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Veer, Robert de - The Influence of the Number of Averaging Points on the Price of Asian Options With an Arithmic Mean

Veer, Robert de - The Influence of the Number of Averaging Points on the Price of Asian Options With an Arithmic Mean

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Bachelor Thesis

International Business

Finance track



The influence of
the number of averaging points
on the price of Asian options
with an arithmic mean





Robert de Veer
ANR: 999656
Wednesday the 20
th
of June, 2007
1
Contents


Section 1. Introduction pp. 2

Section 2. Two types of means to use for averaging pp. 4
Section 2.1. The arithmic mean pp. 4
Section 2.2. The geometric mean pp. 4
Section 2.3. Closed form solutions for Asian options
with a geometric mean pp. 5

Section 3. Using Monte Carlo simulations to price Asian options pp. 6
Section 3.1. Asian options and Monte Carlo simulations pp. 6
Section 3.2. Control variates pp. 7
Section 3.3. Pricing Asian options in practice pp. 8

Section 4. Monte Carlo simulations and results pp. 10
Section 4.1. Variables in the Monte Carlo simulations pp. 10
Section 4.2. Determining the price of an Asian option in
Monte Carlo simulations pp. 11
Section 4.3. Results from the Monte Carlo simulations pp. 12
Section 4.4 Some conclusions pp. 14

Section 5. Conclusion pp. 16

References pp. 17

Appendix. Matlab code Monte Carlo simulations pp. 18
2
Section 1. Introduction

In the late seventies the first commodity-linked bond contracts with an average-value
settlement price were issued. These contracts gave the holder of the contract the right to
receive the average value of the underlying commodity over a certain time interval or the
nominal value of the bond, whichever was higher. Such contracts can be seen as a bond plus
an option on the average value of the commodity, where the exercise price is equal to the
nominal value of the bond. Nowadays average-value options are not only found as an implicit
part of commodity-linked bond contracts, but also as currency options and in interest rate
contracts. Another type of average-value options is the Asian option. Asian options are
options in which the underlying variable is the average price over a period of time. They are
commonly traded on currencies and commodity products which have low trading volumes.
They were originally used in 1987 when Banker’s Trust Tokyo office used them for pricing
average options on crude oil contracts. Since the introduction of these options by the Banker’s
Trust Tokyo office such types of options are called Asian options.
So Asian options are options where the payoff depends on the average price of the
underlying asset during at least some part of the life of the option. There exist two types of
Asian options: Average Price Options (henceforth APOs) and Average strike options
(henceforth ASOs). The payoff of an Average Price Call is the maximum of zero and the
average price of the underlying asset over a certain period of time minus a predefined strike
price. The payoff of an Average Price Put is the maximum of zero and a predefined strike
price minus the average price of an underlying asset over a certain period of time. The payoff
of an Average Strike Call is the maximum of zero and the value of the underlying asset at
maturity of the option minus the average price of the underlying asset over a certain period.
The payoff of an Average Strike Put is the maximum of zero and the average price of the
underlying asset over a certain period of time minus the value of the underlying asset at
maturity of the option.
The average value of the underlying asset, S
AVG,
can be calculated in two ways: as the
arithmic mean and as the geometric mean. The arithmic mean is the most common type of
mean, but no closed form solution for pricing Asian options does exist for the arithmic mean.
For the geometric mean a closed form solution does exists. More details about those two types
of means are discussed in the next section.

