Int. Fin. Markets, Inst.

and Money 20 (2010) 490–508

Contents lists available at ScienceDirect

Journal of International Financial

Markets, Institutions & Money
j o u rn al h om ep ag e: w w w . e l s e v i e r . c o m / l o c a t e / i n t f i n

The valuation of contingent claims using alternative

numerical methods夽
Chuang-Chang Chang a, Jun-Biao Lin b,∗
a
Department of Finance, National Central University, Taiwan
b
Department of Money and Banking, National Kaohsiung First University of Science and Technology,
2 Jhuoyue Rd., Nanzih, Kaohsiung City, 811, Taiwan, ROC

a r t i c l e i n f o a b s t r a c t

Article history: This study compares the computational accuracy and efficiency of
Received 23 November 2009 three numerical methods for the valuation of contingent claims
Accepted 22 June 2010
written on multiple underlying assets; these are the trinomial
Available online 30 June 2010
tree, original Markov chain and Sobol–Markov chain approaches.
The major findings of this study are: (i) the original Duan and
JEL classification:
Simonato (2001) Markov chain model provides more rapid con-
C63
vergence than the trinomial tree method, particularly in cases
G32
where the time to maturity period is less than nine months; (ii)
Keywords: when pricing options with longer maturity periods or with mul-
Trinomial tree method tiple underlying assets, the Sobol–Markov chain model can solve
Markov chain methods the problem of slow convergence encountered under the original
Low-discrepancy
Duan and Simonato (2001) Markov chain method; and (iii) since
Multivariate contingent claims
conditional density is used, as opposed to conditional probability,
Executive stock options
we can easily extend the Sobol–Markov chain model to the pricing
of derivatives which are dependent on more than two underlying
assets without dealing with high-dimensional integrals. We also
use ‘executive stock options’ (ESOs) as an example to demonstrate
that the Sobol–Markov chain method can easily be applied to the
valuation of such ESOs.
© 2010 Elsevier B.V. All rights reserved.

1. Introduction

The lattice approach continues to play an important role in the pricing of derivatives because it
is capable of evaluating both European and American options and it is very easy to implement and

夽
The earlier version of this paper was presented at First Asia Conference on Financial Engineering and Markets 2008.
∗ Corresponding author. Tel.: +886 7 6011000x3121.
E-mail address: jblin@ccms.nkfust.edu.tw (J.-B. Lin).

1042-4431/$ – see front matter © 2010 Elsevier B.V. All rights reserved.
doi:10.1016/j.intfin.2010.06.006
 C.-C. Chang, J.-B. Lin / Int. Fin. Markets, Inst. and Money 20 (2010) 490–508 491

understand. Following the development of a simple multiplicative-binomial model for the valuation
of options by Cox et al. (1979) (hereafter, the CRR model), there have been many modifications to this
model.
One of these modifications involved the extension of the lattice approach to the pricing of mul-
tivariate derivatives; Boyle (1988), for example, used the trinomial tree methodology for the pricing
of options with two underlying assets, whilst Boyle et al. (1989) subsequently developed a numerical
approximation method based on n-dimension extension of the binomial method. Given the require-
ment to increase the convergence speed, Kamrad and Ritchken (1991) went on to develop an extension
of the trinomial tree approach for the pricing of derivatives with multivariate underlying assets.
Broadie and Detemple (1996), Figlewski and Gao (1999) and Heston and Zhou (2000) subsequently
went on to use various techniques aimed at enhancing the accuracy and/or efficiency of the lattice
approaches. More recently, an alternative numerical method for the pricing of derivatives, the Markov
chain method, was proposed by Duan and Simonato (2001), who demonstrated that this method was
capable of pricing derivatives equally as well, or indeed even better, than the binomial tree approach.
Although the excellent performance of their approach was also found under a time-varying volatility
framework, when used for the valuation of options with longer time to maturity periods, it is clear that
the original Duan and Simonato Markov chain model has a particular problem of slow convergence.
In this study, we adopt the ‘low-discrepancy Markov chain’ approach (Duan et al., 2001; Duan
and Lin, 2006) in an attempt to overcome the problem of slow convergence encountered by Duan
and Simonato; the Sobol sequences approach is also incorporated into the original Markov chain
approach.1 The use of the Sobol sequences approach facilitates the creation of the Markov chain states,
thereby enhancing the convergence speed of the Markov chain method (hereafter referred to as the
Sobol–Markov chain method).
To determine the relative accuracy and efficiency in the pricing of derivatives, we compare three
different numerical approaches in this study. The first of these approaches is the trinomial tree method;
we adopt this method, as opposed to the binomial tree method, essentially because, according to the
finance literature, the convergence speed performance of the former is better than that of the latter.
The other two methods are the original Markov chain approach and the Sobol–Markov chain approach.
In order to determine the relative efficiency and accuracy of the abovementioned numerical methods,
we adopt binary options with two underlying assets as our example in this study.
According to worldwide observations of the financial markets, derivatives with non-tradable
underlying assets and long maturity periods have recently gained in popularity. For example, as noted
by Hall and Murphy (2002), almost 94 per cent of all S&P 500 companies granted options to their
senior executives in 1999. These so-called ‘executive stock options’ (ESOs) usually have a maturity
period of five years, or possibly even up to ten years, and are usually set up with a specific lock-out
period during which the holders cannot exercise the options.
Clearly, therefore, given that ESOs have the property of non-tradable underlying assets, the effective
pricing of such derivatives with non-tradable underlying assets and long maturity periods becomes
an issue of some importance. Thus, in this study we set out to demonstrate that the Sobol–Markov
chain approach can be adopted for the accurate valuation of derivatives with non-tradable underlying
assets and long maturity periods. Using the Sobol–Markov chain approach, we evaluate one particular
application, American-style ESOs with the properties of ‘absolute performance incentives’ (APIs) and
‘relative performance incentives’ (RPIs), and then discuss the differences between ESOs with these API
and RPI properties. This study further demonstrates that the Sobol–Markov chain approach contributes
to the finance literature by providing a useful tool for the pricing of derivatives with non-tradable
underlying assets and long maturity periods.
The remainder of this paper is organized as follows. A brief introduction to the three numerical
methods, the trinomial tree, original Markov chain and Sobol–Markov chain approaches is provided

1
The low-discrepancy Markov chain approach for the valuation of multivariate assets was provided by Duan et al. (2001).
Duan and Lin (2006) subsequently went on to use the Sobol sequences to enhance the convergence speed of the Markov chain
method when valuing interest rate options; the Sobol sequences method is a type of low-discrepancy approach commonly used
to reduce variance in Monte Carlo simulations.
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in Section 2, followed, in Section 3, by presentation of the numerical results of the comparisons of the
computational accuracy and efficiency between the alternative derivative pricing methods. Using an
ESO as an example, Section 4 demonstrates the method of implementing the above three numerical
approaches to the pricing of multivariate derivatives. Finally, the conclusions drawn from this study
are presented in Section 5.

2. The models

As noted above, three methods are used in this study for the pricing of derivatives. Firstly, we
introduce the trinomial tree method; this is used in preference to the binomial tree method since it
has been demonstrated within the literature that a trinomial tree has a better convergence property.2
Secondly, we demonstrate the use of the original Markov chain method, as proposed by Duan and
Simonato (2001), as an alternative numerical approach to the pricing of options. We also extend the
Duan and Simonato (2001) model to the pricing of derivatives with multiple underlying assets and
longer time to maturity periods. Thirdly, we go on to incorporate a low-discrepancy sequence into the
original Markov chain approach in an attempt to enhance the convergence speed during the pricing of
multivariate derivatives. For the purpose of conciseness, we introduce only the Markov chain method
and its extension, the Sobol–Markov chain method, in the following sections.

