Week4 Handout

Exotic Options Variance reduction Antithetic variates
wi3425TU—Monte Carlo methods
L.E. Meester
Week 4
1/ 31
Week 4—Program for this week
1 Pricing exotic options by simulation

Exotic options: quick overview (from Chapter 19)
Pricing, an example
Some advantages and disadvantages
2 Variance reduction—the big picture (§21.2)
Efficiency from several angles
3 Antithetic variates
Principle: applied to the π-example
Analysing the uniform case
Analysing the normal case
How to tell when/whether AV reduce the variance?
Interpretation for path dependent options
Don’t forget: Do the weekly practice material and upload your
solutions and we’ll provide you with feedback!
2/ 31
Points of attention for Monte Carlo simulations (cont’d)

5 Consistency. In some situations a quantity may be estimated in
more than one way or using several methods. The resulting
estimates should then be consistent: differences between them,
expressed in the number of (appropriately computed) standard
errors, should not be too big. If they are, then something is wrong
and should be checked. . .
6 Mistakes, checks. Everybody makes mistakes: errors of reasoning,
programming errors, etcetera. So, use every opportunity you have to
catch those mistakes. Never blindly believe the final answer your
program spits out, but scrutinize intermediate results for errors.
Usually, there are enough things around that you might check. If
necessary, create a testing opportunity, for example a special case
for which you know the answer.
7 Random seeds. Initialise the randomgenerator(s) so that your
results are reproducible. Set a seed chosen by yourself: if we all
mimick Higham and start our program with rand(’state’,100)
and randn(’state’,100), how random is that?
3/ 31
Exotic Options Variance reduction Antithetic variates Overview Pricing Pros and cons

Pricing, an example

4/ 31
Chapter 19: Exotic options
1 American options: early exercise possible. Good idea?

Call: no In the money? (St > E ): sell one short.
Put: depends, it can be better in certain situations.
Exercise strategy: involves (debating) the decision whether to
exercise at time t; this involves
the (possibly whole) price path {Su , 0 ≤ u ≤ t}.
2 Barrier options. For example, the up-and-out-call: a call

option that becomes void if a certain price level B is crossed.
There are many variations:
(up/down)-(out/in)-(call/put) options;
double or partial barriers;
Parisian options.
5/ 31
3 Lookback options:
Define price maximum S max := max0≤t≤T St
and price minimum S min := min0≤t≤T St .
Floating strike lookback call: payoff at time T of S(T ) − S min .
Fixed strike lookback call: payoff at T of max(S max − E , 0).
4 Asian options: based on average price over whole price path.
5 Bermudan options, Shout options, Indonesian options, et
cetera.
What makes exotic options special/complex:

the nature of the path dependency—often the whole path
plays a role;
early exercise may be possible as well.
6/ 31

Pricing, an example

7/ 31
Asset path model: geometric Brownian motion
Model for (asset) prices S(t0 ), . . . , S(tn ) at time instances

t0 = 0 < t1 < · · · < tn = T based on empirical “fact” that the
returns S(ti+1 )−S(ti )
S(ti ) (appear to) have a normal distribution.
This motivates the geometric Brownian motion model, whose
discrete grid values can be represented as
S(ti+1 ) = S(ti ) exp (µ − σ 2 /2)(ti+1 − ti ) + σ ti+1 − ti · Zi ,

p
with µ: the drift,

σ: the volatility,
Z0 , . . . , Zn : independent N (0, 1) random variables.
8/ 31
Pricing exotic options by simulation
For many this is the only way to determine their prices.

Simulate paths on a grid i∆t, i = 0, 1, 2, . . . and according to
the risk-neutral distribution:
√
S((i + 1)∆t) = S(i∆t) exp (r − σ 2 /2)∆t + σ ∆t · Zi .
Estimate prices based on these paths.