3
One would like to price Asian options which payoff is based on the arithmic mean,
because the arithmic mean is the most common type of mean. Pricing Asian options with
arthmic mean has been studied extensively in the literature. Unfortunately no closed-form has
been found, because the log of an aritmic mean is not lognormal anymore. The log of a
geomteric mean is still lognormal and closed-form solutions for Asian options with geometric
do exist, Kemna and Vorst (1990). Thompson (1999) provided tight analytic bounds for the
Asian option price with arithmic mean by the use of approximations for Brownian motions.
These bounds are quite complicated and therefore too complicated to use straightforward.
Geman and Yor (1993) computed the Laplace transform of the price of continuously sampled
Asian options with arithmic mean, but problems arise for Asian options with low volatility
and/or short maturity. Another extensively applied method to value Asian options is the use of
Monte Carlo simulations.
The first author introducing the use of Monte Carlo simulation to price options was
Boyle (1977). In his paper the author even discusses the use of control variates and antithetic
variables which make Monte Carlo simulations faster and more accurate by reducing the
standard error per series of trials. Another very important paper in the field of Monte Carlo
simulations for security pricing was written by Boyle, Broadie, and Glasserman (1997). In
this paper a very broad overview of the use of Monte Carlo simulations for security pricing.
The effectiveness of Monte Carlo simulations is illustrated by the use of variance reduction
techniques for pricing Asian options. The closed form solution for Average Price Options
with a geometric average of Kemna and Vorst (1990) is very useful for variance reduction.
Whereas in most of the literature about Asian options, both with geometric and
arithmic mean, it is assumed that the average price of the underlying asset is continuously
sampled, the arithmic mean is in practice based on a number of averaging points. Therefore
this thesis is about the influence of the number of averaging points (over a certain time
interval) on the price of Asian options with arithmic mean. Monte Carlo simulations will be
used to show that there are differences in the price of Asian options with arithmic mean,
depending on the number of averaging points taken to determine the average strike or the
average price of the underlying asset over a certain time interval.
First, the differences between the arithmic mean and the geometric mean will be
discussed in section 2. In section 3 it will be explained how control variates can be used to
improve the efficiency and accuracy of the Monte Carlo simulations. In section 4 elaborates
on the Monte Carlo simulations and some results are presented. Conclusions which can be
drawn from the Monte Carlo simulations will be given in section 5. Section 6 will conclude.
4
Section 2. Two types of means to use for averaging

Mathematically the payoff of an APO is given by π = max(0, δ(S
avg
– K)), with S
avg

the average price of the underlying asset during the life of the option, K the predefined
exercise price and with δ = 1 if the option is a call and δ = -1 if the option is a put. The payoff
of an ASO can be is given by π = max(0, δ(S
T
– S
avg
)), with S
avg
again the average price of the
underlying asset during the life of the option, T the maturity of the option, S
T
the price of the
underlying asset at time T, and also with δ = 1 if the option is a call and δ = -1 if the option is
a put.
As mentioned before, there are two types of means to determine the average price of
the underlying asset over time, namely the arithmic mean and geometric mean. In this section
both types of means will be discussed.

Section 2.1. The arithmic mean
The arithmic mean is an average which is often used in mathematics. What we do to
determine the arithmic mean is summing up all observations and divide the sum by the
number of observations:
( )
n
n
i
i
x x x
n
x
n
x + + + = =

=
...
1 1
2 1
1
,
with x
i
the i
th
observation and n the number of observations.
While the arithmic is very easy to calculate and therefore often very useful to use it is
unfortunately not for pricing APOs and ASOs. In finance it is assumed that assets follow a
geometric Brownian motion over time, i.e. dS = µdt + σdW with a certain expected return µ,
variance σ
2
, and W the Brownian motion. For assets which follow a geometric Brownain
motion we cannot find any analytic solutions for APOs and ASOs if calculated by using the
arithmic mean, because the log of an aritmic mean is not lognormal anymore.

Section 2.2. The geometric mean
In the literature about Asian options authors often refer to the geometric mean,
because it has the nice property that it can be used together with the lognormality assumption
of stock prices. As opposed to the arithmic mean, the log of a geomteric mean is still
lognormal. To calculate the geometric mean we take the product of all observations and take
the n
th
root of this product:
5
n
n
n
n
i
i
x x x x ⋅ ⋅ ⋅ =
|
|
¹
|

\
|

=
....
2 1
/ 1
1
,
with x
i
the i
th
observations and n the number of observations.
Why the geometric mean is very useful in the context of the lognormality assumption
can be made very clear by having a closer look at the formula for the geometric mean:
(
¸
(

¸

=
|
|
¹
|

\
|
∑ ∏
= =
n
i
i
n
n
i
i
x
n
x
1
/ 1
1
ln
1
exp
This is the same as computing the arithmic mean of the logarithm transformed values
of x
i
(i.e. the arithmic mean of the log scale) and then taking the exponential of that particular
arithmic mean to return the computation to the original scale. For this geometric mean the
lognormal properties still hold and can be combined with the lognormal properties of the
prices of assets over time without causing infeasible equations.