2.1. Markov chain method of pricing derivatives with one underlying asset

In this section, we demonstrate the concept of the Markov chain method. Assume that we have the
following stochastic differential equation:

dSt = rSt dt + hSt dWt (1)

where r and h are both constant, and W is a standard Brownian motion with respect to the risk-
neutralized probability measure, Q.
Following Duan and Simonato (2001), the key concept of the Markov chain approach is that a
discrete state process can be used to replace the dynamic process given in Eq. (1). Hence, this implies
that a time-homogenous Markov process can be approximated by an m-state Markov chain. Before
we can begin to construct an appropriate finite-state Markov chain, we must adjust the stochastic
process of St . We can obtain the adjusted process under the following steps, deriving the equation
under measure Q, as follows:
St+
 1
 
ln = r− h  + h(Wt+ − Wt ) (2)
St 2

We then define an adjusted asset price, Xt , as follows:

 1
 
Xt = ln St − r − h t = ln S0 + hWt (3)
2

The reasons for using Xt , as opposed to St , are as follows. Firstly, we need a large number of maximum
and minimum values of the states, and we also need to determine whether there is any trend within the
target process, particularly when dealing with the problem of longer-term maturity periods. Secondly,
if there is a trend within the target process, with a fixed number of states of the Markov chain, the
partition will become very coarse.
Once the target Markov process has been effectively defined, we can then select the m states for
the Markov chain approximation; however, before we can select the set of asset prices, we must first
of all decide the overall state-space interval for Xt . From Eq. (3), we have X0 = ln S0 at time 0; therefore,
the overall time interval may be selected as [X0 − Ix , X0 + Ix ].

2
See, for example, Boyle et al. (1989), Kamrad and Ritchken (1991) and Ekvall (1996).
 C.-C. Chang, J.-B. Lin / Int. Fin. Markets, Inst. and Money 20 (2010) 490–508 493

From Duan and Simonato (2001), we know that the term Ix is the conditional standard deviation of
the asset return over the life of the option contract multiplied by a scaling factor, which implies that:

Ix = ı(m) hT
√
where hT is the standard deviation of the asset return at time T, and ı(m) is a scaling factor. Once
we decide the overall time interval, the m discrete values can then be calculated by the following
equation:
2i − m − 1
x(i) = X0 + Ix , i ∈ {1, . . . , m} (4)
m−1
We can also calculate the transition probability of the return distribution of the underlying asset
under the m states. Similar to a lattice approach, once the future paths of the underlying asset price
are spanned, it is quite a straightforward matter to obtain the option price, irrespective of whether
these are America- or European-style options. For the case of American options, in order to obtain the
holding value of the option at time t, we need to calculate the expected payoff of the underlying asset
at time t + 1; this is then discounted by the risk-free rate.
The conditional expected values are required for the calculation of the current option values; and
indeed, the Markov chain method facilitates the computation of both the transition probability and
the possible underlying asset prices in the future. These are then multiplied together and discounted
by the risk-free rate to produce the current option values. Based on the foregoing discussion, it is a
simple matter to demonstrate a link between the lattice method and the Markov chain method.

2.2. Markov chain method of pricing derivatives with multiple underlying assets

Given that Kamrad and Ritchken (1991) have already demonstrated the trinomial procedure, in
this study we focus more on the Markov chain approaches, including the original Markov chain and
Sobol–Markov chain methods.

2.2.1. The original Markov chain pricing method with multiple underlying assets
Based upon the calculation procedures involved in the pricing of options under the Markov chain
method with one underlying asset, one way of pricing options with two underlying assets would be
to construct two sets of state variables based upon the initial values of two assets; hence we can have
pair values for two assets. Suppose, for example, that we have two m sets of state variables (si1 , si2 ,
. . ., sim ), i = 1, 2 for two respective assets.
Following the Markov chain method, we can have m × m states (pairs) for these two contingent
claims. These m × m states are denoted by (s11 , s21 ), (s11 , s22 ), (s11 , s23 ), . . ., (s1m , s2m ). Once we have
these pairs of states, we can then construct the transition probability based upon the bivariate normal
density.

2.2.2. The Sobol–Markov chain pricing method with multiple underlying assets
One of the disadvantages of the original Markov chain method is the rapid growth in the number
of states in the case of multivariate contingent claims. For example, if we create only 100 states for
every asset, then for the case of two assets, we must construct a 10,000 × 10,000 transition probability
matrix. Clearly, if we wish to increase the number of states for every asset, in an attempt to increase
the computational accuracy, there will be a requirement to calculate a huge transition probability
matrix.
Hence, in this study, in order to enhance the convergence speed of the original Markov chain
method, we employ low-discrepancy sequencing to construct the possible multi-asset states under
the Markov chain framework. Low-discrepancy sequencing, which is a well-known method used in
Monte Carlo simulations for reducing variance, comprises of a sequence which fills n-space more
uniformly than that achieved by random points. In contrast to uncorrelated random numbers, these
low-discrepancy sequences are artificial series of numbers, coming from the numerical evaluation of
an integral, which are intended to cover the n-space more uniformly.
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There are several ways of generating quasi-random sequences, such as the Halton, Faure and Sobol
sequences, amongst others. In this study, we use the Sobol sequencing method, primarily because this
method uses a shorter cycle length in the high dimensions than either the Halton or Faure sequences;
that is, based upon the same number of points, the Sobol sequences should ‘fill in the gaps’ within
the existing sequence at a much more rapid rate. Once we obtain the Sobol sequences in the high
dimensions, we can then apply these points to create the states of the Markov chain method, which
we can then refer to as the Sobol–Markov chain method for the pricing of multiple contingent claims.
We therefore use the low-discrepancy process to obtain points that evenly cover the n-space, and
once we have the sequence, we can then easily transfer these sequence numbers to construct the
appropriate states for the Markov chain. The Sobol sequence for two-dimensions with 16 points is
provided in the table below for the case of two assets. Once we have these series of numbers, we can
then transfer them individually into the asset prices; as a result, we have 16 pairs of points representing
two-dimensional discrete asset prices.

Series 1 Series 2 Series 1 Series 2

1 0.5 0.5 9 0.8125 0.8125

2 0.25 0.75 10 0.0625 0.5625
3 0.75 0.25 11 0.5625 0.0625
4 0.375 0.625 12 0.1875 0.9375
5 0.875 0.125 13 0.6875 0.4375
6 0.125 0.375 14 0.4375 0.1875
7 0.625 0.875 15 0.9375 0.6875
8 0.3125 0.3125 16 0.46875 0.84375

Once we have these discrete asset prices, following the original Markov chain method, we can
then use the bivariate density function to construct the transition probabilities. It is obvious that by
increasing the number of Sobol sequences, we can then obtain more discrete asset prices which will
more completely cover the two-dimensional space and produce a more accurate result for derivative
pricing.
Another important issue is, as noted by Duan et al. (2001) and Duan and Lin (2006), that transition
probability becomes a problem if we wish to deal with multivariate contingent claims, essentially
because, for the case of multiple assets, we need to have high-dimensional integrals. In order to solve
this problem, we use density as opposed to probability in this study to obtain the transition probability.
We can base the conditional density value on the current asset value in order to obtain the discrete
asset values; the probability can then be calculated by dividing all of these conditional density values
by the sum of the density values, and by so doing, we can avoid the high-dimensional integrals for
multivariate assets

3. Numerical examples and convergence tests

3.1. Options with one underlying asset

We use numerical examples to reveal the convergence and accuracy of the two computational
algorithms (the trinomial tree and original Markov chain methods) for the pricing of derivatives,
demonstrating firstly, the valuation of European options. For those cases where the underlying asset
follows a displaced log-normal distribution, the numerical results of the valuation of the options are
provided in Table 1.
As argued by Camara and Chung (2006), “the displaced process might describe the evolution of
the value of an all-equity-financed firm which is composed of risk-less assets and a risky project”. We
assume that the current stock price is 50, the annualized risk-less interest rate is 0.05, the annualized
return volatility of the underlying asset is 0.2 and the option maturity periods range from one month
to three years. Apart from the ˛, which is adopted from Camara and Chung (2006), all other parameters
are adopted from Duan and Simonato (2001).
The first panel in Table 1 is based on the ((m − 1)/2)-step trinomial tree model where m is the
number of discrete asset prices, whilst the second panel presents the results of the Duan and Simonato
 C.-C. Chang, J.-B. Lin / Int. Fin. Markets, Inst. and Money 20 (2010) 490–508
Table 1
Results for European put options with one underlying asset and displaced distributiona .

