SHORT-MATURITY ASYMPTOTICS FOR OPTION PRICES WITH INTEREST RATE EFFECTS

Abstract

We derive the short-maturity asymptotics for option prices in the local volatility model in a new short-maturity limit [Formula: see text] at fixed [Formula: see text], where [Formula: see text] is the interest rate and [Formula: see text] is the dividend yield. In the case of practical relevance [Formula: see text] being small, however, our result holds for any fixed [Formula: see text]. The result is a generalization of the Berestycki–Busca–Florent formula (Berestycki et al., 2002) [Asymptotics and calibration of local volatility models, Quantitative Finance 2, 61–69] for the short-maturity asymptotics of the implied volatility which includes interest rates and dividend yield effects of [Formula: see text] to all orders in [Formula: see text]. We obtain the analytical results for the ATM volatility and skew in this asymptotic limit. Explicit results are derived for the CEV model. The asymptotic result is tested numerically against the exact evaluation in the square-root model [Formula: see text], which demonstrates that the new asymptotic result is in very good agreement with the exact evaluation in a wide range of model parameters relevant for practical applications.