Section 2.3. Closed form solutions for Asian options with a geometric mean
In the literature closed formed solutions for the price of the APO with geometric mean
can be found. Kemna and Vorst (1990) give a proof for the closed form solution for the price
of an APO when the geometric average is used. The price of a call and a put can be given by:
( )( ) ( ) ( ) ( ) ( )
( ) ( ) ( )( ) ( ) ( )
1 2
2 1
exp ) ( exp
exp ) ( exp
d N t T r b S d N t T r K p
d N t T r K d N t T r b S c
t
APO
G
t
APO
G
− − − ⋅ − ⋅ − − ⋅ =
⋅ − − ⋅ − ⋅ − − ⋅ =

where N(x) is the cumulative normal distribution function of:
( ) ( )
( )
( ) ( )
( ) t T
t T b
K
S
d
t T
t T b
K
S
d
A
t
A
t
− ⋅
− ⋅ ⋅ − + |
¹
|

\
|
=
− ⋅
− ⋅ ⋅ + + |
¹
|

\
|
=
σ
σ
σ
σ
2
2
2
1
5 . 0 ln
5 . 0 ln

with S
t
the price of the asset at time t, K the exercise price, T the maturity of the option, and
where the adjusted volatility σ
A
and dividend yield b are given by:
|
|
¹
|

\
|
− − =
=
6 2
1
3
2
σ
σ
σ
D r b
A

with σ is the observed volatility, r is the risk free rate, and D is the dividend yield which will
without loss of generality be negelected in the remainder of this thesis.
6
Section 3. Using Monte Carlo simulations to price Asian options

Section 3.1. Asian options and Monte Carlo simulations
When we cannot find analytic solutions for options prices an alternative is to make use
of Monte Carlo simulations. The idea of Monte Carlo simulations is that we sample different
paths of a stochastic variable (one sample path is called a trial). If the stochastic variable is the
underlying asset of some derivative then The price of a derivative with an underlying asset
related to a stochastic variable is determined by a number of trials of that stochastic variable.
For every trial a ‘trial payoff of the derivative is calculated. The resulting Monte Carlo price
of the derivative is equal to the arithmic average of the ‘trial payoffs’. In our case of APOs
and ASOs the underlying asset is an asset on which the options are based. For each trial we
can calculate the arithmic average and consequently for every trial we can find the payoff for
an APO or ASO. At the end we sum all ‘trial prices’ of APOs and ASOs divide that sum by
the number of trials which will gives us the Monte Carlo price for APOs and ASOs.
The above procedure can be formulated more mathematically and is based on the
lecture notes of Financial Models (2006) written by J.M. Schumacher. If we take a function
denoted by φ and a distribution for a variable x
i
denoted by v, then the only requirement for
using Monte Carlo simulations correctly is that ∫ φ
2
dv is finite. The Monte Carlo estimate is
given by:

=
=
n
i
i
x
n
1
) (
1
φ φ
The variance of the error of the Monte Carlo estimate is given by:
( )

− =
2 2
) (
1
φ φ σ E
n
err

This implies also that the size of the confidence interval around the Monte Carlo estimate is
proportional to n / 1 . Because the confidence interval of the Monte Carlo method does not
decrease linearly if the number of trials increases, some methods for variance reduction can be
used to decrease the size of the confidence interval of a Monte Carlo estimate instead of just
increasing the number of trials which would be inefficient in terms of computational time.
One of those variance reduction techniques is the method of control variates. We elaborate in
this technique after we say how to simulate a path for an underlying asset of an APO or ASO.