Maturity = 1 month Maturity = 3 months Maturity = 9 months Maturity = 3 years

K/S 1.10 1.00 0.90 1.10 1.00 0.90 1.10 1.00 0.90 1.10 1.00 0.90
Theoretical priceb 4.7971 0.8146 0.0055 4.6551 1.2894 0.1084 4.6162 1.8924 0.4850 4.2784 2.4414 1.1791

Trinomial tree prices ((m − 1)/2 steps)

m = 101 4.7966 0.8138 0.0054 4.6548 1.2895 0.1077 4.6148 1.8956 0.4841 4.2790 2.4504 1.1851
m = 201 4.7970 0.8144 0.0055 4.6545 1.2901 0.1085 4.6186 1.8951 0.4846 4.2810 2.4443 1.1821
m = 301 4.7970 0.8146 0.0055 4.6538 1.2901 0.1081 4.6178 1.8944 0.4849 4.2756 2.4407 1.1792
m = 401 4.7970 0.8147 0.0055 4.6553 1.2901 0.1084 4.6170 1.8940 0.4854 4.2806 2.4384 1.1789
m = 501 4.7970 0.8147 0.0055 4.6546 1.2900 0.1085 4.6152 1.8936 0.4852 4.2795 2.4404 1.1803

Original Markov chain prices (time step = 1 month)

m = 101 4.7970 0.8146 0.0054 4.6555 1.2905 0.1087 4.6191 1.8968 0.4875 4.2987 2.4540 1.1881
m = 201 4.7970 0.8146 0.0055 4.6552 1.2895 0.1085 4.6171 1.8932 0.4854 4.2795 2.4379 1.1740
m = 301 4.7971 0.8146 0.0055 4.6551 1.2895 0.1084 4.6166 1.8929 0.4852 4.2755 2.4342 1.1714
m = 401 4.7971 0.8146 0.0055 4.6550 1.2895 0.1084 4.6164 1.8927 0.4851 4.2740 2.4330 1.1703
m = 501 4.7971 0.8145 0.0055 4.6551 1.2894 0.1084 4.6163 1.8926 0.4850 4.2732 2.4323 1.1700
a
The option maturity periods range between one month and three years; we assume that the current stock price, S(0), is 50, the annualized risk-less interest rate, r, is 0.05, the annualized
volatility of the underlying asset return, , is 0.2, and the parameter ˛ is 10.
b
The theoretical values are computed by the closed-form solution of Camara and Chung (2006). All parameters are adopted from Duan and Simonato (2001) with the exception of ˛,
which is adopted from Camara and Chung (2006).

495
496 C.-C. Chang, J.-B. Lin / Int. Fin. Markets, Inst. and Money 20 (2010) 490–508

(2001) Markov chain model with a time interval of one month. We compare the convergence and
accuracy between the trinomial tree and original Markov chain models by using the same number of
discrete asset prices. Several interesting findings are summarized as follows.
Firstly, we find that the original Markov chain model converges more rapidly than the trinomial
tree method, particularly in those cases where the time to maturity is less than nine months. This
result is not at all surprising since, as noted earlier, the lattice approach can be regarded as a special
case of the Markov chain approach. By assigning a different transition probability, the Markov chain
method will reduce to the lattice approach. Secondly, we find that the original Duan and Simonato
(2001) Markov chain method cannot accurately value these options in those cases where maturity is in
excess of nine months. Based upon the same states (e.g., m = 501), but with longer maturity, the more
rapid convergence effect of the Markov chain model is reduced; thus, in order to solve the problem,
the numbers of states must be increased. Finally we should point out that it is quite a straightforward
matter to use the two computational algorithms to value American options, since either of these two
methods can tackle the early exercise problems that are encountered when dealing with the calculation
of American-style options.
Apart from the design of the transition probabilities, the major difference between the lattice and
Markov chain approaches is the relationship between the number of time steps and the discrete asset
values. Under the lattice approach, given a particular maturity period, the time steps and number
of discrete asset prices are simultaneously generated, which implies that if we wish to obtain more
accurate results under the lattice approach, the only one way would be to reduce the time interval (or
increase the number of discrete asset prices).
However under the Markov chain method, the length of the time steps and the number of asset
prices are two independent sets; thus, this time-state separation advantage makes it much easier for
us to value some products when the length of the time steps needs to be fixed (e.g., at one day or one
week). By increasing the number of discrete asset values, whilst retaining a fixed length of time steps,
we can obtain more accurate results. The results for American put options with displaced log-normal
distributions are presented in Table 2.
Given that there is no closed-form solution for the American options, we use the trinomial tree
model with 10,000 time steps as the benchmark; on the basis of continuous early exercise; this can
normally be viewed as the theoretical value. The first panel of Table 2 is based upon the ((m − 1)/2)-step
trinomial tree, where m is the number of discrete asset prices.
As in the case of European options, we use the number of discrete asset prices, from 101 to 501, to
carry out a comparison of the results between the trinomial tree and original Markov chain methods. In
contrast to the trinomial tree method, we do not need to increase the number of exercise points when
we increase the number of discrete asset prices; this is once again due to the time-state separation
which is inherent in the Markov chain method.
The results presented in Table 2 are based upon a time step of one day; however, we can of course
change the time step without increasing or reducing the number of discrete asset prices, again as a
result of the property of separation. Since the early exercise is on a daily basis, this implies that the
convergence speed of the Markov chain method should be lower than the theoretical values; and
indeed, as Table 2 shows, the original Markov chain method does converge quite well for short-term
options with one underlying asset.

3.2. Options with two underlying assets

The results of the pricing of binary options with two underlying assets are presented in Table 3,
with the binary option being written on two assets with different distributions.
We assume that the current stock price, S(0), is 40, the annualized risk-less interest rate, r, is 0.05,
the annualized return volatility of the underlying assets,  1 and  2 , are 0.3, the correlation coefficient,
, of these two assets is equal to 0.5, and the maturity of the options ranges between one month and
three years. All of the other parameters are adopted from Duan and Simonato (2001). The payoff of
this binary option is US$1.00 when both of these asset prices are greater than the exercise prices. We
use one-month time steps for both the original Markov chain method and the Sobol–Markov chain
method.
 C.-C. Chang, J.-B. Lin / Int. Fin. Markets, Inst. and Money 20 (2010) 490–508
Table 2
Results for American put options with one underlying asset and displaced distributiona .

