E4718 Spring 2008: Derman: Lecture 6: Extending Black-Scholes; Local Volatility Models Page 1 of 34

Lecture 6: Extending Black-Scholes;

Local Volatility Models
Copyright Emanuel Derman 2008

Summary of the course so far:

• Black-Scholes is great but not perfect by any means.

• The smile violates it badly in all markets.

• The best approach is therefore to replicate - static if possible, else dynamic,

• Hedging errors and transactions costs mess things up. Which hedge to use?
Implied volatility hedging leads to uncertain path-dependent total P&L;
realized volatility hedging leads to a deterministic final P&L, but uncertain
P&L along the way. Real life is more complex than either of these cases.

• You can strongly replicate any European payoff out of puts and calls, stati-
cally, independent of any valuation model. You can weakly replicate exotic
options out of standard options, often only approximately. Weak replication
needs a model that tells you the future smile.

• Some models for the smile: local volatility, stochastic volatility, jump dif-
fusion.

This lecture:

• review of binomial models;

• the local volatility model.

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6.1 The Binomial Model for Stock Evolution

We intend to study ways of modifying the Black-Scholes model so as to
accommodate the smile. It’s easiest to begin in the binomial framework where
intuition is clearer.
Copyright Emanuel Derman 2008

In the Black-Scholes framework, a stock with no dividend yield is assumed to

evolve according to

d ( ln S ) = μdt + σdZ . Eq.6.1

The expected logarithmic return of the stock per unit time is μ ; the expected
2
return on the stock price, from Ito’s lemma, is μ + σ ⁄ 2 . The volatility of
returns is σ, so that the total variance in time Δt is σ2Δt.

We model the evolution of the stock

price over an instantaneous time Δt u up
by means of a one-period binomial q
tree. The expected drift and expected μΔt mean
ln S 1
volatility (quantities that determine
the future evolution, for it is the
future we are concerned with) must 1-q
be extracted or predicted from what d down
we observe about the stock price Δt
from an investor’s point of view. We
have to calibrate the binomial evolution so as to be consistent with
Equation 6.1, which means determining the parameters q, u, and d. The param-
eter q is the investor’s estimates of the future probability of a move up with
logarithmic return u. The investor’s point of view is often called the q measure.

How do we choose q, u and d to match the continuous-time evolution of

Equation 6.1? To match the mean and variance of the return, must require that

qu + ( 1 – q )d = μΔt
2 2 2
Eq.6.2
q [ u – μΔt ] + ( 1 – q ) [ d – μΔt ] = σ Δt

By substituting the first equation for μΔt into the second, one can rewrite the
two equations above as

qu + ( 1 – q )d = μΔt
2 2
Eq.6.3
q ( 1 – q ) ( u – d ) = σ Δt

There are two constraints on the three variables q, u, and d, so there are a vari-
ety of solutions to the equation, and we have the freedom to pick convenient

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 E4718 Spring 2008: Derman: Lecture 6: Extending Black-Scholes; Local Volatility Models Page 3 of 34

ones. Convenience here means “easy to think about” or “converges faster to

the continuous limit.”

6.1.1 First Solution: The Cox-Ross-Rubinstein Convention

Copyright Emanuel Derman 2008

Choose u + d = 0 for convenience, so that stock price always returns to the

same level after successive up and down moves, thereby keeping the center of
the tree fixed. Then

( 2q – 1 )u = μΔt
2 2
4q ( 1 – q )u = σ Δt

1
Notice that q = 1/2 if Δt = 0 so write q ~ --- + ε . Then squaring the first equation
2
and dividing by the second leads to

2 2
( 2q – 1 ) 2 μ Δt
----------------------- ≈ 4ε = -----------
4q ( 1 – q ) σ
2

so that

μ
ε ≈ ------ Δt
2σ
1 μ
q ≈ --- + ------ Δt Eq.6.4
2 2σ
u = σ Δt
d = – σ Δt

We can check that these choices lead to the right drift and volatility. The mean
return of the binomial process is

μ
⎛ 1--- + ------ μ
⎞ ( σ Δt ) – ⎛ 1--- – ------ ⎞
Δt ⎝ 2 2σ Δt⎠ ( σ Δt ) = μΔt
⎝ 2 2σ ⎠

The variance is

2 1 μ μ
q ( 1 – q ) ( u – d ) ≈ --- ⎛⎝ 1 + --- Δt⎞⎠ ⎛⎝ 1 – --- Δt⎞⎠ 4σ Δt ≈ σ Δt – μ ( Δt )
2 2 2 2
4 σ σ

2
This variance is a little smaller than it should be, because of the ( Δt ) term.
But as Δt → 0 , this term becomes negligible relative to the O ( Δt ) term, so

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 E4718 Spring 2008: Derman: Lecture 6: Extending Black-Scholes; Local Volatility Models Page 4 of 34

that the convergence to the continuum limit is a little slower than if it matched
the variance exactly.

For small enough Δt there is no riskless arbitrage with this convention – the up
return σ Δt in the binomial tree always lies above the return μΔt , which lies
Copyright Emanuel Derman 2008

above the down state – σ Δt , because (Δt)0.5>>Δt.