7
For the underlying asset of APOs and ASOs we can generate trials following a path by
simulating T/∆t steps.
ε σ
σ
µ ⋅ ∆ ⋅ + ∆
|
|
¹
|

\
|
− ⋅ =
+
t t S S
t t
2
exp
2
1

with ε a random number chosen from the standard normal distribution.
If we have n paths of the underlying asset we calculate for each path the arithmic mean of
n
S .
This arithmic mean is used to price the payoff of an APO or ASO as if the underlying asset
would have followed that particular path. This procedure is repeated n times. The arithmic
mean of all payoffs is the prices for the APO or ASO.

Section 3.2. Control variates
The idea of the use of control variates is that we have next to a random variable X
which we want to compute by the use of Monte Carlo simulation another random variable Y
which is correlated to the variable we want to compute. We can define a third random variable
Z by
( ) ( ) ( ) ( ) Y E Y X EY Y X Y X E Z
y
xy
Y
X
XY
− − = − − = =
2
σ
σ
σ
σ
ρ ,
the expectation of the variable Z is equal to the expectation of the variable X (thus EZ = EX).
Thus, if we want to compute the variable X we also can compute the variable Z. And due to
the construction of the variable Z the variance of variable Z is smaller than the variance of
variable X. In fact the variance of variable Z is given by
( ) ( )
2
2 2
var 1 var var
y
xy
x XY
X Y X Z
σ
σ
σ ρ − = − = = .
One can easily verify that the correlation between the variables X and Y the variance of
variable X dramatically decreases and that it can be used as a very efficient way to reduce the
size of the confidence interval of the variable X. So, the stronger the correlation between
random variables X and Y the better in terms of efficiency.
In order to use the above method, variable Y should have the following two properties:
1.) Y is correlated to the variable X
2.) We have to know EY
The correlation between the variables X and Y and the volatilities of the variables X and Y
can be derived from the Monte Carlo simulation samples.
8
Assume that the variable X is the payoff of an APO or ASO both with an arithmic
mean. Take as variable Y for the APO with arithmic mean the payoff of an APO with a
geometric mean and for the ASO with arithmic mean the payoff of a European call option.
Variable Y satisfies in both cases the two required conditions on Y. At first, both the payoffs
of an APO or ASO calculated with an arithmic mean have a very high correlation with
respectively the payoff of an APO with geomteric mean and the payoff of a European call
option. And secondly, we know the expectation of EY in in the first case. The expected payoff
of an APO calculated with a geometric mean can be derived form the closed form solution for
APOs (Kemna and Vorst, 1990). The expected payoff of the European call option can be
derived from the well-known Black-Scholes formula for options (see next paragraph). In the
Monte Carlo simulations it turned out that the correlation between an APO with arithmic
mean and an APO with arithmic mean is 0.999 and that the correlation between an ASO with
arithmic mean and a European call option is approximately 0.89.
The payoff of a European call option is given by max(S
T
– K, 0), in which S
T
is the
price of the underlying asset at the maturity of the option T and K is the predefined strike
price. European call options have the property that they never can be exercised before the
maturity of the option. The closed form solution (EY) is given by Black-Scholes (1973):
) ( ) exp( ) ( ) , (
2 1 0
d rT K d S T S C Φ ⋅ − ⋅ − Φ ⋅ = , where
Φ is the standard normal cumulative distribution function of
( ) ( )
( ) ( )
T d
T r K S
d
T r K S
d
σ
σ
σ
σ
σ
− =
− +
=
+ +
=
1
2
0
2
2
0
1
2
2 / / ln
2
2 / / ln

with r is the risk-free rate per year and σ the yearly volatiltiy of the underlying asset.