Maturity = 1 month Maturity = 3 months Maturity = 9 months Maturity = 3 years

K/S 1.10 1.00 0.90 1.10 1.00 0.90 1.10 1.00 0.90 1.10 1.00 0.90
Theoretical priceb 5.0000 0.8305 0.0056 5.0139 1.3448 0.1111 5.2808 2.0837 0.5193 6.1027 3.3048 1.5233

Trinomial tree prices ((m − 1)/2 steps)

m = 101 5.000 0.8297 0.0054 5.0106 1.3442 0.1104 5.2749 2.0830 0.5173 6.0914 3.2886 1.5214
m = 201 5.000 0.8303 0.0055 5.0134 1.3450 0.1111 5.2778 2.0842 0.5188 6.0870 3.3013 1.5208
m = 301 5.000 0.8305 0.0055 5.0135 1.3452 0.1107 5.2805 2.0842 0.5189 6.0990 3.3023 1.5215
m = 401 5.000 0.8305 0.0055 5.0133 1.3452 0.1111 5.2794 2.0842 0.5193 6.0973 3.3014 1.5212
m = 501 5.000 0.8306 0.0055 5.0131 1.3452 0.1111 5.2799 2.0841 0.5193 6.1014 3.3013 1.5222

Original Markov chain prices (time step = 1 month)

m = 101 5.0000 0.8349 0.0058 5.0178 1.3705 0.1198 5.3633 2.2071 0.5967 6.6447 3.8893 1.9976
m = 201 5.0000 0.8311 0.0056 5.0135 1.3510 0.1133 5.3019 2.1170 0.5400 6.3100 3.5324 1.7052
m = 301 5.0000 0.8303 0.0056 5.0128 1.3473 0.1120 5.2898 2.0988 0.5288 6.1990 3.4117 1.6083
m = 401 5.0000 0.8300 0.0056 5.0125 1.3459 0.1116 5.2854 2.0921 0.5246 6.1580 3.3666 1.5724
m = 501 5.0000 0.8299 0.0056 5.0124 1.3452 0.1114 5.2833 2.0888 0.5227 6.1385 3.3450 1.5553
a
The option maturity periods range between one month and three years; we assume that the current stock price, S(0), is 50, the annualized risk-less interest rate, r, is 0.05, the annualized
volatility of the underlying asset return, , is 0.2, and the parameter ˛ is 10.
b
The theoretical values are computed by the trinomial tree prices with 10,000 steps. All parameters are adopted from Duan and Simonato (2001) with the exception of ˛, which is
adopted from Camara and Chung (2006).

497
 498
Table 3
Results for European binary call options with two underlying assets and log-normal and normal distributiona .

Maturity = 1 month Maturity = 3 months Maturity = 9 months Maturity = 3 years

S = 40 S = 40 S = 40 S = 40 S = 40 S = 40 S = 40 S = 40

C.-C. Chang, J.-B. Lin / Int. Fin. Markets, Inst. and Money 20 (2010) 490–508
K = 35 K = 40 K = 35 K = 40 K = 35 K = 40 K = 35 K = 40
Theoretical priceb 0.9351 0.3424 0.8054 0.3470 0.6756 0.3509 0.5272 0.3388

Trinomial tree prices (≈ m/2 steps)
m = 29 × 29 0.9148 0.2899 0.7724 0.2945 0.6581 0.2989 0.4929 0.2980
m = 39 × 39 0.9263 0.2973 0.8170 0.3006 0.6366 0.3047 0.4859 0.3059
m = 49 × 49 0.9369 0.3200 0.7909 0.3045 0.7028 0.3089 0.5600 0.3003
m = 59 × 59 0.9460 0.3141 0.8286 0.3166 0.6859 0.3506 0.5501 0.3424
m = 69 × 69 0.9321 0.3057 0.8103 0.3182 0.6725 0.3146 0.5422 0.3179
m = 79 × 79 0.9427 0.3078 0.7947 0.3124 0.6615 0.3167 0.5358 0.3123

Original Markov chain prices (time step = 1 month, number of states = m × m)

m = 29 × 29 0.9293 0.3790 0.7803 0.3758 0.6913 0.3665 0.5467 0.3660
m = 39 × 39 0.9268 0.3672 0.8202 0.3642 0.7017 0.3553 0.5189 0.3469
m = 49 × 49 0.9429 0.3602 0.8086 0.3573 0.6627 0.3751 0.5482 0.3568
m = 59 × 59 0.9400 0.3556 0.8011 0.3526 0.6759 0.3663 0.5299 0.3459
m = 69 × 69 0.9382 0.3522 0.7955 0.3494 0.6852 0.3602 0.5164 0.3381
m = 79 × 79 0.9370 0.3498 0.8153 0.3469 0.6628 0.3554 0.5358 0.3456

Sobol–Markov chain prices (number of sequences = m × m)

m = 29 × 29 0.9369 0.3495 0.8095 0.3496 0.6811 0.3569 0.4956 0.3245
m = 39 × 39 0.9341 0.3378 0.8076 0.3325 0.6606 0.3349 0.4928 0.2994
m = 49 × 49 0.9349 0.3445 0.8096 0.3424 0.6777 0.3434 0.5204 0.3248
m = 59 × 59 0.9335 0.3410 0.8073 0.3446 0.6744 0.3407 0.5145 0.3158
m = 69 × 69 0.9350 0.3402 0.8078 0.3411 0.6754 0.3408 0.5235 0.3241
m = 79 × 79 0.9349 0.3428 0.8058 0.3459 0.6745 0.3480 0.5256 0.3337
a
The option maturity periods range between one month and three years; we assume that the current stock price, S(0), is 40, the annualized risk-less interest rate, r, is 0.05, the annualized
volatility of the underlying asset returns,  and  2 , are 0.3, and that the correlation coefficients, , of these two assets are equal to 0.5.
b
The theoretical values were computed by Camara (2005). All other parameters are adopted from Duan and Simonato (2001).
 C.-C. Chang, J.-B. Lin / Int. Fin. Markets, Inst. and Money 20 (2010) 490–508 499

We can see from Table 3 that the Sobol–Markov chain method has much better convergence than
both the multivariate trinomial method and the original Duan and Simonato (2001) Markov chain
method. For these three methods, under similar numbers of states, we find that the Sobol–Markov
chain method provides superior overall performance in the pricing of binary options with either short-
term or long-term maturity periods.
As noted earlier, in order to obtain better results for the original Markov chain method under a
framework of two assets, 79 × 79 states may be necessary; however, using the Sobol–Markov chain
method, we can get very similar results with only 29 × 29 states. This result provides evidence to
show that the Sobol–Markov chain method is capable of providing efficient and accurate valuation of
multivariate contingent claims. Clearly, this also enables us to use the Sobol–Markov chain method
under fewer numbers of states than the original Markov chain method for the pricing of weather
derivatives traded in the over-the-counter market, and for the valuation of executive stock options
with maturity periods in excess of three years.
Table 3 therefore demonstrates that the performance of the Sobol–Markov chain approach is supe-
rior to both the lattice approach and the original Markov chain approach. However, in order to facilitate
a more general comparison, we use the ‘root-mean-squared relative error’ (RMSE), which is defined as:

 j
1
RMSE =  e2 k
(5)
j
k=1

where ek = (Pk * − Pk )/Pk is the relative error, Pk * is the numerical price, Pk is the theoretical binary
option price, and j is the number of options under consideration. The different parameters for these
options are as follows, the option strike prices are K1 = 36, 40 and K2 = 36, 40; and the volatility of both
asset 1 ( 1 ) and asset 2 ( 2 ) = 0.2, 0.3. The various time to maturity periods, t, are 1 month, 3 months,
1.5 years and 3 years.
The results presented in Table 3 are obtained under the same number of discrete asset prices;
hence, with an increase in the time to maturity period of the option, there will be a corresponding
reduction in computational accuracy. We therefore undertake a comparison of the models in this study
based upon two distinct groups; the first relating to options with shorter time to maturity periods (one
month and three months), and the second relating to options with longer time to maturity periods
(1.5 years and 3 years).
The results for options with shorter time to maturity periods are presented in Table 4, from which
we can clearly see that the Markov chain method has better convergence than the lattice approach irre-
spective of whether we adopt the original Markov chain or Sobol–Markov chain method. Both methods
have lower percentage errors than the lattice approaches, and indeed, this becomes even more obvi-
ous when we refer to the RMSE for these three models. As shown in Table 4, the Sobol–Markov chain
method has the lowest RMSE.
The results for options with longer time to maturity periods are provided in Table 5 from which we
can again see that the Sobol–Markov chain has much more rapid convergence than the other models.

