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 $\mathcal{L}(Z_t|Y_t = y)$ if $X_{\cdot}=(Y_\cdot,Z_{\cdot})$. 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.