Section 3.3 Pricing Asian options in practice
In practice there are three degrees of freedom in the choice how to price an Asian
option by contract. These three degree of freedoms are: 1.) the choice whether the average
asset price is calculated as an arithmic mean or as a geometric mean; 2.) the choice on how
many points in time the average is based; 3.) the choice when to ‘spot’ an asset price (e.g. at
noon or as a closing price).
In this thesis we focus on Asian options with the average asset price calculated as the arithmic
mean. The main research question deals with the second degree of freedom and from the
results from Monte Carlo simulations we might find some interesting results in the next
9
section. When to ‘spot’ an asset price is no issue in the analysis, time steps taken in the Monte
Carlo simulation will be of equal length. In practice we actually have (in a normal week) five
trading days followed by two non-trading days, the influence on the volatility and day count
issues in contract are also neglected.
10
Section 4. Monte Carlo simulations, results and some conclusions

By the use of Monte Carlo simulation we want to find prices for the Average Price Option and
the Average Strike Option with arithmic mean. We also incorporate variate reduction
techniques (see previous section).

Section 4.1. Variables in the Monte Carlo simulations
First of all a number of variables have to chosen. Of those variables the number trials per
simulation is the most important one. To determine the number of trials one should focus on
the trade-off between accuracy and calculation time. I this thesis I would like to have very
small confidence intervals. Based on the correlation between the ASO option with arithmic
mean and the European call option of 0.89, I choose for 10,000 trials. This equal to a
confidence interval of the ASO with arithmic mean of 2 * (1 - 0.89) * Var X ≈ 0.04. Of
course the confidence interval of the price of the APO with arithmic mean will be much
lower, but the same random numbers are used for both options in the Monte Carlo
simulations.
The other variables that have to be chosen are: yearly volatility of the stock (15%),
value of the stock at t=0 (€ 100,-), the risk-free rate (3%), the maturity of the option (0.5
years), and the length of time steps (different values). All variables with exception of the
length of time steps are taken as being constant; different values for the length of time steps
were used in the Monte Carlo simulations. For the length of time steps we start with a length
of one month. All other, decreased length of time steps are multiples of the start value. In
section 4.3. we will go more into detail about this variable..
The most important aspect of Monte Carlo simulations is the simulation of the
behavior of the asset price. From the Black-Scholes formula it is derived that the value of the
asset at a time t can be generated by the formula:
|
|
¹
|

\
|
⋅ ⋅ +
|
|
¹
|

\
|
− ⋅ =
− t t t
dt dt r S S ε σ
σ
2
exp
2
1

with r the yearly risk-free rate, σ the yearly volatility of the asset, dt the length of the time
step, and ε a sample from the standard normal distribution i.e. ε ~ N(0,1) i.i.d per trial and per
time step.


11
Section 4.2. Determing the price of an Asian option in the Monte Carlo simulation
Average Price Option
As strike price at the option’s maturity we take K
APO
=100. So at t=0 the APO is at-the
money. As described above we simulate the behavior of the asset 10,000 times, so we have
10,000 different values of the asset at a time t (said to be S
t
). If we calculate the geometric
average per trial with all S
t
per trial calculated then we can also calculate the price of an Asian
Price Option with a geometric average. Now we have the payoff of 10,000 APOs with
geometric mean given 10,000 times the behavior of the stock price simulated. In finance the
price of a derivative is equal to its future (expected) payoffs. In Monte Carlo simulations
every trial has an equal probability of occurring because the samples from the standard
normal distribution are taken independent of each other both over time as over trial. So we
can determine the expected future payoff of an APO with geometric mean by taking the
averages of all 10,000 calculated payoffs. The same procedure can be followed to find a price
for APOs with an arithmic mean.
The next step is to determine the variance of both derivatives and the correlation between the
two derivatives. We can do this in the regular way by taking the sample variance (two times)
and the sample correlation (one time). It is important in this perspective that the payoffs of
both derivatives per trial are calculated by implying the same error term ε in the asset
behavior per trial. Now we have enough information for the control variate technique (see
section 3.2). The expected variance of an APO price is now given with a standard deviation
equal to square root of the variation divided by the number of simulations.

