Application of The Malliavin Calculus Fo

Motivation
The Malliavin Calculus

The Greeks
Computation of the Greeks of B-S Model
Computation of the Greeks of S.V. Model
Computation of the Greeks of Heston Model
References
Application of the Malliavin Calculus for

Computation of Greeks in Black-Scholes and
Stochastic Volatility Models
Bilgi YILMAZ,
Bülent Alper İNKAYA,
Yeliz YOLCU OKUR
26TH EROPEAN CONFERANCE ON OPERATIONAL RESEARCH

ROME 1 − 4 JULY, 2013
October 7, 2013
Bilgi YILMAZ Application of the Malliavin Calculus for Computation of Greeks i

Motivation
The Greeks
References
Table of contents
1 Motivation
2 The Malliavin Calculus

2.1 The Malliavin Tools for Computations of the Greeks
3 The Greeks
4 Computation of the Greeks of B-S Model

4.1 Delta
4.2 Gamma
4.3 Vega
4.4 Rho
5 Computation of the Greeks of S.V. Model

5.1 Computation of the Greeks for S. V. Models
5.2 Delta
5.3 Gamma
6 Computation of the Greeks of Heston Model

6.1 Delta
7 References

Motivation
The Greeks
References
Motivation
The structures of the payoff function of some contingent

claims are very complex; for this reason evaluating their
Greeks could be awkward.
Sometimes the contingent claim does not have a closed price
formula.
In the context of Malliavin calculus, the integration by parts
formula helps us to avoid differentiating the payoff function of
a contingent claim.
Using Malliavin calculus, one can find a formula for a quantity
that can be combined with Monte-Carlo simulations and get
results very quickly.

Motivation
The Greeks
Computation of the Greeks of B-S Model 2.1 The Malliavin Tools for Computations of the Greeks
References
The Malliavin Derivative on Wiener Space

Let DtW t∈[0,T ] be the Malliavin derivative on the direction of W

and lets denote P the set of random variables F : Ω −→ R and the

function F has a representation as below,
Z T Z T
F (w ) = f f1 (t) dWt , · · · , fn (t) dWt (1)
0 0
where f (x1 , · · · , xn ) = α aα x α is a polynomial with variables

P
x1 , · · · , xn , and deterministic functions fi ∈ L2 ([0, T ]) ([2]).

Motivation
The Greeks
References
Propositon 1: Malliavin derivative

We have,
k=n Z T Z T
X ∂f
DtW F = f1 (t) dWt , · · · , fn (t) dWt (2)
∂xk 0 0
k=0
Propositon 2: Malliavin derivative for Itô integrals

Let (ut )t∈[0,T ] be a Ft -adapted process, such that ut ∈ Dom D W then we have,
Z T Z T
W W
Dt ur dWr = Dt us dWs + ut (3)
0 t
Proof: see ([2]).

Motivation
The Greeks
References
Proposition 2 continoue. . .
u and for F ∈ Dom D W assume that

For any stochastic process
u· D·W F ∈ Dom D W ,

D E Z T
DuW F = D F,u W
= ut DtW Fdt (4)
L2 ([0,T ]) 0
Proof: see ([2]).

Motivation
The Greeks
References
Skorohod Integral
The Skorohod integral is denoted δ (·) and defined on (Ω, F, P).
That is, given an arbitrary random variable F and a process u in a
certain domain ([3]). Consider F is a Malliavin differentiable
random variable, Skorohod R Tintegrable and ut is an adapted process.
Then, δ (Fu) = F δ (u) − 0 ut (Dt F ) dt and
Z T
E [F δ (u)] = E ut (Dt F ) dt
0
Proposition
For a For a process ut adapted to, the Skorohod integral δ (u)
RT
corresponds to the Itô integral 0 ut dWt . Proof: see ([2]).

Motivation
The Greeks
References
Definition
A Greek is essentially the derivative of a financial quantity’s
discounted options payoff function with respect to any parameters
of associated with the contingent claim [1].
Remark
The Greeks are generally used hedging.
Some of the risks are inherent to the model.
There are also risks concerning changes of model parameters.