6.1.2 Another Solution: The Jarrow-Rudd Convention

We must satisfy the constraints

qu + ( 1 – q )d = μΔt
2 2
q ( 1 – q ) ( u – d ) = σ Δt

Now for convenience we choose q = 1/2, so that the up and down moves have
equal probability. Then

u + d = 2μΔt
u – d = 2σ Δt

and so

u = μΔt + σ Δt
Eq.6.5
d = μΔt – σ Δt

The mean return is exactly μ; the volatility of returns is exactly σ, so that con-
vergence to the continuum limit is faster than in the Cox-Ross-Rubinstein con-
vention.

Let’s look at the evolution of the stock price as we iterate over many time peri-
ods; (We’ll examine it more closely when we discuss binomialization or dis-
cretization of various stochastic processes later.)

u d
(e + e )
E [ S ] = --------------------- S
2
2
σ Δt – σ Δt ⎛ σ⎞
2 μ Δt
μΔt ( e +e ) μΔt ⎛ σ Δt⎞ ⎝ + -----
2⎠
= e ---------------------------------------- ≈ e 1 + ------------ ≈ e
2 ⎝ 2 ⎠

2
so that the expected return on the stock price is μ + σ ⁄ 2 .

In the limit Δt → 0 , both the CRR and the JR convention describe the same
process, and there are many other choices of u, d, and q that do so too.

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Here we are modeling purely geometric Brownian motion which leads to the
Black-Scholes formula. We will use these binomial processes, and trinomial
generalizations of them, as a basis for modeling more general stochastic pro-
cesses that can perhaps explain the smile.
Copyright Emanuel Derman 2008

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6.2 The Binomial Model for Options Valuation

6.2.1 Options Valuation
One can decompose the stock S and the bond B into two primitive state-contin-
Copyright Emanuel Derman 2008

gent (Arrow-Debreu) securities Πu and Πd that pay out only in the up or down
state.

stock 1S U = Su/S security Πu 1

1 πu

D = Sd/S 0

bond 1B R = erΔt security Πd 0

1 πd

R = erΔt 1

Define Πu = α1S + β1. Note that because it is riskless, the sum

Πu+ Πd = 1/R

Then

1
α = -------------------
αU + βR = 1 (U – D)
so that Eq.6.6
αD + βR = 0 –D
β = -----------------------
R(U – D)

and so the securities are given by the linear combinations

R1 S – D1 B U1 B – R1 S
Π u = -------------------------- Π d = -------------------------- Eq.6.7
R(U – D) R( U – D)

The values of these state-contingent securities are

R–D p U–R 1–p

π u = ----------------------- ≡ --- π d = ----------------------- ≡ ------------ Eq.6.8
R(U – D) R R(U – D) R

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where

R–D U–R
p = -------------- 1 – p = -------------- Eq.6.9
U–D U–D
Copyright Emanuel Derman 2008

are the risk-neutral no-arbitrage probabilities that don’t depend on expected

returns at all. This the p measure.

Note that the first equation in Equation 6.9 can be rewritten as

pU + ( 1 – p )D = R , or

pS u + ( 1 – p )S d
S = ------------------------------------- Eq.6.10
R

so that in this measure the current stock price is the risklessly discounted
expected future value, or the expected future stock price is the forward price.

Now any option C which pays Cu in the up-state and Cd in the down-state is
replicated by C= CuΠu + CdΠd with value

pC u + ( 1 – p )C d
C = --------------------------------------- Eq.6.11
R

Equation 6.10 and Equation 6.11 express the value of the underlying stock and
the replicated option as the discounted expected value of the terminal payoffs
in the risk-neutral probability measure defined by p. One can regard
Equation 6.10 as defining the measure p given the values of S, Su and Sd; one
can regard Equation 6.11 as specifying the value C in terms of the option pay-
offs and the value of p.

6.2.2 The Black-Scholes Partial Differential Equation and the

Binomial Model
The Black-Scholes PDE can be obtained by taking the limit of the binomial
pricing equation as Δt → 0. We’ll use the Cox-Ross-Rubinstein choice of q, u
& d to illustrate this convergence. Let

u = σ Δt d = – σ Δt

Then the option value is given by

RC = pC u + ( 1 – p )C d Eq.6.12

where

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RS – S d S u – RS
p = ------------------ 1 – p = ------------------ Eq.6.13
Su – Sd Su – Sd

Now substitute Su = euS, Sd = edS and R = erΔt in the two equation directly
Copyright Emanuel Derman 2008

above, so that all terms are re-expressed in terms of the variables r, σ and S .

When you write Equation Eq.6.12 on page 7 in terms of these variables, you
obtain

rΔt σ Δt – σ Δt
e C = pC ( e S, t + Δt ) + ( 1 – p )C ( e S, t + Δt )

Substituting the equation for p in terms of the same variables, and performing a
Taylor expansion to leading order in Δt , one can show that

2
∂C 1∂ C 2 2 ∂C
CrΔt = { rSΔt } + --- 2 { S σ Δt } + Δt Eq.6.14
∂S 2 ∂S ∂t

Dividing by Δt leads to the BS equation. Note that the expected growth rate of
the stock, μ, appears nowhere in the equation.

You can derive many of the PDEs of stochastic processes (the mean hitting
time, for example) in this way.

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6.3 Extending the Black-Scholes Model (Read

this section but it won’t be covered in class.)
Many of the extensions to Black-Scholes involve extending the BS formula by
Copyright Emanuel Derman 2008

clever transformations of the numeraire in which the stock is valued or the

number of shares or the scale in which one measures time.We can start with the
simplest case, zero rates and zero dividend yield, and work our way progres-
sively up to more complex cases.