Average Strike Option
It is not possible to have an at-the-money ASO, because we don’t know what the
exercise price S
AVG
will be. So for the strike price we have to take an arbitrary value. In the
simulations I have chosen for K
ASO
= 100.9419, which is equal to the expected asset price at
the maturity of the option.
For the simulation we use the same procedure as for the APOs, in fact we use also the
same error term ε to save calculation time. Instead of calculating the price of an ASO with
geometric mean we calculate the price of a call. With this Monte Carlo price of the call, the
exact value is given by the well-known Black-Scholes formula, we can determine the
correlation coefficient between both derivatives and the variance of the derivatives itself.
Finally we can determine the price of an ASO with arithmic mean with a standard deviation
equal to square root of the variation divided by the number of simulations.
12

Section 4.3. Results from the Monte Carlo simulations
Unfortunately, the Monte Carlo simulations required a very large calculation time, e.g.
by taking the time steps equal to one day we have 180
1
times we calculate the asset price for
one trial, multiply 180 with 10,000 trials and we get 1.8 million asset prices. All asset prices
have to be stored in order to determine the arithmic and geometric averages of the asset price
for every trial.

The following values for the length of the time steps have been taken over a half year
to simulate the behavior of an asset:
dt = Approximately steps of
180/6 = 30 1 month
180/12 = 15 2 weeks
180/24 = 7.5 1 week
180/42 = 30/7 4 days
180/60 = 3 3 days
180/90 = 2 2 days
180/132 = 15/11 1.5 day
180/180 = 1 1 day
Table 1. Length of the different time steps

The closed-from value of an Average Strike Option with geometric mean and strike
price €1 00,- was calculated to be € 2.7939. And the value of a European call option and strike
price € 100.9419 was calculated to be € 3.1355.

In the table 2 the results for the Average Price Option and its volatility per different length of
time step (dt), the Average Strike Option and it’s volatility per dt, and the average value of the
stock and it’s volatility per dt can be found.




1
I assume there are roughly 360 days a year and ignored (unpurpose) the business count convention of 252
trading days a year
13
APO stdv APO ASO stdv ASO
dt = 1 month 2.8598 0.000058 2.7020 0.0019576
dt = 2 weeks 2.8554 0.000057 2.7591 0.0021026
dt = 1 week 2.8529 0.000057 2.8475 0.0021741
dt = 4 days 2.8508 0.000055 2.7915 0.0021754
dt = 3 days 2.8507 0.000056 2.8238 0.0021781
dt = 2 days 2.8499 0.000056 2.8361 0.0022524
dt = 1.5 day 2.8492 0.000056 2.7969 0.0021921
dt = 1 day 2.8491 0.000055 2.8486 0.0022261
Table 2. Prices of Asian Options given different lengths of time steps

Figure 1 and figure 2 are the graphical representation of the price of the APO and the ASO
respectively.


Figure 1. The price of an APO given different lengths of time steps
14

Figure 2. The price of an ASO given different lengths of time steps


Section 4.4. Some conclusions
In this section some conclusions about the relationship between the number of
averaging points and the prices of APOs and ASOs, both with arithmic mean, are given and
based on the use of Monte Carlo simulations. Of course the conclusions are defended, but also
their weaknesses are not neglected.

APOs with arithmic mean
One could say that “the price of an Average Price Option with arithmic mean
decreases as more averaging points are taken into account to determine the average price of
the underlying asset.” We see in the Monte Carlo simulation that when the number of
averaging points is increased, this is equivalent to reducing the length of time steps, the curve
of APO prices with arithmic mean is downward sloping. The fact that we also have very low
standard deviations of the Monte Carlo prices only supports this conclusion. Most likely the
15
price of an APO with arithmic mean will converge to a certain level, but it is not possible to
give from the results an indication what that level might be.
My second conclusion is that “an Average Price Option with arithmic mean should
have a higher price than an Asian Price Option with geometric mean.” This is because the
price of an APO with arithmic mean is convex over time and already very steady in the tail of
our simulations (see figure 1), it is almost for sure that the price of an APO with arithmic
mean will never decrease to the level of an APO with geometric mean (closed-form solution).
Also if we have a closer look at the average payoff of an APO with arithmic mean in the
Monte Carlo simulation and it is compared with the average payoff of an APO with geometric
mean we also see that the payoffs of APOs with geometric mean are always less than those of
APOs with arithmic mean. This holds for all different values of dt. This would imply that the
geometric mean is always smaller than the arithmic mean for some series of (positive)
numbers. I have not done any research on this property, so I cannot say it is true for every
series of numbers.