Motivation
The Greeks
References
Table: The Important Greeks in Finance

Name Symbol Derivative
∂V
Delta ∆ ∂S0
∂2V
Gamma Γ ∂S02
∂V
Rho ρ ∂r
∂V
Theta Θ ∂t
∂V
Vega ν ∂σ

Motivation
4.1 Delta
The Greeks
4.2 Gamma
4.3 Vega
4.4 Rho
References
Black-Scholes Model
The modeling stock prices and computing option values was

developed by Black and Sholes in 1970 ([4]). Their model makes
the assumption that the stock prices evolve according to a
geometric Brownian motion and satisfies, the SDE,
dSt = rSt dt + σSt dWt ,
and yields the price process,
σ2

St = S0 exp r− t + σWt
2
Where r is risk-free rate and σ volatility of the stock.

Motivation
4.1 Delta
The Greeks
4.2 Gamma
4.3 Vega
4.4 Rho
References
Black-Scholes Model
Suppose an option with payoff φ and assume that the payoff φ is
squared integrable (EQ [φ2 ] < ∞). The price of this option at time
t = 0 will be RT
V0 = EQ [e − 0 rs ds φ] (5)
Since the value of the option at time t = 0 is equal to the equation
(5), we should take the derivative of this expectation, with respect
to a parameter λ which is one the parameter of φ, that is S0 , σ or
r . For this reason, now assume that the payoff function φ can be
written as a function of λ, which is represented as φ = f (λ). Then
we have the derivative of Φ with respect to λ as below,

∂V0 −rT ′ ∂Fλ −rT ∂Fλ
=e EQ f (Fλ ) =e EQ f (Fλ ) H Fλ
∂λ ∂λ ∂λ
(6)
Motivation
4.1 Delta
The Greeks
4.2 Gamma
4.3 Vega
4.4 Rho
References
Integration by Parts Formula for B-S Model
Propositon 3
Let F and G are two random variables F ∈ DomDW . Consider an

H valued random variable u such that D u F = hDF , uih 6= 0 a.s.
and Gu (D u F )−1 ∈ Domδ. for any continuously differentiable
function function f with bounded derivative we have,
h ′ i
E f (F ) G = E [f (F ) H (F , G )] (7)

where H (F , G ) = δ Gu (D u F )−1

Motivation
4.1 Delta
The Greeks
4.2 Gamma
4.3 Vega
4.4 Rho
References
The Delta of Black-Scholes Model
Suppose we have a European option with payoff φ that follows a

geometric Brownian motion (St )t∈[0,T ] with risk-free rate r ,
maturity T , volatility σ, and initial condition S0 .
Then applying the proposition 3 (7) with F = ST , G = ST and
u = 1 we obtain,
e −rT
∆= E [φ (ST ) WT ] .
σS0 T
Where WT is the Wiener process that drives the geometric
Brownian motion.

Motivation
4.1 Delta
The Greeks
4.2 Gamma
4.3 Vega
4.4 Rho
References
The Gamma of Black-Scholes Model

Then applying the proposition 3 (7) with F = ST , G = ST2 and
u = 1 we obtain,
2
e −rT WT − T
Γ= 2 E φ (ST ) − WT .
S0 σT σT

Brownian motion.

Motivation
4.1 Delta
The Greeks
4.2 Gamma
4.3 Vega
4.4 Rho
References
The Vega of Black-Scholes Model

Then applying the proposition 3 (7) with F = ST ,
G = ST (WT − σT ) and u = 1 we obtain,
2
−rT WT − T
ν=e E φ (ST ) − WT .
σT

Brownian motion.

Motivation
4.1 Delta
The Greeks
4.2 Gamma
4.3 Vega
4.4 Rho
References
The Rho of Black-Scholes Model

Using the solution of 1 we obtain,
ρ = −T (V0 + S0 δ) .

Motivation
The Greeks 5.1 Computation of the Greeks for S. V. Models
Computation of the Greeks of B-S Model 5.2 Delta
Computation of the Greeks of S.V. Model 5.3 Gamma
References
Stochastic Volatility Model
dSt
= rt dt + σ (t, Yt ) dWt , (8)
St
dYt = u (t, Yt ) dt + v (t, Yt ) dZt , (9)
p ′
dZt = ρdWt + 1 − ρ2 dWt , (10)
hdWt , dZt i = ρdt, (11)
Where ρ is the correlation between standard Brownian motions, rt

is the interest rate, σ (t, Yt ) is the volatility.