6.3.1 Base Case: Black-Scholes with zero dividend yield, zero

rates, and the riskless bond as the numeraire.

C BS ( S, t, K, T, σ ) = SN ( d 1 ) – KN ( d 2 )
2
ln S ⁄ K ± v ⁄ 2
d 1, 2 = -----------------------------------
v
v = σ T–t

This is really an option to exchange a single bond B with face K for a single
stock S. It’s more insightful to avoid using prices in dollars, as above, and
instead write this using the bond price B as the currency or numeraire ito
denominate all prices.

Let C B = C ⁄ B be the Black-Scholes option price in units of B, and let

S B = S ⁄ B be the stock price in units of B. Then

C B = F ( x, v )
F ( x, ν ) = xN ( d 1 ) – N ( d 2 )

ln x ± v ⁄ 2
2 Eq.6.15
d 1, 2 = --------------------------
v
v = σ T–t

where x = S B .

C B represents the price of an option on the stock SB with strike 1B in units of

B. All prices are now dimensionless in terms of dollars.

6.3.2 Moving to non-zero rates

When the interest rate on the bond B is non-zero, the bond B grows at the risk-
less rate so that dB = rBdt . If we denominate all securities in units of B,

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then B B = 1 B earns zero interest, and in these units the evolution is analogous
to that of Section 6.3.1. We denote the stock price in these units by
rt
S B = S ⁄ B = ( S ⁄ K )e .
Copyright Emanuel Derman 2008

In B units,

C B = F ( x, ν ) Eq.6.16

rτ
as in Equation 6.15, except that now x = S B = ( Se ) ⁄ K .

Converting Equation 6.16 into dollars by multiplying both sides by the initial
value of B , we obtain for the price C in dollars

– rτ – rτ
C ≡ BC BM ≡ Ke F ( x, ν ) = Ke [ xN ( d 1 ) – N ( d 2 ) ]
– rτ rτ
= Ke [ ( Se ⁄ K )N ( d 1 ) – N ( d 2 ) ]
– rτ
= SN ( d 1 ) – Ke N ( d2 )

which is the standard Black-Scholes formula.

6.3.3 Stochastic interest rates

In the case above, the volatility in the Black-Scholes formula is actually the
volatility of the stock S measured in units of the bond price B. If interest rates
are stochastic then B is stochastic too, and all that must be changed in the BS
formula is the volatility, so that

2 2 2
σ ( S ⁄ B ) = σ S + σ B – 2ρ S, B σ S σ B

You can usually ignore the volatility of the bond compared to the volatility of
the stock, because interest rates volatilities are smaller than stock volatilities
and because bonds have lower duration.

For example, if B = K exp ( – yT ) the dB dy

------- ∼ Ty ------ and so σ B ∼ yTσ y .
B y

For T = 1 year, σ y ∼ 0.1 and y ~ 0.05, we have σ B ∼ 0.005 or half a vol point,
much smaller than the typical 20% volatility of a stock.

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6.3.4 Stock with a continuous known dividend yield d

When a stock pays dividends at a rate d per unit time, it’s similar to a dollar in
the bank paying continuous interest r in its own currency. Just as one dollar
rτ dτ
Copyright Emanuel Derman 2008

grown into e dollars, so one share will grow in e shares of stock.

Therefore, to get the payoff of a European option on one share of stock which
pays off max ( S T – K, 0 ) at expiration T, you can buy an option on less than
– dτ – dτ
one share today, that is on e shares today, whose initial value is Se .

An option on a stock S with dividend yield d is therefore equivalent to a Black-

– dτ
Scholes option on a stock whose initial price is Se . The Black Scholes for-
mula in this case becomes

– dτ – rτ
C BS ( S, t, K, T, r, d, σ ) = Se N ( d 1 ) – Ke N ( d2 )
( r – d )τ 2
ln Se ⁄K±v ⁄2
d 1, 2 = -----------------------------------------------------
v
v = σ T–t

You can get the same result in the binomial model. If the stock pays a dividend
dΔt
yield d, then because one share of stock worth S grows to e shares worth Su
or Sd, the tree of value (rather than price) is

Su
p

(e-dΔt))S

1– p
Sd

Then the risk-neutral no-arbitrage growth condition must take account of divi-
dends as well as stock values to define p measure, so that

rΔt – dΔt ( r – d )Δt

pS u + ( 1 – p )S d = e ( Se ) = Se ≡F

where F is the forward price of the stock, including dividend payments.

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Thus

F – Sd
p = ----------------
Su – Sd
Copyright Emanuel Derman 2008

Since options pay no dividends, their payoff is discounted at the riskless rate

rΔt
pC U + ( 1 – p )C D = Ce

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6.4 Extending Black-Scholes for time-depen-

dent deterministic volatility
Black-Scholes and the binomial model assume that σ is constant no matter
Copyright Emanuel Derman 2008

how S and t change. Suppose now that the stock volatility σ is a function of
(future) time t.

dS
------ = μdt + σ ( t )dZ
S

How do we modify Black-Scholes or the binomial tree method when there is a

term structure of volatilities σ ( t ) ?

Suppose we try to build a CRR tree with σ 1 in period 1 and σ 2 in period 2.