ASOs with arithmic mean
In my opinion we can draw an opposite conclusion about the price of an ASO with
arithmic mean: “The price of an Average Strike Option with arithmic mean increases as more
averaging points are taken into account.” Figure 2 gives us the impression that the price of an
ASO with arithmic mean does increase as the number of averaging points increases. On the
other hand for some values of dt the price of the ASO is lower than for some values with a
larger dt. The only argument in favor of this conclusion is that the confidence intervals of
prices of ASOs with arithmic mean are still a bit large (0.04 cents, whereas prices vary from
279 to 285 cents). If we have a better derivative as control variate (e.g. the closed-form
solution for ASOs with geometric mean) then we might be able to strengthen this conclusion.
16
Section 6. Conclusion

In this thesis we investigated the influence of the number of averaging points on the
price of Asian options with arithmic mean (both Average Price Options and Average Strike
Options). Prices of Asian options were calculated by the use of Monte Carlo simulations. By
incorporating the control variate technique in the Monte Carlo simulations the standard error
of the outcome of the simulations reduced enormously. For APOs with arithmic mean we
used APOs with geometric mean as the control variate, whereas for ASOs with arithmic mean
we used the European call option as the control variate.
The effect of an increasing number of averaging points was ‘measured’ by calculating
the prices for the Asian options with different lengths of the time steps taken in the Monte
Carlo simulations while letting the maturity of the option unchanged. A comparison of the
Asian option prices with different numbers of averaging points lead a number of conclusions
of which one is the most important one: “An increase in the number of averaging points has
the opposite effect on Average Price Options with arithmic mean as it has on Average Strike
Options with arithmic mean.” An increase has a positive effect on the price of an ASO and a
negative effect on the price of an APO. The conclusion is not mathematically proven and only
deducted from the Monte Carlo simulation results.
Further research on the influence on the number of averaging points could be more
focused on the price sensitivity of Asian options depending on different volatility levels.
Another interesting topic could be researching the influence of the level of the strike price for
APOs on the price sensitivity of APOs, so comparing prices of far in-the-money and far out-
of-the-money options. Only first, and probably most important is to incorporate the Average
Strike Option with geometric mean in the Monte Carlo simulations in order to reduce the
volatility of the ASO prices.
17
References

Papers:

Boyle, P., Options: A Monte Carlo Approach, Journal of Financial Economics, 4 (1977): 323-
338

Boyle, P., M. Broadie, and P. Glasserman, Monte Carlo methods for security pricing, Journal
of Economic Dynamics and Control, 21 (1997): 1267 - 1321

Broadie, M., Glasserman, P., and Kou, S.G., Connecting discrete and continuous path-
dependent options, Finance and Stochastics, 2 (1999): 55 - 82

Geman, H., and Yor, M., Bessel processes, Asian options, and perpetuities, Mathemetical
Finance, 3 (1993): 349-375

Kemna, A.G.Z., and Vorst, A.C.F., A Pricing Method for Options Based on Average Asset
Values, Journal of Banking and Finance, 14 (1990): 113-129

Thompson, G., Fast narrow bounds on the value of Asian options, Working paper, 1999


Books:

Hull, J., Options, Futures, and Other Derivatives, 6
th
edition

Schumacher, J.M., Financial Models, fall semester 2006
18
Appendix A. Matlab code Monte Carlo simulations

numbsim = 10000;

stepspermonth = [1 2 4 7 10 15 22 30];

for mc = 1:8
n= stepspermonth(mc);
yearlyreturn(n) = 0.08;
yearlyvol(n) = 0.15;
S0(n) = 100;
r(n) = 0.03;
nyears(n) = 0.5;
stepsperyear(n) = 12*n;
totalsteps(n) = nyears(n)*stepsperyear(n)+1;
dt(n)=inv(stepsperyear(n));
mu(n) = yearlyreturn(n)*dt(n);
vol(n) = yearlyvol(n)*sqrt(dt(n));
K(n) = 100;
Kcall(n) = S0(n)*exp(yearlyreturn(n)*nyears(n));

