Adjoint expansions in local Lévy models

We propose a novel method for the analytical approximation in local volatility models with Levy jumps. The main result is an expansion of the characteristic function in a local Levy model, which is worked out in the Fourier space by considering the adjoint formulation of the pricing problem. Combined with standard Fourier methods, our result provides efficient and accurate pricing formulae. In the case of Gaussian jumps, we also derive an explicit approximation of the transition density of the underlying process by a heat kernel expansion: the approximation is obtained in two ways, using partial integro-differential equation techniques and working in the Fourier space. Numerical tests confirm the effectiveness of the method.