Local Volatility (LV)
Contents
Unraveling Local Volatility: A Deeper Dive into Options Pricing
Local volatility (LV) stands as a cornerstone in quantitative analysis, offering a nuanced approach to understanding volatility in options trading. Let's delve into the intricacies of local volatility, its applications, and its significance in the realm of financial markets.
Deciphering Local Volatility
Introduced by economists Emanuel Derman and Iraj Kani, local volatility provides a dynamic perspective on option volatility, considering factors like strike prices and expiration times. Unlike the Black-Scholes model, which assumes constant volatility across all options, local volatility tailors volatility levels to individual options, offering a more accurate representation of market dynamics.
Utilizing Local Volatility
Local volatility finds its utility in various aspects of options pricing and risk management. It addresses the shortcomings of the Black-Scholes model by accommodating the volatility smile phenomenon observed in real market data, especially during periods of market turbulence. This flexibility makes local volatility particularly valuable in pricing exotic options and assessing market risk.