K, T) (20)
We impose the initial condition S
0
= f
0
. This gives B
0
= 1 A
0
. As f
t
is driftless, the Dupire
local volatility for f
t
is then given by:

mkt
loc
(T, K) = 2

T
C
f
(S
0
, K, T)
K
2

2
K
C
f
(S
0
, K, T)
Finally, from (19), we obtain
mkt
loc
(, ). This exact method relies in ne on fast pricing of vanilla
options in the case of a Black-Scholes log-normal model with ane dividends. This can be achieved
approximately, yet accurately, using a time-averaging method (see appendix C). A similar approach
can be found in [9].
Numerical tests
We now introduce the 2-factor LV-SVMs that we use to illustrate our calibration procedure.
Bergomis LV-SVM. We introduce the Bergomi LV-SVM [3]:
df
t
= f
t
(t, f
t
)
_

t
t
dN
t

T
t
=
T
0
f
T
(t, x
T
t
)
f
T
(t, x) = (1
T
) e

T
x
e

2
T
h(t,T)
2
+
T
e

T
x
e

2
T
h(t,T)
2
x
T
t
= (1 )e
k1(Tt)
X
t
+e
k2(Tt)
Y
t
dX
t
= k
1
X
t
dt +dW
X
t
dY
t
= k
2
Y
t
dt +dW
Y
t
where
T
,
T
,
T
are functions of T and with
h(t, T) = (1 )
2
e
2k1(Tt)
E
_
X
2
t

+
2
e
2k2(Tt)
E
_
Y
2
t

+ 2 (1 ) e
(k1+k2)(Tt)
E[X
t
Y
t
]
E
_
X
2
t

=
1 e
2k1t
2k
1
E
_
Y
2
t

=
1 e
2k2t
2k
2
E[X
t
Y
t
] =
1 e
(k1+k2)t
k
1
+k
2
CALIBRATION OF LOCAL STOCHASTIC VOLATILITY MODELS 7
Instead of working with
T
, we prefer to use two new parameters as in [3]: , which is the volatility
of a very short volatility and
T
which is an adjustment factor:

T
= 2

T
1
T
+
T

T
2-factor log-normal LV-SVM. The 2-factor log-normal LV-SVM (considered in [8] with (t, f) =
1) is a three-factor SVM dened by the following SDEs
df
t
=
_
V
t
f
t
(t, f
t
)dN
t
(21)
dV
t
= k(V
t
V
0
t
)dt +V
t
dW
t
dV
0
t
= k
0
(V
0
t
V
00
)dt +
0
V
0
t
dW
0
t
Here N
t
, W
t
and W
0
t
are three correlated Brownian motions and V
t
a
2
t
.
Calibration examples. The calibration procedure is tested for both model on the SP500 smile
(19-Feb-2008) with market dividends using the sets of parameters displayed in tables (1), (2) and
(3). The Bergomi model parameters are those used in [3] and we have chosen the parameters
of the 2-factor log-normal model so as to get the same volatility-of-volatility term-structure and
approximately the same at-the-money (ATM) skew.
130%
28%
k
1
8
k
2
0.35
0%

fX
70%

fY
35%

T
0
VS (SP500, 19-Feb-08)
Table 1. Values of , , k
1
, k
2
, used in the Bergomi model.

19-Feb-08 87% 21% 106%
19-March-08 36% 11% 94%
19-Apr-08 35% 0% 96%
19-May-08 30% 0% 99%
19-Jun-08 29% 0% 100%
Table 2. Values of , , , used in the Bergomi model.
260%
0
90.11%
k 8 k
0
0.35
V
00
6.25% V
0
0
6.25%
V
0
6.25%
V V
0 36.24%

