What is Local Volatility (LV)?
Local volatility is a volatility measure used in quantitative analysis that helps to provide a more comprehensive view of volatility by factoring in both strike prices and expirations from the Black Scholes Model to produce pricing and risk statistics for options. Local volatility is similar to implied volatility and can be extrapolated from it.
Understanding Local Volatility (LV)
The concept of local volatility was introduced by Emanuel Derman and Iraj Kani. Local volatility attempts to identify the actual volatility of an option across a range of strike prices and expirations. Local volatility seeks to use two-factor analysis to provide a more accurate actual volatility reading than implied volatility. When plotted, local volatility will generally fit the data more closely than implied volatility. Some academics have mused that, while implied volatility can be used to obtain the correct price, local volatility is the more appropriate input from a logical standpoint.
Local volatility essentially replaces the constant volatility function that is calculated from strike price and expiration. Instead, local volatility answers the same question of risk in a different way by looking at the asset price and time, which results in a different view of the volatility around an option given the same inputs. Because local volatility is often extrapolated from implied volatility, it is sensitive to changes in the implied volatility. This means that small changes in implied volatility result in more drastic shifts in local volatility.
How Local Volatility (LV) is Used
One of the main criticisms of the original Black Scholes model is that it attempted to lock the volatility of the underlying asset at a constant level for the entire life of the option. This doesn't reflect the actual market data we have but the model is still one of the most effective valuation schemes for options. In reality, the market can produce volatility smile which was noted in earnest after the 1987 stock market crash. This sent academics and traders looking for better ways to represent volatility. Local volatility is one of the products that has emerged from that search.
Local volatility can be particularly useful in pricing exotic options that are difficult to fit standard models. It is designed to match market prices and can be used to value all combinations of strike prices and expirations compared to the single expiration that implied volatility covers. That said, both local volatility and implied volatility are often studied together and compared to historical volatility. Whereas local and implied volatility are generated from current option price levels using the Black Scholes Model, historical volatility can be used to generate a Black Scholes Model price that is tempered by past data of actual pricing fluctuations.