σ 1 Δt + σ 2 Δt 2
Se

σ 1 Δt
Se
σ 1 Δt – σ 2 Δt 2
Se
S – σ 1 Δt + σ 2 Δt 2
Se
– σ 1 Δt
Se
– σ 1 Δt – σ 2 Δt 2
Δt Δt Se

Then, as you can see, the tree doesn’t “close” in the second period unless σ i is
constant. Of course no one can demand that the tree close; it’s just computa-
tionally convenient in order to avoid an exponentially growing number of final
states. But it’s preferable to have it close and use the same binomial algorithm
for European and American options even when volatility is a deterministic
function of time.

To make the tree close, we can instead change the spacing between levels in
the tree. Since each move up or down in the price tree from time level i - 1 to i
is multiplied σ i Δt i , we can guarantee that the tree will close provided that
σ i Δt i is the same for all periods, or

σ 1 Δt 1 = σ 2 Δt 2 = ... = σ N Δt N Eq.6.17

Thus, though the tree looks the same from a topological point of view, each
step between levels involves a step in time that is smaller when volatility in the
period is larger, and vice versa.

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One difficulty (but not an insuperable one) with this approach is that you don’t
easily know how many time steps you require to get to a definite expiration,
because the time steps vary with volatility. Once you know the term structure
of volatilities, you can solve for the number of time steps needed.
Copyright Emanuel Derman 2008

Here’s an illustration on a crude binomial tree with coarse periods. For an

accurate calculation we’d need many more periods. Suppose we believe vola-
tility will be 10% in year 1 and 20% in year 2. We choose the first period to be
one year long and then solve for the second period.

period 1 period 2

σ 0.1 0.2

2 0.01 0.04
σ

Δt 1 1/4

We use the CRR convention in which up and down moves given by σ i Δt i . to

illustrate the tree:
1
0.1 + --- 0.2
2 0.2
100e = 100e
0.1
100e 1
0.1 – --- 0.2
2
100e = 100
100

– 0.1
100e
1
– 0.1 – 0.2 ---
2 – 0.2
100e = 100e

Δt 1 = 1 Δt 2 = 0.25

In essence, we build a standard binomial tree with price moves generated by

± σ Δt
e , where σ Δt is the same for all periods, and then we choose σ to
match the term structure of volatility in each period and then adjust Δt . The
stock prices at each node on the tree remains the same as with constant volatil-
ity; the tree is topologically identical to a constant volatility tree. However, we
reinterpret the times at which the levels occur, and the volatilities that took
them there vary according to the table above. A single tree with the same prices
at each node can represent different stochastic processes with different volatili-
ties moving through different amounts of time.

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 E4718 Spring 2008: Derman: Lecture 6: Extending Black-Scholes; Local Volatility Models Page 15 of 34

The tree in the illustration above

extended to 1.25 years. We would
need a total of 4 periods to span the
entire second year at a volatility of
0.2, but only one period for the first
Copyright Emanuel Derman 2008

year, so that 5 steps are necessary to

span two years.

More generally, if you have a defi-

nite time T to expiration, then

N N 2
σ1 σ = 0.2
T = ∑ Δti = Δt 1 ∑ -----2-
σi
σ = 0.1
Δt = 1 Δt = 1 ⁄ 4
i=1 i=1

and the number of periods necessary to span the time to expiration is given by
solving for N in the equation above.

__________

Note 1: Even though the nodes in the tree above have prices corresponding to a
CRR tree with σ i Δt i = 0.1 , the binomial no-arbitrage probabilities vary
with Δt i , because for each fork in the tree,

rΔt – σ Δt
e –e
p = -----------------------------------
σ Δt – σ Δt
e –e

σ Δt rΔt
Even though e is the same over all time steps Δt , the factor e varies
from step to step with the value of Δt , so that p varies from level to level.

Note 2: The total variance at the terminal level of the tree is the same as before

N T
2 2 2 2
Σ (T – t) ≡ ∑ σ i Δt i → ∫ σ ( s ) ds ≈ Nσ 1 Δt 1
i=1 t

Valuing an option on this tree leads to the Black-Scholes formula with the rele-
vant time to expiration, the relevant interest rates and dividends at each period,
and a total variance
T
2 1 2
Σ = ----------- ∫ σ ( s ) ds Eq.6.18
T–t
t

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Example of a CRR tree with variable volatility, 20% year one, 40% year 2

CRR Tree with variable volatility

sqrt of annual
Vol is 20% for one year, 40% for second, average variance is 31.6%
is 31.6%
Copyright Emanuel Derman 2008

sigma 0.2 0.4 0.4 0.4 0.4

delta t 1 0.25 0.25 0.25 0.25
Time 0 1 1.25 1.5 1.75 2
sig*sqrt(delta 0.2 0.2 0.2 0.2 0.2 0.2
u 1.221 1.221 1.221 1.221 1.221
r_annual 0.1

risk neutral stock tree CRR-style with variable sigma(t)

271.83
222.55
182.21 182.21
149.18 149.18
122.14 122.14 122.14
100.00 100.00 100.00
81.87 81.87 81.87
67.03 67.03
54.88 54.88
44.93
36.79

Time 0 1 1.25 1.5 1.75 2

p-tree 0.699 0.510 0.510 0.510 0.510

Two year put struck at 100

0.000
0.000
0.000 0.000
1.985 0.000
6.318 4.149 0.000
9.309 11.139 8.672
19.328 18.965 18.127
28.804 30.613
40.465 45.119
52.713
63.212