fV
77.93%
fV
0 35%
Table 3. 2-factor log-normal SVM parameters.
After calibrating the models using the technique just outlined above, we have computed vanilla
smiles using a Monte Carlo pricer with N = 2
17
paths and a timestep =
1
250
per year. Figures
8 PIERRE HENRY-LABORD
`
ERE
Vol ATM
15.00
17.00
19.00
21.00
23.00
25.00
27.00
29.00
0 2 4 6 8 10
Market LV SVM SVM
Figure 1. ATM volatility as a function of maturity. 2-factor log-normal LV-SVM.
(1), (2), (3) and (4) show the term structure of the at-the-money volatility and the skew for the
market smile (SP500, 19-Feb-08), the naked SVMs and the LV-SVMs. The resulting local volatility
for the Bergomi LV-SVM is plotted on Fig. (5) for dierent time slices. The computational time
is reasonable, at around 30 seconds for maturities up to 10 years. We also give some examples
of ts of the market smile for maturities T = 6 months, T = 1.33Y and T = 4Y (Figs. 6, 7, 8).
Finally, Fig. 9 shows the variance-swap volatility term structure for both the original smile and
that generated by the the LV-Bergomi model after calibration. Even though the general accuracy
is satisfactory, we can notice a small mismatch for intermediate maturities: this can be traced
to imperfect calibration of implied volatilities for far-away strikes: probably in those regions our
mapping induces non-vanishing drifts (13).
Decoupling the vanilla skew and the forward skew: calibrating to a at smile. In order
to study the mixing between local volatility and stochastic volatility, we choose to calibrate our
LV-SVM to a at vanilla smile with an implied volatility
BS
(T, K) = 20%, (T, K) and with zero
rate and dividends. This enables us to highlight dierences between Dupire LVM and LV-SVM
models. Figs. (10), (11), (12) show the term-structure of the ATM volatility, the skew and an
example of calibration. Although our SVM produces a strong skew, the LV-SVM reproduces the
market (zero) skew and therefore gives the same marginals as a Dupire LVM calibrated to the at
smile.
In the next example, we study the forward skew by computing quarterly call spread cliquets
95%105% up to the maturity T = 5Y. We illustrate the fact that an LV-SVM, although calibrated
to the vanilla smile, just like a Dupire LV-SVM, is an SVM and we are therefore able to decouple
the forward skew from the vanilla skew. The coupons (except the rst one) are plotted on g. (13).
By denition, the rst cliquet is a vanilla call spread and therefore the LV-SVM being calibrated
to the at implied volatility surface matches the Black-Scholes price. The subsequent coupons
CALIBRATION OF LOCAL STOCHASTIC VOLATILITY MODELS 9
ATM Skew
-
1
2
3
4
5
6
7
0.1 2.1 4.1 6.1 8.1
Market LV SVM
SVM
Figure 2. ATM skew as dened by 100 (
BS
(T, 95%)
BS
(T, 105%)) as a
function of maturity. 2-factor log-normal LV-SVM.
ATM Vol
21.00
22.00
23.00
24.00
25.00
26.00
27.00
0 1 2 3 4 5 6 7 8 9 10
Market LV SVM SVM
Figure 3. ATM volatility as a function of maturity. Bergomis LV-SVM.
have very close values in the naked SVM and the LV-SVM models, indicating that the LV-SVM
produces a forward skew similar to the naked SVM.
10 PIERRE HENRY-LABORD
`
ERE
ATM Skew
-
1
2
3
4
5
6
0 1 2 3 4 5 6 7 8 9 10
Market LV SVM
SVM
Figure 4. ATM skew as a function of maturity. Bergomis LV-SVM.
Local Volatility
-
0.20
0.40
0.60
0.80
1.00
