Varadhan's formula, conditioned diffusions, and local volatilities

Abstract

Motivated by marginals-mimicking results for It^o processes via SDEs and by their applications to volatility modeling in finance, we discuss the weak convergence of the law of a hypoelliptic diffusions conditioned to belong to a target affine subspace at final time, namely L(Zt|Yt=y) if X⋅=(Y⋅,Z⋅). To do so, we revisit Varadhan-type estimates in a small-noise regime (as opposed to small-time), studying the density of the lower-dimensional component Y. The application to stochastic volatility models include the small-time and, for certain models, the large-strike asymptotics of the Gyongy-Dupire's local volatility function. The final product are asymptotic formulae that can (i) motivate parameterizations of the local volatility surface and (ii) be used to extrapolate local volatilities in a given model