4. The application of executive stock options

From a financial perspective, principal-agent problems will invariably exist between shareholders
and managers; and indeed, the alignment of the interests of the agents with those of the principals
remains a difficult issue. One way of attempting to solve this problem is to use so-called compensation
policies, of which, the granting of ‘executive stock options’ (ESOs) is the most common and popular
approach.
In this study, we follow the settings of Camara (2001) to examine how the value of ESOs is affected
by absolute performance incentives (APIs) and relative performance incentives (RPIs). In contrast to
the focus in Camara (2001) on the valuation of European-style ESOs, we consider the pricing property
of American-style ESOs, essentially because it has been reported in Huddart and Lang (1996) that
ESOs were usually American-style options. From their examination of samples of firms between 1982
and 1994, Huddart and Lang found that options were usually exercised prior to expiration. They also
 500
Table 4
Binary option results for shorter-term (1 month and 3 months) time to maturitya .

(1) (2) (3) (4) (5) (6) (7) ((7) − (6))/(6) (8) (8) − (6)/(6) (9) (9) − (6)/(6)
K1 K2 1 2 t (%) (%) (%)

36 36 0.2 0.2 1 0.9651 0.9632 −0.0020 0.9624 −0.0028 0.9652 0.0001

36 36 0.2 0.2 3 0.8597 0.8567 −0.0034 0.8567 −0.0035 0.8609 0.0015
36 36 0.2 0.3 1 0.9651 0.9632 −0.0020 0.9624 −0.0028 0.9652 0.0001
36 36 0.2 0.3 3 0.8597 0.8567 −0.0034 0.8567 −0.0035 0.8609 0.0015

C.-C. Chang, J.-B. Lin / Int. Fin. Markets, Inst. and Money 20 (2010) 490–508
36 36 0.3 0.2 1 0.8853 0.8876 0.0026 0.8821 −0.0036 0.8852 −0.0002
36 36 0.3 0.2 3 0.7519 0.7391 −0.0170 0.7388 −0.0174 0.7539 0.0026
36 36 0.3 0.3 1 0.8853 0.8876 0.0026 0.8821 −0.0036 0.8852 −0.0002
36 36 0.3 0.3 3 0.7519 0.7391 −0.0170 0.7388 −0.0174 0.7539 0.0026
36 40 0.2 0.2 1 0.5230 0.4859 −0.0709 0.5118 −0.0214 0.5240 0.0019
36 40 0.2 0.2 3 0.5148 0.4815 −0.0647 0.5168 0.0041 0.5146 −0.0003
36 40 0.2 0.3 1 0.5136 0.4765 −0.0723 0.5118 −0.0036 0.5148 0.0023
36 40 0.2 0.3 3 0.5002 0.4667 −0.0670 0.4857 −0.0290 0.4971 −0.0061
36 40 0.3 0.2 1 0.5055 0.4709 −0.0685 0.4946 −0.0216 0.5059 0.0008
36 40 0.3 0.2 3 0.4768 0.4448 −0.0671 0.4741 −0.0056 0.4765 −0.0005
36 40 0.3 0.3 1 0.4968 0.4621 −0.0699 0.4946 −0.0044 0.4968 0.0000
36 40 0.3 0.3 3 0.4641 0.4319 −0.0693 0.4474 −0.0360 0.4613 −0.0061
40 36 0.2 0.2 1 0.5151 0.5029 −0.0238 0.5156 0.0010 0.5137 −0.0027
40 36 0.2 0.2 3 0.5233 0.5183 −0.0095 0.5113 −0.0229 0.5230 −0.0005
40 36 0.2 0.3 1 0.5151 0.5031 −0.0232 0.5156 0.0010 0.5137 −0.0027
40 36 0.2 0.3 3 0.5233 0.5189 −0.0084 0.5113 −0.0229 0.5230 −0.0005
40 36 0.3 0.2 1 0.4998 0.4624 −0.0749 0.5156 0.0316 0.4995 −0.0007
40 36 0.3 0.2 3 0.4971 0.4599 −0.0747 0.5113 0.0287 0.4971 0.0000
40 36 0.3 0.3 1 0.7998 0.4624 −0.0749 0.5156 0.0316 0.4995 −0.0007
40 36 0.3 0.3 3 0.4971 0.4599 −0.0747 0.5113 0.0287 0.4971 0.0000
40 40 0.2 0.2 1 0.3551 0.3259 −0.0822 0.3498 −0.0151 0.3549 −0.0007
40 40 0.2 0.2 3 0.3692 0.3434 −0.0700 0.3644 −0.0130 0.3675 −0.0048
40 40 0.2 0.3 1 0.3503 0.3211 −0.0834 0.3498 −0.0015 0.3486 −0.0049
40 40 0.2 0.3 3 0.3609 0.3350 −0.0718 0.3470 −0.0387 0.3577 −0.0090
40 40 0.3 0.2 1 0.3471 0.3123 −0.1002 0.3498 0.0078 0.3491 0.0060
40 40 0.3 0.2 3 0.3549 0.3200 −0.0983 0.3644 0.0269 0.3557 0.0024
40 40 0.3 0.3 1 0.3424 0.3078 −0.1010 0.3498 0.0215 0.3428 0.0013
40 40 0.3 0.3 3 0.3470 0.3124 −0.0997 0.3470 −0.0003 0.3459 −0.0033

RMSE 0.0627 0.0191 0.0031

a
The number of states for the three methods is 79 × 79. We assume that the current stock price, S(0), is 40, the annualized risk-less interest rate, r, is 0.05, and that the correlation
coefficients, , of these two assets are equal to 0.5. Columns (1) and (2) represent the option strike prices for assets 1 and 2, K1 and K2 ; Columns (3) and (4) represent the volatility
parameters for assets 1 and 2,  1 and  2 ; Column (5), t, refers to the different times to maturity. Column (6) shows the theoretical values of the binary options. Columns (7)–(9) represent
the results for the binary options based on the trinomial tree, original Markov chain and Sobol–Markov chain methods. The RMSE is the root of mean squared errors defined in Eq. (5).
Table 5
Valuation of binary options for longer (1.5 years and 3 years) times to maturitya .

(1) (2) (3) (4) (5) (6) (7) (7) − (6)/6 (8) (8 − (6)/6 (9) (9 − (6)/6
K1 K2 1 2 T (%) (%) (%)

36 36 0.2 0.2 1.5 0.6772 0.6904 0.0189 0.6669 −0.0158 0.6776 −0.0006
36 36 0.2 0.2 3 0.6157 0.6083 −0.0096 0.6187 0.0073 0.6142 0.0024
36 36 0.2 0.3 1.5 0.6772 0.6904 0.0189 0.6669 −0.0158 0.6776 −0.0006
36 36 0.2 0.3 3 0.6157 0.6083 −0.0096 0.6187 0.0073 0.6142 0.0024
36 36 0.3 0.2 1.5 0.5717 0.5746 −0.0021 0.5775 0.0029 0.5758 −0.0072