1.20
1.40
0.70 0.80 0.90 1.00 1.10 1.20 1.30 1.40
1.33 2.33 4.00
7.01 0.58
Figure 5. Local volatility (t, ) for the Bergomi LV-SVM for dierent time slices
as a function of the spot level. Calibration time on a Full 10Y implied volatility
surface with a Pentium 4 CPU 2.40 Ghz, 1 GB of RAM: 30 seconds.
CALIBRATION OF LOCAL STOCHASTIC VOLATILITY MODELS 11
T= 6 Months
10.00
15.00
20.00
25.00
30.00
35.00
40.00
0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.4
Market SVM LV SVM
Figure 6. Fit of the market smile for T = 6 months. Bergomis LV-SVM.
T= 1.33 Years
10.00
15.00
20.00
25.00
30.00
35.00
40.00
0.5 0.6 0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8
Market SVM LV SVM
Figure 7. Fit of the market smile for T = 1.33Y. Bergomis LV-SVM.
Conclusion
We have proposed an easy-to-implement method for calibrating a generic LV-SVM. We have illus-
trated our calibration procedure to the Bergomi model and the 2-factor log-normal model. The
12 PIERRE HENRY-LABORD
`
ERE
T= 4 Years
10.00
15.00
20.00
25.00
30.00
35.00
40.00
0.5 0.6 0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2.0
Market SVM LV SVM
Figure 8. Fit of the market smile for T = 4Y. Bergomis LV-SVM.
VS term structure
15.00
17.00
19.00
21.00
23.00
25.00
27.00
0 1 2 3 4 5 6 7 8 9 10
LV-SVM
SVM
Figure 9. Variance swap term structure for Bergomis SVM and LV-SVM models
as a function of maturity.
local volatility Bergomi model aords in ne: control on the vanilla smile, the term-structure and
smile of volatility-of-volatility in addition to the decoupling of the vanilla skew and the forward
skew. In this respect, this model can be seen as a perfect push-button black box. However,
the reader should be cautioned against blindly calibrating the model to everything and should
CALIBRATION OF LOCAL STOCHASTIC VOLATILITY MODELS 13
ATM Vol
17.00
17.50
18.00
18.50
19.00
19.50
20.00
20.50
0 2 4 6 8 10
Market LV SVM SVM
Figure 10. ATM volatility as a function of maturity. Bergomis LV-SVM.
ATM Skew
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
0 2 4 6 8 10
Market
LV SVM
SVM
Figure 11. ATM skew as a function of maturity. Bergomis LV-SVM.
check for example that the local volatility is not sabotaging the SVM. In the authors perspective,
(t, f) should be close to 1 at-the-money and its skew not too pronounced so that the dynamical
properties of the underlying SVM are preserved. In particular, we have illustrated that the forward
skew as produced by the naked SVM is preserved by the LV-SVM.
14 PIERRE HENRY-LABORD
`
ERE
13.00
15.00
17.00
19.00
21.00
23.00
25.00
27.00
29.00
31.00
33.00
0.50 0.70 0.90 1.10 1.30 1.50 1.70 1.90
LV SVM, T=1.33Y Market SVM, T=1.33Y
LV SVM, T=5Y SVM, T=5Y
Figure 12. Fit of the market smile for dierent time slices. Bergomis LV-SVM.
Quaterly 95%-105% call spread cliquet
4.80%
4.90%
5.00%
5.10%
5.20%
5.30%
5.40%
0.25 0.75 1.25 1.75 2.25 2.75 3.25 3.75 4.25 4.75
Black-Scholes
LV+SVM
SVM
Figure 13. Quarterly 95%105% call spread cliquet. Maturity T = 5Y.
Appendix
A: Malliavins representation. Proceeding similarly as in [7, 6], we derive the following result
giving a simpler probabilistic representation of the eective local volatility. First, we introduce the
CALIBRATION OF LOCAL STOCHASTIC VOLATILITY MODELS 15
three Ito processes
t
, Y
(1)
t
and Y
(2)
t
:
d
t
= a
t
(f
t
(t, f
t
))