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Page 17 of 34

smile-lecture6.fm
Constant volatility of 20% First 3-months volatility is 10%
sigma 0.2 0.2 0.2 0.2 0.2 sigma 0.1 0.2 0.2 0.2 0.2
delta t 0.25 0.25 0.25 0.25 0.25 delta t 1 0.25 0.25 0.25 0.25
Time 0 0.25 0.5 0.75 1 1.25 Time 0 1 1.25 1.5 1.75 2
sig*sqrt(delta 0.1 0.1 0.1 0.1 0.1 0.1 sig*sqrt(delta 0.1 0.1 0.1 0.1 0.1 0.1
u 1.105 1.105 1.105 1.105 1.105 u 1.105 1.105 1.105 1.105 1.105
r_annual 0.05 r_annual 0.05
risk neutral stock tree CRR-style with variable sigma(t) risk neutral stock tree CRR-style with variable sigma(t)
164.87 164.87
149.18 149.18
134.99 134.99 134.99 134.99
122.14 122.14 122.14 122.14
E4718 Spring 2008: Derman: Lecture 6: Extending Black-Scholes; Local Volatility Models

110.52 110.52 110.52 110.52 110.52 110.52

100.00 100.00 100.00 100.00 100.00 100.00
90.48 90.48 90.48 90.48 90.48 90.48
81.87 81.87 81.87 81.87
74.08 74.08 74.08 74.08
67.03 67.03
60.65 60.65
Time 0 0.25 0.5 0.75 1 1.25 Time 0 1 1.25 1.5 1.75 2
0.536 0.536
0.536 0.536
0.536 0.536 0.536 0.536
0.536 0.536 0.536 0.536
p-tree 0.536 0.536 0.536 p-tree 0.725 0.536 0.536
0.536 0.536 0.536 0.536
0.536 0.536 0.536 0.536
0.536 0.536
0.536 0.536
0.200 0.200
0.200 0.200
0.200 0.200 0.200 0.200
vol computed 0.200 0.200 vol computed 0.089 0.200
0.200 0.200 0.200 0.200
0.200 0.200
0.200 0.200
Copyright Emanuel Derman 2008

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6.5 Calibrating a binomial tree to term structures

Suppose we know the yield curve and the implied volatility term structure.
How do we build a binomial tree to price options that’s consistent with it? We
have to make sure to use the right forward rate and the right forward volatility
Copyright Emanuel Derman 2008

at each node.

Example:
Term structure
of zero coupons: Year 1 Year 2 Year 3
5% 7.47% 9.92%
2
( 1.0747 )
Forward rates: 5% 10% = ----------------------- – 1
1.05
15%

Term structure
of Implied vols: Σ 1 Σ2 Σ3
20% 25.5% 31.1%
2 2 2 2
Forward vols: Σ1 Σ 12 = 2Σ 2 – Σ 1 Σ 23 = 3Σ 3 – 2Σ 2
20% 30% 40%

Now build a (toy) tree with different forward rates/vols:

r: 5% 10% 15%
σ 20% 30% 40%
σ1 2 σ1 2
Δt 2 = ⎛ ------⎞ Δt 1 Δt 3 = ⎛ ------⎞ Δt 1
Δt Δt 1 ⎝ σ 2⎠ ⎝ σ 3⎠
= 0.44Δt 1 0.25Δt 1

A possible scheme:
For the first year use Δt 1 = 0.1 and take 10 periods of 0.1 years per step.

Then Δt 2 = 0.044 and we need about 23 periods for the second year.

Finally, Δt 3 = 0.025 and we need 40 periods for the third year.

In each period the up and down moves in the tree are generated by

σ Δt ( 0.2 )0.316
e = e = 1.065 .

Using forward rates and forward volatilities over three years produces a very
different tree from using just the three-year rates and volatilities over the whole
period, especially for American-style exercise.

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6.6 Local volatility binomial models

In the previous section we extended the constant-volatility geometric Brown-
ian motion picture underlying the Black-Scholes model to account for a vola-
tility that can vary with future time. Now we head off in a new direction for
Copyright Emanuel Derman 2008

several classes -- learning how to make realized volatility σ = σ ( S, t ) a func-

tion of future stock price S and future time t.

There are several reasons to do this. First, because there is some indication
from equity index behavior that realized volatility does go up when the market
goes down, at least over short periods; and second, because we want to see if
this simple extension of Black-Scholes can then lead to an explanation of the
smile.

Some references on Local Volatility Models (there are many more).

• The Volatility Smile and Its Implied Tree, Derman and Kani, RISK, 7-2
Feb.1994, pp. 139-145, pp. 32-39 (see www.ederman.com for a PDF copy
of this.

• The Local Volatility Surface by Derman, Kani and Zou, Financial Analysts
Journal, (July-Aug 1996), pp. 25-36 (see www.ederman.com for a PDF
copy of this). Read this to get a general idea of where we’re going.

• Rebonato’s book, Chapters 11 and 12. Good general coverage.

• Also Clewlow and Strickland’s book, Implementing Options Models.

• Also Peter James’s book Option Theory.

• Gatheral’s book The Volatility Surface.