C.-C. Chang, J.-B. Lin / Int. Fin. Markets, Inst. and Money 20 (2010) 490–508
36 36 0.3 0.2 3 0.5032 0.5358 0.0523 0.5062 −0.0058 0.5092 −0.0118
36 36 0.3 0.3 1.5 0.5717 0.5746 −0.0021 0.5775 0.0029 0.5758 −0.0072
36 36 0.3 0.3 3 0.5032 0.5358 0.0523 0.5062 −0.0058 0.5092 −0.0118
36 40 0.2 0.2 1.5 0.4764 0.4644 −0.0392 0.4794 −0.0081 0.4833 −0.0143
36 40 0.2 0.2 3 0.4640 0.4470 −0.0454 0.4642 −0.0087 0.4683 −0.0094
36 40 0.2 0.3 1.5 0.4537 0.4365 −0.0454 0.4572 −0.0002 0.4573 −0.0078
36 40 0.2 0.3 3 0.4380 0.4144 −0.0522 0.4447 0.0172 0.4372 0.0018
36 40 0.3 0.2 1.5 0.4178 0.4109 −0.0418 0.4310 0.0051 0.4288 −0.0256
36 40 0.3 0.2 3 0.3940 0.4071 0.0063 0.3976 −0.0173 0.4046 −0.0261
36 40 0.3 0.3 1.5 0.4002 0.3883 −0.0471 0.4125 0.0122 0.4075 −0.0179
36 40 0.3 0.3 3 0.3726 0.3791 −0.0031 0.3827 0.0062 0.3803 −0.0201
40 36 0.2 0.2 1.5 0.5262 0.4970 −0.0648 0.5457 0.0266 0.5315 −0.0100
40 36 0.2 0.2 3 0.5153 0.5082 −0.0200 0.5062 −0.0238 0.5186 −0.0064
40 36 0.2 0.3 1.5 0.5262 0.4970 −0.0648 0.5457 0.0266 0.5315 −0.0100
40 36 0.2 0.3 3 0.5153 0.5093 −0.0179 0.5062 −0.0238 0.5186 −0.0064
40 36 0.3 0.2 1.5 0.4685 0.4365 −0.0740 0.4804 0.0190 0.4714 −0.0061
40 36 0.3 0.2 3 0.4386 0.4141 −0.0594 0.4457 0.0122 0.4403 −0.0037
40 36 0.3 0.3 1.5 0.4685 0.4365 −0.0740 0.4804 0.0190 0.4714 −0.0061
40 36 0.3 0.3 3 0.4386 0.4129 −0.0623 0.4457 0.0122 0.4403 −0.0037
40 40 0.2 0.2 1.5 0.3940 0.3681 −0.0864 0.4125 0.0238 0.4029 −0.0223
40 40 0.2 0.2 3 0.4024 0.3893 −0.0519 0.3976 −0.0316 0.4106 −0.0198
40 40 0.2 0.3 1.5 0.3764 0.3493 −0.0898 0.3953 0.0301 0.3837 −0.0192
40 40 0.2 0.3 3 0.3811 0.3632 −0.0585 0.3827 −0.0079 0.3857 −0.0120
40 40 0.3 0.2 1.5 0.3583 0.3323 −0.0919 0.3725 0.0182 0.3659 −0.0208
40 40 0.3 0.2 3 0.3535 0.3334 −0.0708 0.3582 −0.0016 0.3588 −0.0147
40 40 0.3 0.3 1.5 0.3443 0.3162 −0.0953 0.3579 0.0241 0.3495 −0.0148
40 40 0.3 0.3 3 0.3337 0.3123 −0.0782 0.3456 0.0201 0.3388 −0.0149

RMSE 0.0549 0.0168 0.0133

a
Columns (1) and (2) represent the strike prices for options with underlying asset 1, K1 , and underlying asset 2, K2 ; Columns (3) and (4) represent the volatility parameters for the
returns of underlying asset 1,  1 , and underlying asset 2,  2 ; Column (5), T, refers to different times to maturity. Column (6) shows the theoretical values of the binary options. Columns
(7)–(9) represent the results for the binary options based on the trinomial tree, original Markov chain and Sobol–Markov chain methods. The number of states for the three methods is
79 × 79. We assume that the current stock price, S(0), is 40, the annualized risk-less interest rate, r, is 0.05, and that the correlation coefficients, , of the returns of the two underlying

501
assets are equal to 0.5. The RMSE is the root of mean squared errors defined in Eq. (5).
502 C.-C. Chang, J.-B. Lin / Int. Fin. Markets, Inst. and Money 20 (2010) 490–508

found that most ESO contracts were designed with a vesting period, during which the holders could not
exercise the options; therefore, vesting periods will also be discussed in this study. As demonstrated
in Kole (1997), the average duration of the vesting periods in ESO contracts was about two years.

4.1. Economic settings

In line with Camara (2001), we make the following assumptions. Firstly, we assume that contingent
claims are marketable, and that both processes of the underlying stock price, S, and stock index value,
I, follow a GM process. The second assumption is that there is a representative agent who has a power
utility function.
Based upon the above assumptions, the payoff of a relative performance-based ESO can be
expressed as follows:

S(T )eqT /S
S(T ) − K if S(T ) > K and >X
ESOR I(T )eqI T /I (6)
0 if otherwise

where q (qI ) are the continuous dividend yields of the underlying stock (stock index). The payoff is
positive if the total stockholder return S(T)eqT /S is higher than a threshold X times the index return
I(T)eq I T /I; otherwise the payout of the incentive is zero. The current value of this ESO is then given by
the following equation:
√ √
ESOR = Se−qT N2 [˛  T − d1 , d2 +  T , ˛ ] − Ke−rT N2 [−d1 , d2 , ˛ ] (7)

where
 I
˛ = −
I I
ln(X) + (˛2 /2)T
d1 = √
˛ T (8)
˛2 =  2 + I2 − 2I
ln(S/K) + (r − q − ˛2 /2)T
d2 = √
 T
and N2 [. . .] is the cumulative bivariate standard normal random variable. The current value of an ESO
under an API design is as follows:
√
ESOA = Se−qT N[d2 +  T ] − Ke−rT N[d2 ] (9)

and N[. . .] is the cumulative standard normal random variable.

Under an API design, we use the original Markov chain method to price both European- and
American-style ESOs since we need to consider only one asset, the underlying stock price. Under an RPI
design, we use the Sobol–Markov chain to calculate the ESO values since we have to simultaneously
calculate both the underlying stock price and the index value.
We assume that the initial stock price, S, is 100, the dividend yield of the stock, q, is 2 per cent,
the annualized risk-less rate, r, is 5 per cent, the option time to maturity period, T, is five years, the
vesting period, , is two years, the annualized return volatility of the stock, , is 20 per cent, and the
annualized return volatility of the index,  I , is 15 per cent. We also assume that X = 1, and that the
correlation coefficient, , between the underlying stock and index returns is 0.5625. Table 6 shows
the numerical results for ESOs under an API design.
The benchmark values of the American-style options are calculated by least squared Monte Carlo
simulations with 20 × 200,000 simulation results. From the payoff of the ESOs under an API design, we
know that the option values are affected only by individual stock prices; we therefore use the original
Markov chain method for the calculation of these options. In order to examine the convergence pattern
and speed, the number of states ranging between 301 and 2001 are shown for both the European- and
American-style ESOs under the original Markov chain method.
 C.-C. Chang, J.-B. Lin / Int. Fin. Markets, Inst. and Money 20 (2010) 490–508 503

Table 6
Executive stock options under API designa .