for i = 1:numbsim
S(1,i,n) = S0(n);
end

for i = 1:numbsim
for t=2:totalsteps(n)
z(t)=normrnd(0,1);
S(t,n) = S(t-1,i,n)* exp(((r(n) - (yearlyvol(n)^2/2))*dt(n)) + yearlyvol(n)*sqrt(dt(n))*z(t));
end
call(i,n) = exp(-r(n)*nyears(n)) * max(S(totalsteps(n),i,n)-Kcall(n),0);
end

dstar = 0.5*(r(n)-(yearlyvol(n)^2)/6)*nyears(n);
voladj = yearlyvol(n)/sqrt(3);
d = (log(S0(n)/K(n))+0.5*(r(n)+(yearlyvol(n)^2)/6)*nyears(n))/(yearlyvol(n)*sqrt(nyears(n)/3));
EgeometricAPOcall(n) = exp(dstar)*S0(n)*normcdf(d) - K(n)*normcdf(d-
yearlyvol(n)*sqrt(nyears(n)/3));
d1call = (log(S0(n)/Kcall(n))+(r(n)+(yearlyvol(n)^2)/2)*nyears(n))/(yearlyvol(n)*sqrt(nyears(n)));
d2call = d1call - (yearlyvol(n)*sqrt(nyears(n)));
Ecall(n) = S0(n)*normcdf(d1call)-Kcall(n)*exp(-r(n)*nyears(n))*normcdf(d2call);

for i = 1:numbsim
arithmicavgP(i,n) = mean(S(:,i,n));
geometricavgP(i,n) = geomean(S(:,i,n));
end

for i = 1:numbsim
APOcallarithmic(i,n) = exp(-r(n)*nyears(n))*max(arithmicavgP(i,n)-K(n),0);
APOcallgeometric(i,n) = exp(-r(n)*nyears(n))*max(geometricavgP(i,n)-K(n),0);
ASOcallarithmic(i,n) = exp(-r(n)*nyears(n))*max(S(totalsteps(n),i,n)-arithmicavgP(i,n),0);
call(i,n) = exp(-r(n)*nyears(n))*max(S(totalsteps(n),i,n)-Kcall(n),0);
end

covavgshelpAPO = cov(APOcallarithmic(:,n),APOcallgeometric(:,n));
covavgshelpASO = cov(ASOcallarithmic(:,n),call(:,n));
volParithmicAPO(n)=sqrt(covavgshelpAPO(1,1));
volPgeometricAPO(n)=sqrt(covavgshelpAPO(2,2));
volParithmicASO(n)=sqrt(covavgshelpASO(1,1));
volPgeometricASO(n)=sqrt(covavgshelpASO(2,2));
19
corravgsAPO(n) = covavgshelpAPO(1,2)/(volParithmicAPO(n)*volPgeometricAPO(n));
corravgsASO(n) = covavgshelpASO(1,2)/(volParithmicASO(n)*volPgeometricASO(n));

for i = 1:numbsim
APOcall(i,n) = APOcallarithmic(i,n)-
corravgsAPO(n)*(volParithmicAPO(n)/volPgeometricAPO(n))*(APOcallgeometric(i,n)-
EgeometricAPOcall(n));
ASOcall(i,n) = ASOcallarithmic(i,n)-
corravgsASO(n)*(volParithmicASO(n)/volPgeometricASO(n))*(call(i,n)-Ecall(n));
end

priceAPOcall(n)=mean(APOcall(:,n));
priceASOcall(n)=mean(ASOcall(:,n));
volpriceAPOcall(n)=sqrt(var(APOcall(:,n)))/numbsim;
volpriceASOcall(n)=sqrt(var(ASOcall(:,n)))/numbsim;
end

priceAPOcall
priceASOcall
volpriceAPOcall
volpriceASOcall

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