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There's a diamond in the Docks district, I think in that house in the northeast corner of the district. (If you buy the map, it will be marked on your mini-map.)
Just a warning, none of the weapons that smith makes are awesome. They are a slight upgrade to the weapon you give him. For example, the greatsword adds 2 fire damage to the sword. The nice thing about this is you can use that great sword to bash the chests that are normally immune to weapons.
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