European style American style (time step = 1 day)

Without vesting With vesting Without vesting With vesting

Benchmark priceb 22.0111 16.1961 22.0352 (0.1144) 16.1913 (0.04247)

Original Markov chain prices

m = 301 22.0075 16.1944 23.2779 16.7225
m = 401 22.0074 16.1945 22.7519 16.5014
m = 501 22.0081 16.1946 22.5016 16.3959
m = 601 22.0083 16.1947 22.3625 16.3373
m = 701 22.0084 16.1948 22.2772 16.3015
m = 801 22.0087 16.1948 22.2213 16.2779
m = 901 22.0088 16.1949 22.1823 16.2615
m = 1001 22.0089 16.195 22.1543 16.2497
m = 1101 22.0091 16.195 22.1334 16.2409
m = 1201 22.0091 16.1951 22.1173 16.2342
m = 1301 22.0092 16.1952 22.1047 16.2289
m = 1401 22.0093 16.1952 22.0947 16.2247
m = 1501 22.0093 16.1952 22.0865 16.2213
m = 1601 22.0094 16.1953 22.0799 16.2184
m = 1701 22.0095 16.1953 22.0743 16.2161
m = 1801 22.0095 16.1953 22.0696 16.2141
m = 1901 22.0096 16.1954 22.0656 16.2124
m = 2001 22.0096 16.1954 22.0622 16.2110
a
We assume that the current stock price, S(0), is 100, the exercise price, K, is 100, the annualized risk-less interest rate, r, is
0.05, the annualized volatility of the underlying asset return, , is 0.2, and the annualized dividend yield, d, is 0.02. For ESOs
without vesting periods, the option maturity period, T, is five years. For ESOs with vesting periods, the vesting period is two
years and the option maturity period, T, is five years.
b
The least squares Monte Carlo method is used for the calculation of the American-style ESO values as the benchmark. The
benchmark value includes the mean and S.D. of 20 × 10,000 simulation results.

Table 7
Executive stock options under RPI designa .

European style (time step = 2 weeks) American style (time step = 2 weeks)

Without vesting With vesting Without vesting With vesting

Benchmark priceb 21.0279 15.8401 21.4808 (0.0133) 15.9772 (0.0692)

Sobol–Markov chain prices

m = 8000 19.5746 15.4529 20.3833 15.6756
m = 8500 20.2177 15.7873 20.9929 15.9982
m = 9000 20.0783 15.6397 20.8090 15.8541
m = 9500 20.4075 15.7539 21.1458 15.9731
m = 10000 20.6884 15.9138 21.3574 16.1100
m = 10500 20.5649 15.8668 21.1922 16.0514
m = 11000 20.3475 15.6791 20.9709 15.8500
m = 11500 20.3410 15.6566 20.9762 15.8471
m = 12000 20.6649 15.7795 21.2993 15.9645
m = 12500 20.5996 15.7003 21.2262 15.8815
m = 13000 20.5187 15.6355 21.1570 15.8165
m = 13500 20.4528 15.5515 21.0666 15.7210
m = 14000 20.7217 15.7191 21.3175 15.8909
m = 14500 21.0167 15.8829 21.5827 16.0499
m = 15000 20.9103 15.8284 21.4910 16.0016
a
We assume that the current stock price, S(0), is 100, the exercise price, K, is 100, the annualized risk-less interest rate, r, is
0.05, the annualized volatility of the underlying asset return, , is 0.2, the annualized volatility of the index return,  I , is 0.15,
and the dividend yield, d, is 0.02. For ESOs without vesting periods, the option maturity period, T, is five years; for ESOs with
vesting periods, the vesting period is two years and the option maturity period, T, is five years. The number of states for the
Sobol–Markov chain is 15,000, and the time step is two weeks.
b
The least squares Monte Carlo method is used for the calculation of the American-style ESO values as the benchmark; the
benchmark value includes the mean and S.D. of 20 × 200,000 simulation results.
504 C.-C. Chang, J.-B. Lin / Int. Fin. Markets, Inst. and Money 20 (2010) 490–508

Table 8
Absolute performance-based incentives for increasing shareholder wealtha .

Current stock price European-style ESOs American-style ESOs

Without vesting With vesting Without vesting With vesting

Option price Delta option price Delta Option price Delta Option price Delta

50 1.4213 0.1456 0.3464 0.0529 1.4219 0.1456 0.3464 0.0550

60 3.4031 0.2532 1.2504 0.1346 3.4043 0.2533 1.2506 0.1401
70 6.5061 0.3671 3.1497 0.2492 6.5086 0.3673 3.1501 0.2594
80 10.7217 0.4741 6.2771 0.3768 10.7267 0.4745 6.2779 0.3922
90 15.9410 0.5672 10.6655 0.4988 15.9513 0.5679 10.6667 0.5192
100 22.0111 0.6442 16.1962 0.6040 22.0314 0.6455 16.1981 0.6287
110 28.7730 0.7058 22.6747 0.6882 28.8103 0.7079 22.6784 0.7165
120 36.0813 0.7539 29.8924 0.7522 36.1461 0.7572 29.8997 0.7834
130 43.8133 0.7909 37.6613 0.7990 43.9193 0.7958 37.6752 0.8325
140 51.8691 0.8190 45.8279 0.8324 52.0340 0.8259 45.8535 0.8679
150 60.1704 0.8403 54.2748 0.8556 60.4159 0.8495 54.3192 0.8929
a
We assume that the current stock price, S(0), ranges from 50 to 150, the exercise price, K, is 100, the annualized risk-less
interest rate, r, is 0.05, the annualized volatility of the underlying asset return, , is 0.2, the annualized volatility of the index
return,  I , is 0.15, and the dividend yield, d, is 0.02. For ESOs without vesting period, the option maturity period, T, is five years;
for ESOs with vesting period, the vesting period is two years and the option maturity period, T, is five years. The number of
states for the Sobol–Markov chain is 15,000, and the time step is two weeks.

Although the time to maturity period for European-style options is in excess of three years, the
error percentage is less than 0.1 per cent, even when only 301 states are used. For American-style
options, when 901 states (or more) are used, the results under the original Markov chain method fall
into one standard deviation for both ESOs, either with or without vesting periods.
The numerical results for ESOs under an RPI design are presented in Table 7, with the Sobol–Markov
chain method being used to calculate the option values; the reason for this is that both individual stock
and index processes are considered for ESOs under an RPI design. Again, it is obvious that, with an
increase in the number of states, both European- and American-style ESOs converge to the benchmark
values.
The numerical results for European- and American-style options with different initial stock prices
are presented in Tables 8 and 9, under both API and RPI designs. When employing the Sobol–Markov

Table 9
Incentives for increasing shareholder wealth under RPI design.

Currenta stock price European-style ESOs American-style ESOs

Without vesting With vesting Without vesting With vesting

Option price Delta Option price Delta Option price Delta Option price Delta

50 1.4163 0.1445 0.3462 0.0528 1.3467 0.1397 0.3373 0.0516

60 3.3753 0.2492 1.2486 0.1342 3.2727 0.2479 1.2227 0.1314
70 6.4080 0.3564 3.1376 0.2472 6.3189 0.3592 3.1076 0.2484
80 10.4657 0.4525 6.2263 0.3704 10.4433 0.4651 6.2119 0.3726
90 15.3998 0.5312 10.5134 0.4842 15.5518 0.5571 10.5497 0.4907
100 21.0279 0.5915 15.8401 0.5772 21.4910 0.6350 16.0016 0.5944
110 27.1763 0.6357 21.9785 0.6466 28.1092 0.6788 22.3779 0.6675
120 33.6992 0.6670 28.7015 0.6949 35.2587 0.7339 29.4654 0.7250
130 40.4842 0.6886 35.8205 0.7266 42.8362 0.7891 37.1023 0.8000
140 47.4485 0.7033 43.1948 0.7466 50.7637 0.7970 45.1619 0.8300
150 54.5337 0.7131 50.7275 0.7589 58.9843 0.8314 53.5365 0.8519
a
We assume that the current stock price, S(0), ranges from 50 to 150, the exercise price, K, is 100, the annualized risk-less
interest rate, r, is 0.05, the annualized volatility of the underlying asset return, , is 0.2, the annualized volatility of the index
return,  I , is 0.15, and the dividend yield, d, is 0.02. For ESOs without vesting period, the option maturity period, T, is five years;
for ESOs with vesting period, the vesting period is two years and the option maturity period, T, is five years. The number of
states for the Sobol–Markov chain is 15,000, and the time step is two weeks.
 C.-C. Chang, J.-B. Lin / Int. Fin. Markets, Inst. and Money 20 (2010) 490–508 505