N.B.: a discrete time sampling of the continuous time model.
To be chosen: grid size ∆t. Considerations:

Smaller ∆t: more accurate path–representation,
but requires more CPU time: halving ∆t means (roughly)
doubling the work.
9/ 31
Example: pricing the up-and-out-call
Part of code from UpAndOutCall.m:
for i = 1:M
Z= randn(N,1);
Svals=S*cumprod(exp((r-0.5*sigma^2)*Dt+sigma*sqrt(Dt)*Z));
Smax = max(Svals);
notout=Smax<B;
V(i) = notout*exp(-r*T)*max(Svals(end)-E,0);
end
With ∆t = 0.01 and M = 104 we find

an estimated price of 0.1117 with s.e. 0.0031.
Exact price in 4 decimals is 0.0983. Is this OK?
10/ 31
Problem: Some barrier-crossings may be “missed” by the discretely

sampled path; consequence here: price is overestimated.
HigF71sampled.m: coarse (blue) versus fine grid (red)
11/ 31

Pricing, an example

12/ 31
Pricing exotic options by simulation:

Advantages:
flexibility;
can price options that cannot be priced any other way.
Disadvantages:
often very CPU intensive;
possibly biased (often intractable).
Coming weeks:
More examples.
Analysis of bias in some special cases.
13/ 31
Exotic Options Variance reduction Antithetic variates Efficiency

Pricing, an example

14/ 31
Variance reduction—the big picture (§21.2)
Recall the π-example from week 1:

Method 1 to estimate π: based on X1 with
E [X1 ] = π, Var(X1 ) = π(4 − π) ≈ 2.697.
√
Method 2: X2 = 4 1 − U 2 with standard uniform U,
E [X2 ] = π, Var(X2 ) = 32/3 − π 2 ≈ 0.797.
The variance Var(X2 ) is 0.797
2.697 ≈ 0.296 of Var(X1 ), which means
2.697
that Method 2 is 0.797 ≈ 3.4 times as efficient as Method 1.
Equivalent manifestations:
Method 2 is 3.4 times as efficient as Method 1.
√
With same M: s.e. of Method 2 is factor 3.4 ≈ 1.8 smaller.
Method 2 at M replications: as accurate as 1 with 3.4 × M.
Method 2 is “3.4 times as fast.” (provided . . . )
15/ 31
Efficiency is determined by:

the number of replications;
the amount of work (CPU time) per replication.
A more refined comparison:
Method 1:
CPU time (or cost) per replication: 1
Var(X1 ) = σ12
Method 2:
CPU time (or cost) per replication: R2
Var(X2 ) = σ22 = R1 σ22
Supose, the computing budget is N.
σ1
Method 1: can do N runs; s.e. is √ .
N √
√
Method 2: M = N
R2 runs; s.e. σ2
√
M
= √R1 σ1 = R1 R 2 · σ1
√
N
.
N/R2
Conclusion: variance reduction is obtained if R1 R2 < 1.

N.B. Most of the time we only look at R1 . (R2 is “messy”)
16/ 31
Exotic Options Variance reduction Antithetic variates Principle Uniform case Normal When good? Application

Pricing, an example

17/ 31
1st variance reduction method: Antithetic variates (§21.4)
R1 √
Old example: I = 0 e u du. We can see this as
h √ i
I =E e U with U a U (0, 1)-random variable.
Monte Carlo can be done with iid standard uniforms U1 ,. . . ,UM

and
√ M
Ui 1 X
Xi = e and IM = Xi .
M
i=1
It is easy to come up with some alternatives:

√
Xia = e 1−Ui , 1 − Ui is also U (0, 1)-distributed.
Xi + Xia
E[Xi ]+E[Xia ]
Yi = , E [Yi ] = 2 = I.
2
Try this in Matlab: antithet.m.
18/ 31
Summary simulation results with 104 replications:
basis for √
MC Iˆ ± s.e. rel.eff. wrt X
X = exp( √ U) 2.00093 ± 0.00442 1
X a = exp( 1 − U) 1.99874 ± 0.00442 1
(X + X a )/2 1.99983 ± 0.00033 ≈ 175
Just as with the common random numbers method for the Greeks,
the success of this approach is explained by the correlation.
We have
ρ (X , X a ) ≈ −0.989.
19/ 31

Pricing, an example

20/ 31
Analysis: the uniform case (§21.5)
Suppose I = E [f (U)] for U ∼ U (0, 1) and some function f .