Motivation
References
Integration by Parts Formula for S.V. Model
Proposition 4
Let I be an open interval of R. F λ λ∈I ∈ Dom D W is

continuously differentiable families. (ut )t∈[0,T ] is a process

u∂λ F λ
DuW F λ 6= 0, a.s.on ∂λ F λ 6= 0 , λ ∈ I , and D

W λ is continuous in
u F
W

Dom δ , then
∂λ F λ W

∂ h i
λ
EQ f F = EQ f F ζ δ (u)
∂λ DuW F λ
∂λ F λ

W λ
− Du + ∂λ H
DuW F λ

Motivation
References
The model
Lets consider that the functions u (t, Yt ) and v (t, Yt ) are both
stochastic functions define as, u (t, Yt ) ∈ C 2 ([0, T ] × R),
v (t, Yt ) ∈ C 2 ([0, T ] × R) and such that t ∈ [0, T ].
The solution of equation (8) is,
Z T T
1 2
Z
ST = S0 exp σ (t, Yt ) dWt + rt − σ (t, Yt ) dt
0 0 2
(12)

Motivation
References
Computation of the Greeks
first lets define a function G (t, T ) for 0 ≤ t ≤ T as (13),

Z T
∂σ
G (t, T ) = σ (t, Yt ) + (v , Yv ) DtW [dWv − σ (v , Yv ) dv ]
t ∂y
(13)
For further information see [5]

Motivation
References
Computation of the Delta
Using the proposition 4 and the function G (t, T ) we obtain,

1 1
∆ = E f (ST ) R T δ W (u)
S0
0 ut G (t, T ) dt
RT RT
us ut DsW G (t, T ) dtds

− ST 1 − 0 s R 2
T
0 u t G (t, T ) dt

Motivation
References
Computation of the Gamma
The Gamma is the second derivative of E [f (ST )] with respect to

S0 .

1 HST W
Γ = E f (ST ) δ (u)
S0 DuW ST
2
H DuW ST + ST DuW ST DuW H + HST DuW DuW ST

∂
− 2
+ H
S0 (DuW ST ) ∂S0

Motivation
References
where
 
RT RT
1 0 us ut DsW G (t, T ) dtds 
H = RT δ W (u)−ST 1 − s

R 2 
0 ut G (t, T ) dt T
ut G (t, T ) dt
0

Motivation
References
RT RT
W us ut DsW G (t, T ) dtds W
Du H = − 0 0R δ (u)
T u G (t, T ) dt 2

0 t
RT RT W
0 us ut Ds G (t, T ) dtds
Z T
0
− ST ut G (t, T ) dt − RT
0 0 u t (t, T ) dt
G
RT RT RT
ur us ut DrW DsW G (t, T ) dtdsdr
− 0 r s R 2
T
0 ut G (t, T ) dt
R R 2
T T W
s us ut Ds G (t, T ) dtds

0
+2 R 3
T u G (t, T ) dt
0 t

Motivation
References
 
RT RT
∂ 1 0 s us ut DsW G (t, T ) dtds 
H = − ST  1 −

2
∂S0 S0
R 
T
0 u t G (t, T ) dt

Motivation
The Greeks
References
The Heston Model

√
In the S.V. model√choosing σ (t, Yt ) = Yt , u (t, Yt ) = κ (θ − Yt )
and v (t, Yt ) = ǫ Yt we obtain the Heston model as,
dSt p
= rt dt + Yt dWt (14)
St
where
p h p ′
i
dYt = κ (θ − Yt ) dt + ǫ Yt ρdWt + 1 − ρ2 dWt (15)
Where r is risk-free rate, θ is long run average price, κ controls how

strongly Yt is drawn towards θ, and ǫ is the volatility of volatility.

Motivation
The Greeks
References
Computatiton of Delta for the Heston Model
Choosing u = 1 in the delta of the S.V. we have the delta as,

1 1
∆ = E f (ST ) R WT
S0 0 T G (t, T ) dt
 
RT RT W
s Ds G (t, T ) dtds 

0
− ST 1 −

R 2 
T
0 G (t, T ) dt

Motivation
The Greeks
References
Thank you for your attention!

