Local Volatility

DEFINITION of 'Local Volatility'

A model used in quantitative finance to calculate the unpredictability of the underlying current asset of a financial derivative. Because of the treatment of the underlying asset price as the sole random variable, local volatility models are not suitable for the pricing of all options, such as cliquet options.


Local variance, another calculation used in quantitative finance, is the square of local volatility.

BREAKING DOWN 'Local Volatility'

Local volatility models are often used alongside stochastic volatility models in order to compare assumptions on different derivative valuations. The local volatility model "knows" volatilities in advance, while in stochastic volatility models volatility is treated as an uncertainty. The concept of local volatility was put forth by Emanuel Derman and Iraj Kani.




RELATED TERMS
  1. Financial Modeling

    The process by which a firm constructs a financial representation ...
  2. Cliquet

    An extended exotic option that periodically settles and resets ...
  3. Binomial Option Pricing Model

    An options valuation method developed by Cox, et al, in 1979. ...
  4. Binomial Tree

    A graphical representation of possible intrinsic values that ...
  5. Black Scholes Model

    A model of price variation over time of financial instruments ...
  6. Option Pricing Theory

    Any model- or theory-based approach for calculating the fair ...
Related Articles
  1. Options & Futures

    Breaking Down The Binomial Model To Value An Option

    Find out how to carve your way into this valuation model niche.
  2. Options & Futures

    The "True" Cost Of Stock Options

    Perhaps the real cost of employee stock options is already accounted for in the expense of buyback programs.
  3. Options & Futures

    The Benefits And Value Of Stock Options

    The pros and cons of corporate stock options have been debated since the incentive was created. Learn more about stock option basics and the cost of stock options.
  4. Options & Futures

    Understanding Option Pricing

    Take advantage of stock movements by getting to know these derivatives.
  5. Options & Futures

    The ABCs Of Option Volatility

    The mystery of options pricing can often be explained by a look at implied volatility (IV).
  6. Options & Futures

    How To Sell Put Options To Benefit In Any Market

    Selling a put option is a prudent way to generate additional portfolio income and gain exposure to desired stocks while limiting your capital investment.
  7. Options & Futures

    How To Buy Oil Options

    Crude oil options are the most widely traded energy derivative in the New York Mercantile Exchange.
  8. Economics

    The Truth about Productivity

    Why has labor market productivity slowed sharply around the world in recent years? One of the greatest economic mysteries out there.
  9. Retirement

    Roth IRAs Tutorial

    This comprehensive guide goes through what a Roth IRA is and how to set one up, contribute to it and withdraw from it.
  10. Options & Futures

    What Does Quadruple Witching Mean?

    In a financial context, quadruple witching refers to the day on which contracts for stock index futures, index options, and single stock futures expire.
RELATED FAQS
  1. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  2. What is after-hours trading? Am I able to trade at this time?

    After-hours trading (AHT) refers to the buying and selling of securities on major exchanges outside of specified regular ... Read Full Answer >>
  3. Do plane tickets get cheaper closer to the date of departure?

    The price of flights usually increases one month prior to the date of departure. Flights are usually cheapest between three ... Read Full Answer >>
  4. How do hedge funds use equity options?

    With the growth in the size and number of hedge funds over the past decade, the interest in how these funds go about generating ... Read Full Answer >>
  5. Can mutual funds invest in options and futures? (RYMBX, GATEX)

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  6. Is Colombia an emerging market economy?

    Colombia meets the criteria of an emerging market economy. The South American country has a much lower gross domestic product, ... Read Full Answer >>
Hot Definitions
  1. Short Selling

    Short selling is the sale of a security that is not owned by the seller, or that the seller has borrowed. Short selling is ...
  2. Harry Potter Stock Index

    A collection of stocks from companies related to the "Harry Potter" series franchise. Created by StockPickr, this index seeks ...
  3. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  4. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  5. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  6. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
Trading Center