Key: U and 1 − U have the same distribution.
Each of
X = f (U), X a = f (1 − U), Y = 21 (X + X a )
can serve as basis for simulation to estimate I .

1 PM
If Y1 ,. . . , YM are iid replications of Y , and IˆM = M i=1 Yi ,
then h i 1
E IˆM = I and Var IˆM = Var(Y ) .
M
X and X a are called antithetic variates.
21/ 31
Analysis:
1
+ X a ) = 14 Var(X + X a )

Var(Y ) = Var 2 (X
= 1
4 [Var(X ) + Var(X a ) + 2 Cov(X , X a )]
= 1
2 [Var(X ) + Cov(X , X a )]
= Var(X ) · 12 [1 + ρ (X , X a )].
So, it would be nice if ρ (X , X a ) were (strongly) negative.

In our example ρ ≈ −0.989, so the reduction factor R1 is
1 1 1
2 [1 − 0.989] ≈ 0.0057 and = ≈ 175
R 1 0.0057
With the same number of replications we get more than 1
extra digit of accuracy!
But note: R2 ≈ 2, so in all we gain about a factor 100.
22/ 31

Pricing, an example

23/ 31
Analysis: the normal case (§21.6)
Suppose I = E [f (Z )] for Z ∼ N (0, 1) and some f .

Key: Z and −Z have the same distribution.
Consider
1
X = f (Z ), X a = f (−Z ),
Y = (X + X a ).
2
The same analysis applies, and we find again
Var(Y ) = Var(X ) · 21 [1 + ρ (X , X a )].
If ρ < 0 we always win something.

If ρ = 0 we break even—we neither win nor lose something.
1
Why? R1 = 2 but R2 = 2. The reduction is R = R1 R2 = 1.
24/ 31

Pricing, an example

25/ 31
When do antithetic variates reduce the variance?
This lemma can help us:

Lemma (covariance inequality for comonotone functions)
If X is a random variabele and the functions f and g are monotone
in the same direction, i.e., both nondecreasing or both
nonincreasing, then:
Cov(f (X ), g (X )) ≥ 0.
If they are monotone in the opposite direction, then:
Cov(f (X ), g (X )) ≤ 0.
Proof: (on board).
26/ 31
§21.7 Multivariate version of the lemma
Lemma.
If f and g are functions of n variables, monotone in the same
sense, and X1 , . . . , Xn are independent, then:
Cov(f (X1 , . . . , Xn ), g (X1 , . . . , Xn )) ≥ 0.
N.B. monotone: it is sufficient if this is coordinatewise the same,

i.e., for a subset of the coordinates f and g are both increasing,
and both are decreasing in the remaining coordinates.
N.B. Coordinatewise monotone in opposite sense, then: Cov ≤ 0.
Application: Up-and-out call option. UpAndOutCallanti.m