Fig. 1. Comparison of European-style ESOs under API and RPI designs. Notes: (a) We assume that the current stock price, S(0),
is 100, the exercise price, K, is 100, the annualized risk-less interest rate, r, is 0.05, the annualized volatility of the underlying
asset return, , is 0.2, the annualized volatility of the index return,  I , is 0.15, and the dividend yield, d, is 0.02. (b) For ESOs
without vesting periods, the option maturity period, T, is five years; for ESOs with vesting periods, the vesting period is two
years and the option maturity period, T, is five years.

chain method, we use 15,000 states for the American-style ESOs in order to obtain more accurate
values. We find that the highest values, under both API and RPI designs, are found for American-style
ESOs, results which are generally are in line with our expectations.
The comparative numerical results for different initial stock prices are shown in Fig. 1 for an
European-style design and Fig. 2 for an American-style design. We can see from these figures that
the ESO prices are an increasing function of the stock prices, and that the costs of at-the-money and
in-the-money ESOs are higher under an API design than under an RPI design, irrespective of whether
or not vesting periods are involved; this trend is even more obvious when there is a rise in the under-
lying stock price. However, for European-style ESOs with vesting periods, under both API and RPI
designs, the cost differences are smaller than those without vesting periods under either design; this
phenomenon also exists for the case the American-style ESOs.
We conclude from Figs. 1 and 2 that firms can reduce the costs of their compensation packages,
irrespective of whether they are using American- or European-style ESOs, by using an RPI design as
opposed to an API design, a result which is consistent with the findings of Camara (2001).

Fig. 2. Comparison of American-style ESOs under API and RPI designs with vesting periods. Notes: (a) We assume that the
current stock price, S(0), is 100, the exercise price, K, is 100, the annualized risk-less interest rate, r, is 0.05, the annualized
volatility of the underlying asset return, , is 0.2, the annualized volatility of the index return,  I , is 0.15, and the dividend yield,
d, is 0.02. (b) For ESOs without vesting periods, the option maturity period, T, is five years; for ESOs with vesting periods, the
vesting period is two years and the option maturity period, T, is five years.
506 C.-C. Chang, J.-B. Lin / Int. Fin. Markets, Inst. and Money 20 (2010) 490–508

Fig. 3. Pay performance sensitivity for different initial stock prices under an API design. Notes: (a) We assume that the current
stock price, S(0), is 100, the exercise price, K, is 100, the annualized risk-less interest rate, r, is 0.05, the annualized volatility
of the underlying asset return, , is 0.2, the annualized volatility of the index return,  I , is 0.15, and the dividend yield, d, is
0.02. (b) For ESOs without vesting periods, the option maturity period, T, is five years; for ESOs with vesting periods, the vesting
period is two years and the option maturity period, T, is five years.

The sensitivities (deltas) of the ESOs measure the corresponding change in the wealth of firms’
executives with an increase in the stock price of the firm, which infers that the higher the ESO value,
the stronger the incentive effect. The sensitivity analyses for ESOs are illustrated in Fig. 3 for an API
design and Fig. 4 for an RPI design; these figures show that for at-the-money and in-the-money ESOs,
the pay performance sensitivity for American-style ESOs with vesting periods have the highest value
under both API and RPI designs. This implies that when the stock price is higher than the strike price,
the strongest incentive effect for executives is provided by American-style ESOs with vesting periods.
The respective details of the comparisons between European- and American-style ESOs are pro-
vided in Figs. 5 and 6, under both API and RPI designs. We find that the incentive effects under an API
design are always higher than those under an RPI design, particularly when the option is at-the-money
or in-the-money; however, there is less difference between the API and RPI designs for American-style
ESOs than for European-style ESOs. Such a result indicates that the differences in the incentive effects
of API and RPI designs are somewhat limited for American-style ESOs, irrespective of whether or not
vesting periods are included in the contracts. Hence this reveals that an RPI design does not provide
any greater incentives than an API design for the executives of firms to increase shareholder wealth.

Fig. 4. Pay performance sensitivity for different initial stock prices under an RPI design. Notes: (a) We assume that the current
stock price, S(0), is 100, the exercise price, K, is 100, the annualized risk-less interest rate, r, is 0.05, the annualized volatility
of the underlying asset return, , is 0.2, the annualized volatility of the index return,  I , is 0.15, and the dividend yield, d, is
0.02. (b) For ESOs without vesting periods, the option maturity period, T, is five years; for ESOs with vesting periods, the vesting
period is two years and the option maturity period, T, is five years.
 C.-C. Chang, J.-B. Lin / Int. Fin. Markets, Inst. and Money 20 (2010) 490–508 507

Fig. 5. Comparison of European-style ESOs under API and RPI designs. Notes: (a) We assume that the current stock price, S(0),
is 100, the exercise price, K, is 100, the annualized risk-less interest rate, r, is 0.05, the annualized volatility of the underlying
asset return, , is 0.2, the annualized volatility of the index return,  I , is 0.15, and the dividend yield, d, is 0.02. (b) For ESOs
without vesting periods, the option maturity period, T, is five years; for ESOs with vesting periods, the vesting period is two
years and the option maturity period, T, is five years.

Fig. 6. Comparison of American-style ESOs under API and RPI designs. Notes: (a) We assume that the current stock price, S(0),
is 100, the exercise price, K, is 100, the annualized risk-less interest rate, r, is 0.05, the annualized volatility of the underlying
asset return, , is 0.2, the annualized volatility of the index return,  I , is 0.15, and the dividend yield, d, is 0.02. (b) For ESOs
without vesting periods, the option maturity period, T, is five years; for ESOs with vesting periods, the vesting period is two
years and the option maturity period, T, is five years.

5. Conclusions

This study compares the computational accuracy and efficiency of three numerical approaches to
the valuation of contingent claims written on multiple underlying assets; these are the trinomial tree
approach, the original Markov chain approach and the Sobol–Markov chain approach. We also use
‘executive stock options’ (ESOs) as an example to demonstrate that the Sobol–Markov chain method
can be readily adopted for the valuation of ESOs. The two Markov chain methods are also used to
compare the value and sensitivity of ESOs under both ‘absolute performance incentive’ (API) and
‘relative performance incentive’ (RPI) designs.
The major findings of this study are: (i) the original Duan and Simonato (2001) Markov chain model
converges more rapidly than the trinomial tree method, particularly in those cases where the time to
maturity period is less than nine months; (ii) when pricing options with longer maturity periods and/or
multiple underlying assets, the Sobol–Markov chain model is capable of solving the slow convergence
problem which is encountered under the original Duan and Simonato (2001) Markov chain method;
and (iii) since we adopt the use of conditional density as opposed to conditional probability, we can
508 C.-C. Chang, J.-B. Lin / Int. Fin. Markets, Inst. and Money 20 (2010) 490–508

easily extend the Sobol–Markov chain model to the pricing of derivatives which are dependent on
more than two underlying assets without having to deal with high-dimensional integrals.
We find that firms may reduce the costs of their compensation packages by using European-style
ESOs under an RPI design as opposed to an API design, a finding which is consistent with the results
of Camara (2001). However, when considering American- style ESOs, the differences in the compen-
sation package costs are very small. This indicates that there is very limited scope for firms to reduce
their compensation package costs using American-style ESOs. Since most companies are now using
American-style ESOs, as opposed to European-style ESOs, we conclude that their compensation costs
are virtually identical under both RPI and API designs.
Furthermore, the differences in the incentive effects are only minor, either with or without vesting
periods set in the compensation contracts, which implies that an RPI design does not provide any
greater incentives than an API design for executives to increase shareholder wealth, particularly when
American-style ESOs are used.

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