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6.7 Modeling a stock with a variable volatility σ(S,t)

Our aim is to model the evolution of a stock with a variable volatility σ ( S, t )
and then to value options by the principle of no riskless arbitrage. Converting
Copyright Emanuel Derman 2008

these prices to Black-Scholes implied volatilities, we will then examine the

resultant volatility surface Σ ( S, t, K, T ) .

We’ve just seen that, given a pure term structure of implied volatilities,
Σ ( t, T ) , we can calibrate the forward volatilities σ ( t ) , and that these two
quantities are related to each other through Equation 6.18.

Σ ( t, T ) σ(t)

T t

Can we expect a similar relationship to hold when we move “sideways” in the

strike K and stock-price S direction, relating Σ ( S, t, K, T ) to σ ( S, t ) ?

Σ ( S, K ) σ(s)

K S

More generally, how does the local volatility σ ( S, t ) , a function of future stock
price S and time t, influence the current implied volatility Σ ( S, t, K, T ) as a
function of strike K and expiration T?

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These are some of the questions that will concern us:

• Can we find a unique local volatility surface σ ( S, t ) to match the implied

vol surface Σ ( S, t, K, T ) ?
Copyright Emanuel Derman 2008

• Even if we can find the local volatilities that match the implied volatility
surface, do they represent what actually goes on in the world?

• What do local volatility models tell us about hedge ratios, exotic values,
etc.?

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 E4718 Spring 2008: Derman: Lecture 6: Extending Black-Scholes; Local Volatility Models Page 22 of 34

6.8 Binomial Local Volatility Modeling

How do we build a binomial tree that closes (i.e. is not bushy or exponentially
growing, in order to avoid computational complexity)?
Copyright Emanuel Derman 2008

For any riskless interest rate r and instantaneous volatility σ ( S, t ) , the risk-
neutral binomial fork for constant spacing Δt looks like this.

Su
p
F
S

Sd
Δt

S must satisfy the risk-neutral stochastic differential equation

dS
------ = ( r – d )dt + σ ( S, t )dZ Eq.6.19
S

Taking expectations, we deduce that the expected value of S is the forward

( r – d )Δt
price F = Se . The binomial version of this equivalence is the expected
risk-neutral value one period in the future must satisfy

F = pS u + ( 1 – p )S d Eq.6.20

rΔt
In the case of a discrete dividend D, F = Se –D

2 2 2
Furthermore, Equation 6.19 implies that ( dS ) = σ ( S, t )S dt , so that we
must require approximately, to leading order in Δt , that

2 2 2 2
S σ Δt = p ( S u – F ) + ( 1 – p ) ( S d – F ) . Eq.6.21

We can solve for p from Equation 6.19 and then substitute that value into
Equation 6.20 to obtain

F – Sd
p = ----------------
Su – Sd Eq.6.22
2 2
( F – S d ) ( S u – F ) = S σ Δt

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 E4718 Spring 2008: Derman: Lecture 6: Extending Black-Scholes; Local Volatility Models Page 23 of 34

So, if we know Sd then we can write

2 2
S σ Δt
S u = F + ----------------- Eq.6.23
F – Sd
Copyright Emanuel Derman 2008

and if we know Su then we can correspondingly write

2 2
S σ Δt
S d = F – ----------------- . Eq.6.24
Su – F

We now follow the paper The Volatility Smile and Its Implied Tree, by Derman
and Kani. We can use these formulas to build out the tree at any time level by
starting from the middle node and then moving up or down to successive nodes
at that level. If we choose the central spine of the tree to be, for example, the
CRR central nodes, then, if we know the local volatilities σ ( S, t ) and the for-
ward interest rates at each future period, we can determine the stock prices all
the up nodes and down nodes from equations Equation 6.23 and Equation 6.24.
Given all the nodes in the tree, we can then use equation for p in Eq.6.22 to
compute the risk-neutral probabilities at each node.

There are many ways to choose the central spine of a binomial tree. Here is
one:

For every level with an odd number of nodes (1,3,5, etc.) choose the central
node to have the initial price S.

For every period with even nodes (2,4,6 etc.) choose the two central nodes
in those periods to lie above and below the initial stock price S exactly as in
the CRR tree, generated from the previous central node with price S via the
up and down factors

σ ( S, t ) Δt
U = e
– σ ( S, t ) Δt
D = e

Here σ ( S, t ) is the local volatility at that stock price S and at the level in
the tree corresponding to time t.

We have chosen the spine of the tree to be that of the CRR tree, with all middle
nodes having the value S. But you could equally well choose a tree whose
spine corresponds to the forward price F of the stock, growing from level to
level.

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 E4718 Spring 2008: Derman: Lecture 6: Extending Black-Scholes; Local Volatility Models Page 24 of 34

Here’s an example with the local volatility a function only of the stock price S:

S = 100
σ ( S ) Δt σ ( S )0.1
Δt = 0.01 ; d = 0 , r = 0 ; F ⁄ S = 1 ; Δt = 0.1 ; e = e and
Copyright Emanuel Derman 2008

S
σ ( S ) = max 0.1 + ⎛ --------- – 1⎞ , 0
⎝ 100 ⎠

so that local stock volatility starts out at 10% and increases/falls by 1 percent-
age point for every 1 point rise/drop in the stock price, but never goes below
zero. So, for example, σ ( 100 ) = 0.1 and σ ( 101 ) = 0.11

2 2
S σ Δt
S u = F + ----------------- = 102.2
F – Sd
F – Sd 1
p = ----------------- = ------- = 0.45
Su – Sd 2.2

101
101
F – Sd 1
p = ----------------- = ---
Su – Sd 2 σ = 0.11
p = 0.55

F=100
100 100 (choose)
σ = 0.1 F – Sd 0.8
p = ----------------- = ------- = 0.44
σ Δt Su – Sd 1.8
e = 1.01
–σ Δt
e = 0.99
99
99
σ = 0.09

p = 0.56

2 2
S σ Δt
S d = F – ----------------- = 98.2
Su – F

Thus we have a tree that closes, with nodes and probabilities that produce the
correct discrete version of the desired diffusion.