e-mail: ybilgi@metu.edu.tr

Motivation
The Greeks
References
References
A. Chongo, Computing the Greeks Using the Integration by Parts Formula for the Skorohod Integral,
University of Stellenbosch, University of Stellenbosch, Matieland, 2008.
D. Nualart, The Malliavin Calculus and Related Topics, Probability and its Applications, Springer, Berlin,
Heidelberg, New-York, 2006, ISBN 3-540-28328-5.
E. A. Schiller, Malliavin Calculus for Monte Carlo Simulation with Financial Applications. Technical report,
Department of Mathematics, Princeton University, MIT, Cambridge, USA, May 2009, Princeton University.
F. Black and M. Scholes. The pricing of options and corporate liabilities. Journal of Political Economy,
81(3):637-654, 1973.
Y. El-Khatib. Computations of Greeks in stochastic volatility models via the Malliavin calculus, 2009.

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Motivation

The Malliavin Calculus

Application of the Malliavin Calculus for

26TH EROPEAN CONFERANCE ON OPERATIONAL RESEARCH

Bilgi YILMAZ Application of the Malliavin Calculus for Computation of Greeks i

2 The Malliavin Calculus

4 Computation of the Greeks of B-S Model

5 Computation of the Greeks of S.V. Model

6 Computation of the Greeks of Heston Model

Bilgi YILMAZ Application of the Malliavin Calculus for Computation of Greeks i

The structures of the payoff function of some contingent

Bilgi YILMAZ Application of the Malliavin Calculus for Computation of Greeks i

The Malliavin Derivative on Wiener Space

The Malliavin Derivative on Wiener Space

and lets denote P the set of random variables F : Ω −→ R and the

where f (x1 , · · · , xn ) = α aα x α is a polynomial with variables

Bilgi YILMAZ Application of the Malliavin Calculus for Computation of Greeks i

The Malliavin Derivative on Wiener Space

Propositon 1: Malliavin derivative

Propositon 2: Malliavin derivative for Itô integrals

Proof: see ([2]).

Bilgi YILMAZ Application of the Malliavin Calculus for Computation of Greeks i

The Malliavin Derivative on Wiener Space

Proof: see ([2]).

Bilgi YILMAZ Application of the Malliavin Calculus for Computation of Greeks i

Bilgi YILMAZ Application of the Malliavin Calculus for Computation of Greeks i

Bilgi YILMAZ Application of the Malliavin Calculus for Computation of Greeks i

Table: The Important Greeks in Finance

Bilgi YILMAZ Application of the Malliavin Calculus for Computation of Greeks i

The modeling stock prices and computing option values was

dSt = rSt dt + σSt dWt ,

and yields the price process,

Where r is risk-free rate and σ volatility of the stock.

Bilgi YILMAZ Application of the Malliavin Calculus for Computation of Greeks i

Integration by Parts Formula for B-S Model

Let F and G are two random variables F ∈ DomDW . Consider an

Bilgi YILMAZ Application of the Malliavin Calculus for Computation of Greeks i

The Delta of Black-Scholes Model

Suppose we have a European option with payoff φ that follows a

Bilgi YILMAZ Application of the Malliavin Calculus for Computation of Greeks i

The Gamma of Black-Scholes Model

Suppose we have a European option with payoff φ that follows a

Where WT is the Wiener process that drives the geometric

Bilgi YILMAZ Application of the Malliavin Calculus for Computation of Greeks i

The Vega of Black-Scholes Model

Suppose we have a European option with payoff φ that follows a

Where WT is the Wiener process that drives the geometric

Bilgi YILMAZ Application of the Malliavin Calculus for Computation of Greeks i

The Rho of Black-Scholes Model

Suppose we have a European option with payoff φ that follows a

Bilgi YILMAZ Application of the Malliavin Calculus for Computation of Greeks i

Stochastic Volatility Model

Where ρ is the correlation between standard Brownian motions, rt

Bilgi YILMAZ Application of the Malliavin Calculus for Computation of Greeks i

Integration by Parts Formula for S.V. Model

continuously differentiable families. (ut )t∈[0,T ] is a process

Bilgi YILMAZ Application of the Malliavin Calculus for Computation of Greeks i

Bilgi YILMAZ Application of the Malliavin Calculus for Computation of Greeks i

Computation of the Greeks

first lets define a function G (t, T ) for 0 ≤ t ≤ T as (13),

Bilgi YILMAZ Application of the Malliavin Calculus for Computation of Greeks i

Computation of the Delta

Using the proposition 4 and the function G (t, T ) we obtain,