REDUCED-ORDER MODELS FOR THE IMPLIED VARIANCE UNDER LOCAL VOLATILITY

Ekkehard W. Sachs () and Marina Schneider ()
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Ekkehard W. Sachs: Department of Mathematics, University of Trier, 54286 Trier, Germany
Marina Schneider: Department of Mathematics, University of Trier, 54286 Trier, Germany

International Journal of Theoretical and Applied Finance (IJTAF), 2014, vol. 17, issue 08, 1-23

Abstract: Implied volatility is a key value in financial mathematics. We discuss some of the pros and cons of the standard ways to compute this quantity, i.e. numerical inversion of the well-known Black–Scholes formula or asymptotic expansion approximations, and propose a new way to directly calculate the implied variance in a local volatility framework based on the solution of a quasilinear degenerate parabolic partial differential equation. Since the numerical solution of this equation may lead to large nonlinear systems of equations and thus high computation times compared to the classical approaches, we apply model order reduction techniques to achieve computational efficiency. Our method of choice for the derivation of a reduced-order model (ROM) will be proper orthogonal decomposition (POD). This strategy is additionally combined with the discrete empirical interpolation method (DEIM) to deal with the nonlinear terms. Numerical results prove the quality of our approach compared to other methods.

Keywords: Implied volatility; local volatility models; partial differential equations; model order reduction; proper orthogonal decomposition; discrete empirical interpolation method (search for similar items in EconPapers)
Date: 2014
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DOI: 10.1142/S0219024914500538

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