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 E4718 Spring 2008: Derman: Lecture 6: Extending Black-Scholes; Local Volatility Models Page 25 of 34

Look at the value of a two-period call struck at 101: the payoff at the top node
is 1.2 with a risk-neutral probability of (0.5)(0.45) for a value of 0.27.

Let’s compare this to the value of a similar call on a CRR tree with a flat 10%
volatility everywhere.
Copyright Emanuel Derman 2008

102

0.5 101 2-period 101 call = 0.5 × 0.5 × 1 = 0.25

100 100

99
98

You can see that in the local volatility tree, as opposed to the constant volatility
tree, there are larger moves up and smaller moves down in the stock price.

Building a binomial tree with variable volatility is in principle possible. In

practice, one may get better (i.e. easier to calibrate, more efficient to price
with, converging more rapidly as Δt → 0 ,etc.) trees by using trinomial trees or
other finite difference PDE approximations. Nevertheless, we will stick to
binomial trees in most of our examples here because of the clarity of the intu-
ition they provide.

You can find more references to trinomial trees with variable volatility in Der-
man, Kani and Chriss, Implied Trinomial Trees of the Volatility Smile, The
Journal of Derivatives, 3(4) (Summer 1996), pp. 7-22, and also in James’ book
on Option Theory which is a good general reference on much of this topic.

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6.9 Looking At The Relation Between Local

Volatilities And Implied Volatilities.
Our aim is to build a local volatility tree that matches the smile. What is the
Copyright Emanuel Derman 2008

relation between local volatilities as a function of S and implied volatilities as a

function of K? Here are some examples to illustrate what we might expect and
to improve our intuition.

Here is a graph of local volatilities that satisfy a positive skew:

σ ( S ) = Max [ 0.1 + ( S ⁄ 100 – 1 ), 0 ] .

The volatility grows by one point for every one percent rise in the stock price,
irrespective of time, but never drops below zero.

sig(S)

0.5

0.45

0.4

0.35

0.3

0.25

0.2

0.15

0.1

0.05

0
0

2
0

3
8

stock price s

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 E4718 Spring 2008: Derman: Lecture 6: Extending Black-Scholes; Local Volatility Models Page 27 of 34

Here is the binomial local-volatility tree for the stock price, assuming
Δt = 0.01, S = 100, r = 0.
Copyright Emanuel Derman 2008

This is a tree with flat volatility 0.1, usual CRR type

stock tree sig = 0.1, p = 0.5
104.08 2 ( F – Sd ) ( Su – F )
103.05 σ = ---------------------------------------
2
- = 0.01
S Δt
102.02 102.02
σ = 0.1
101.01 101.01
100 100 100
99 99
98.02 98.02
97.04
96.08

stock tree sigma(s,t) This is a tree with variable local volatility

2 ( F – Sd ) ( Su – F )
105.04 σ = ---------------------------------------
2
-
S Δt
103.51
( 1.28 ) ( 1.53 )
102.23 102.23 = -----------------------------------
2
- = 0.018
101.01 101.01 ( 103.5 ) ( 0.01 )
100 100 100 σ = 0.135
99 99
98.21 98.21
97.39
96.76
0.456
0.488
0.453 0.453
p-tree 0.498 0.498
0.441 0.441
0.509
0.434
0.135
0.122
0.110 0.110
vol(stock) 0.100 0.100 vol ranges from 13.5 to 7.5
0.090 0 . 0 9 0 as stock ranges from 103.5 to 97.4
0.082
0.074

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3/7/08
Copyright Emanuel Derman 2008

NUMERICAL ILLUSTRATION OF RELATION BETWEEN LOCAL AND IMPLIED VOL

local vol tree LOCAL VOL TREE CALL STRUCK AT 1 0 2 ( sig=12%)

105.04 3.040
103.51 1.510
102.23 102.23 0.790 0.230
101.01 101.01 0.386 0.104
100 100 100 0.204 0.052 0.000
99 99 0.023 0.000
98.21 98.21 0.000 0.000
97.39 0.000
96.76 0.000

stock tree with 11% vol CALL TREE FOR STOCK TREE ON RIGHT STRIKE = 102
104.50 2.498
103.36 1.355
102.22 102.22 0.730 0.224
101.11 101.11 0.391 0.112
100.00 100.00 100.00 0.208 0.055 0.000
98.91 98.91 0.028 0.000
97.82 97.82 0.000 0.000
E4718 Spring 2008: Derman: Lecture 6: Extending Black-Scholes; Local Volatility Models

96.75 0.000
95.70 0.000
11%, which is the average of the local volatilities between 100 and 102.
The local volatility tree below shows that the CRR implied volatility for a
given strike is roughly the average of the local volatilities from spot to that
strike. We demonstrate that a call with strike 102 has the same value on the
local volatility tree as it does on a fixed-volatility CRR tree with a volatility of

smile-lecture6.fm
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3/7/08
Copyright Emanuel Derman 2008

local vol tree LOCAL VOL TREE CALL STRUCK AT 1 0 3 (sig = 13%)
105.04 2.040
103.51 0.929
102.23 102.23 0.453 0.000
101.01 101.01 0.205 0.000
100 100 100 0.102 0.000 0.000
99 99 0.000 0.000
98.21 98.21 0.000 0.000
atilities between 100 and 103.

