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What Is Local Volatility?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 06 November 2018
  • Copyright Protected:
    2003-2018
    Conjecture Corporation
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Local volatility has to do with assessing the level of risk that is associated with a current asset utilized with a financial derivative. The focus of this type of assessment is to take into consideration the predictability of that asset and project the potential for various events to upset that level of predictability, a situation that in turn would affect the return that the investor can reasonably expect to realize. Since the focus is on nothing more than the price of the asset involved, utilizing this approach for every type of investment is usually not recommended.

The function of local volatility is to help the investor develop a better idea of what type of events could adversely affect the price of the underlying asset used in some sort of derivative deal. From there, the strategy goes on to assess how much of an impact those possible events would have on the outcome of the investment. Using this process to assess the risk level can go a long way toward helping an investor decide if a given investment is a good idea and is likely to generate an equitable amount of returns, or if the investor should focus attention on a different option that carries a lower level of volatility while still offering a chance for a decent return.

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A number of local volatility models are in common use today and are often used alongside other methods to determine the viability of investing in certain types of options. The benefit of using local volatility along with those other methods is that it is possible to focus squarely on factors that affect the price and the eventual return. Other methods will normally account for this factor in part while also involving other considerations. By adding this type of model along with others, the investor can achieve a well rounded understanding of all risk associated with an option, weight that risk against the potential returns, and make an informed decision of whether to buy, sell, or hold onto that option.

Brokers and dealers can aid investors in determining how to employ the idea of local volatility, or even if this approach is necessary or workable with the type of investment that is under consideration. Since assessing local volatility is helpful with some options but of relatively little value with others, a trained investment professional can quickly identify which strategies would serve the purpose of providing the investor with the data needed to make the right decision. Even if local volatility is not the primary factor to consider, the data gleaned from the effort can reinforce information assembled using other assessment methods and increase the chances of choosing the right option.

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