t
dN
t
(22)
dY
(1)
t
=
dB
t
a
t
+
t
ln()Y
(1)
t
dt +
1
2
(f)(f)

a
2
t
Y
(1)
t
dt +
_
1
2
(f)

dt (23)
dY
(2)
t
= (f
t
)

t
_
a
t
dN
t
a
2
t
(f
t
)

dt
_
(24)
with initial conditions
0
= 1, Y
(1)
0
= 0 and Y
(2)
0
= 1 and where we have set dN
t
(dZ
t
+
_
1
2
dW
t
). The prime means a derivative with respect to the forward f. We have (see [11] for
a detailed derivation) that the local volatility associated to the SVM as dened by (1) is
1

loc
(T, f)
2
= (T, f)
2
E
P
T
[1
ln
f
T
f
0
a
2
T

T
]
E
P
T
[1
ln
f
T
f
0

T
]
(25)
with Malliavins weight

T
= Y
(1)
T
T
_
1
2
(f(T, f
T
))

+
_
1
2

1
T
(f
T
)
_
T
0
sdY
(2)
s
B: Extension. As an extension of our method, we could use the following relation to converge
towards the true solution

(i+1)
(T, f)
2
=

mkt
loc
(T, f)
2
E
P
T
[1
ln
f
(i)
T
f
0
a
2
T

(i)
T
]
E
P
T
[1
ln
f
(i)
T
f
0

(i)
T
]
Here the processes
(i)
T
and f
(i)
T
are simulated using the local volatility
(i)
(T, f). To initialize the
Picard iteration
2
, we use
(0)
(T, f) as given by our initial Malliavin-Markovian projection method.
C: B-S approximate formula with dividends. In this section, we derive an ecient approx-
imation for a European call option in the case of a log-normal Black-Scholes model with discrete
dividends:
dS
t
= (r(t)S
t
D
t
) dt +
BS
S
t
dN
t
Other approximations can be found in [2, 1]. Taking (t, S) =
BS
, we get the following SDE for
f
t
as dened by (16):
df
t
= (t) ((t)f
t
+ (1 (t))f
0
) dN
t
with (t) =
BS
(t)
1
, (t) = (1+(t))
1
and (t) = A(t)B(t)
1
. Using a skew averaging method
(see [14]), this diusion can be approximated by a displaced diusion model
df
t
= (t) ( f
t
+ (1 )f
0
) dN
t
with dened by:
=
1
_
_
T
0

2
(t)dt
_
t
0

2
(s)ds
_
_
T
0
(t)
1
dt
_
t
0
(s)
2
ds (26)
1
1
x0
= 1 for x 0, 0 otherwise.
2
The author does not know if this application is contractive although this seems to be conrmed by numerical
experiments.
16 PIERRE HENRY-LABORD
`
ERE
Finally, we obtain:
C(S
0
, K, T) = B(T)
1
C
BS
_
_
S
0
,
K A(T)S
0
B(T)
+ (1 )S
0
,
BS

1
T
_
T
0
(t)
2
dt
_
_
References
[1] Bos, M., Vandermark, S. : Finessing Fixed Dividends, Risk magazine, sept. 2002.
[2] Bos, R., Gairat, A., Shepeleva, A. : Dealing with Discrete Dividends, Risk magazine, Jan. 2003.
[3] Bergomi, L. : Smile dynamics III, Risk Magazine, Oct. 2008.
[4] Dupire, B. : Pricing with a Smile, Risk Magazine 7, 18-20 (1994).
[5] Dupire, B. : A Unied Theory of Volatility, In Derivatives Pricing: The Classic Collection, edited by Peter
Carr, Risk publications.
[6] Ewald, C-O : Local Volatility in the Heston Model: A Malliavin Calculus Approach, Journal of Applied
Mathematics and Stochastic Analysis, 2005:3 (2005) 307-322.
[7] Fournie, E., Lasry, F. , Lebuchoux, J., Lions, J. : Applications of Malliavin Calculus to Monte Carlo Methods
in Finance. II, Finance and Stochastics, 5, 201-236, 2001.
[8] Humez, B. : 2-factor Log-Normal Stochastic Volatility Model, Working paper, Societe Generale (2003).
[9] Grandchamp, N. : Conference ICBI, Global derivatives 2008.
[10] Graham, C., Kurtz, T., Meleard, S., Protter, P., Pulvirenti, M., Talay, D. : Probabilistic Models for Non-linear
Partial Dierential Equations, Lecture Notes in Mathematics 1627, Springer-Verlag (1996).
[11] Henry-Labord`ere, P. : Analysis, Geometry and Modeling in Finance: Advanced Methods in Option Pricing,
Chapman & Hall/CRC, Financial Mathematics Series (2008).
[12] Lee, Roger. W. : Implied and Local Volatilities under Stochastic Volatility, IJTAF, Vol. 4., No. 1 (2001) 45-89.
(see proposition 3.1).
[13] Lipton, A. : The Vol Smile Problem, Risk magazine, Feb. 2007.
[14] Piterbarg, V. : Time To Smile, Risk magazine, May 2005.
[15] Piterbarg, V. : Markovian Projection for Volatility Calibration, Risk magazine, Apr. 2007 (extended version:
working paper, htpp://ssrn.com/abstract=906473).
[16] Romano, M., Touzi, N. : Contingent Claims and Market Completeness in a Stochastic Volatility Model,
Mathematical Finance 7, 399-412 (1997).
[17] Sznitman, A.S. : Topics in propagation of chaos, Ecole dete de probabilites de Saint-Flour XIX - 1989, volume
1464 of Lect. Notes in Math. Springer-Verlag (1991).
E-mail address: pierre.henry-labordere@sgcib.com