97.39 0.000
96.76 0.000

stock tree with 11.5% vol CALL TREE FOR STOCK TREE ON RIGHT STRIKE = 103
104.71 1.707
103.51 0.849
E4718 Spring 2008: Derman: Lecture 6: Extending Black-Scholes; Local Volatility Models

102.33 102.33 0.422 0.000

101.16 101.16 0.210 0.000
100.00 100.00 100.00 0.104 0.000 0.000
98.86 98.86 0.000 0.000
97.73 97.73 0.000 0.000
96.61 0.000
95.50 0.000
Here’s another example for the value of a call with strike 103 on the same tree,
showing that its implied volatility is about 11.5%, the average of the local vol-

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 E4718 Spring 2008: Derman: Lecture 6: Extending Black-Scholes; Local Volatility Models Page 30 of 34

6.10 The Rule of 2: Understanding The Relation

Between Local and Implied Volatilities
We illustrated above that the implied volatility Σ ( S, K ) of an option is approx-
Copyright Emanuel Derman 2008

imately the average of the expected local volatilities σ ( S ) encountered over

the life of the option between spot and strike. This is analogous to regarding
yields to maturity for zero-coupon bonds as an average over future short-term
rates over the life of the bond. In that case, just as forward short-term rates
grow twice as fast with future time as yields to maturity grow with time to
maturity, so local volatilities grow approximately twice as fast with stock
price as implied volatilities grow with strike. This relation is the Rule of 2.

Here is a proof in the linear approximation to the skew from the appendix of
the paper The Local Volatility Surface. Later we’ll prove the Rule of 2 more
rigorously, but first it’s good to understand the intuition behind it.

We restrict ourselves to the simple case in which the value of local volatility
for an index is independent of future time, and varies linearly with index level,
so that

σ ( S ) = σ 0 + βS for all time t Eq.6.25

If you refer to the variation in future local volatility as the “forward” volatility
curve, then you can call this variation with index level the “sideways” volatil-
ity curve.

Consider the implied volatility Σ(S,K) of a slightly out-of-the-money call

option with strike K when the index is at S. Any paths that contribute to the
option value must pass through the region between S and K, shown shaded in
the figure below. The volatility of these paths during most of their evolution is
determined by the local volatility in the shaded region.

Because of this, you can think of the implied volatility for the option of strike
K when the index is at S as the average of the local volatilities over the shaded
region, so that
K
1
Σ ( S, K ) ≈ ------------- ∫ σ ( S' ) dS'
K–S
S
Eq.6.26

By substituting Eq.6.25 into Eq.6.26 you can show that

β
Σ ( S, K ) ≈ σ 0 + --- ( S + K ) Eq.6.27
2

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FIGURE 6.1. Index evolution paths that finish in the money for a call
option with strike K when the index is at S. The shaded region is the
volatility domain whose local volatilities contribute most to the value of
the call option.
Copyright Emanuel Derman 2008

index
level

strike K

spot S

expiration time

Equation 6.27 shows that, if implied volatility varies linearly with strike K at a
fixed market level S, then it also varies linearly at the same rate with the index
level S itself. Equation 6.25 then shows that local volatility varies with S at
twice that rate. You can also combine Eq.6.25 and Eq.6.27 to write the relation-
ship between implied and local volatility more directly as

β
Σ ( S, K ) ≈ σ ( S ) + --- ( K – S ) Eq.6.28
2

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6.11 Some Examples of Local and Implied Vola-

tilities.
Note: In all the figure below, there are two lines or surfaces: the local volatility
Copyright Emanuel Derman 2008

and the implied volatility. They are plotted against one axis which has the
dimension [dollars]. For local volatilities, that axis represent the stock price.
For implied volatilities that axis represents the strike of the option. On exami-
nation you’ll notice that these figures illustrate the Rule of 2.

σ ( S, t ) = 0.1 exp ( – [ S ⁄ 100 – 1 ] ) .

local volatility plotted vs spot

implied volatility
plotted against
strike

2
σ ( S, t ) = 0.1 exp ( – [ S ⁄ 100 – 1 ] )

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l σ ( S, t ) = ( 0.1 + 0.1t ) exp ( – [ S ⁄ 100 – 1 ] )

Copyright Emanuel Derman 2008

Dependent only on S: σ ( S, t ) = 0.1 exp ( – [ S ⁄ 100 – 1 ] )

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Dependent only on t: σ ( S, t ) = 0.1 exp ( – 2 [ t – 1 ] )

Copyright Emanuel Derman 2008

Dependent on S and t: σ ( S, t ) = 0.1 exp ( – 2 [ t – 1 ] ) exp ( – 2 [ S ⁄ 100 – 1 ] )

over entire local volatilities

to expiration

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