Filling the gaps smoothly

摘要

The calibration of a local volatility models to a given set of option prices is a classical problem of mathematical finance. It was considered in multiple papers where various solutions were proposed. In this paper an extension of the approach proposed in Lipton, Sepp 2011 is developed by (i) replacing a piece wise constant local variance construction with a piecewise linear one, and (ii) allowing non-zero interest rates and dividend yields. Our approach remains analytically tractable; it combines the Laplace transform in time with an analytical solution of the resulting spatial equations in terms of Kummer's degenerate hypergeometric functions. (C) 2017 Elsevier B.V. All rights reserved.