Limited speed gain: about 2.3 times, at twice the work. . .
27/ 31

Pricing, an example

28/ 31
Why AV works for (some) path dependent options

Key: The pay-off is often increasing in the simulated Z ’s.
We have the recursion
S(ti ) = S(ti−1 ) exp (r − 12 σ 2 )(ti − ti−1 ) + σ ti − ti−1 · Zi ,

p
which we can solve, and then simplify:

i
Y
exp (r − 12 σ 2 )(tj − tj−1 ) + σ tj − tj−1 · Zj
p
S(ti ) = S(t0 )
j=0
i
X
1 2
p
= S(t0 ) exp (r − 2 σ )(tj − tj−1 ) + σ tj − tj−1 · Zj
j=0
i
X
1 2
p
= S(t0 ) exp (r − 2 σ )(ti − t0 ) + σ tj − tj−1 · Zj .
j=0
29/ 31
So, for i = 1, . . . , n:
i
X
1 2
p
S(ti ) = S(t0 ) · exp (r − 2 σ )(ti − t0 ) + σ tj − tj−1 · Zj
j=1
This represents the prices S(t0 ), . . . , S(tn ) at time points

t0 = 0 < t1 < · · · < tn = T , as functions of:
the (fixed) parameters r , σ, S(t0 );
(t0 , t1 , . . . , tn = T also fixed);
independent N (0, 1)-random variables Z1 , Z2 , . . . , Zn .
Check this:
S(ti ) is increasing as function of Z1 , Z2 , . . . , Zi , (Zi+1 , . . . Zn ).
30/ 31
The (approximation of the) option price often is of the form

e−rT f S(t0 ), S(t1 ), . . . , S(tn ) . (1)
Here the mapping
(s0 , s1 , . . . , sn ) 7→ f (s0 , s1 , . . . , sn )
often is increasing (or at least nondecreasing) in s0 , s1 , . . . , sn .
In those cases:
the payoff (1) is an increasing (or at least nondecreasing)
function of Z1 , Z2 ,. . . , Zn ,
application of antithetic variates will result in some variance
reduction, by the multivariate version of the lemma.
These things also may give insight in other situations, where there
only is some monotonicity.
31/ 31

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Exotic Options Variance reduction Antithetic variates

wi3425TU—Monte Carlo methods

Week 4—Program for this week

1 Pricing exotic options by simulation

Points of attention for Monte Carlo simulations (cont’d)

1 Pricing exotic options by simulation

2 Variance reduction—the big picture (§21.2)

Chapter 19: Exotic options

1 American options: early exercise possible. Good idea?

the (possibly whole) price path {Su , 0 ≤ u ≤ t}.

2 Barrier options. For example, the up-and-out-call: a call

What makes exotic options special/complex:

1 Pricing exotic options by simulation

2 Variance reduction—the big picture (§21.2)

Asset path model: geometric Brownian motion

Model for (asset) prices S(t0 ), . . . , S(tn ) at time instances

S(ti+1 ) = S(ti ) exp (µ − σ 2 /2)(ti+1 − ti ) + σ ti+1 − ti · Zi ,

with µ: the drift,

Pricing exotic options by simulation

For many this is the only way to determine their prices.

Estimate prices based on these paths.

To be chosen: grid size ∆t. Considerations:

Example: pricing the up-and-out-call

Part of code from UpAndOutCall.m:

With ∆t = 0.01 and M = 104 we find

Problem: Some barrier-crossings may be “missed” by the discretely

HigF71sampled.m: coarse (blue) versus fine grid (red)

1 Pricing exotic options by simulation

2 Variance reduction—the big picture (§21.2)

Pricing exotic options by simulation:

1 Pricing exotic options by simulation

2 Variance reduction—the big picture (§21.2)

Variance reduction—the big picture (§21.2)

Recall the π-example from week 1:

Efficiency is determined by:

Conclusion: variance reduction is obtained if R1 R2 < 1.

1 Pricing exotic options by simulation

2 Variance reduction—the big picture (§21.2)

1st variance reduction method: Antithetic variates (§21.4)

Monte Carlo can be done with iid standard uniforms U1 ,. . . ,UM

It is easy to come up with some alternatives:

Summary simulation results with 104 replications:

1 Pricing exotic options by simulation

2 Variance reduction—the big picture (§21.2)

Analysis: the uniform case (§21.5)

Suppose I = E [f (U)] for U ∼ U (0, 1) and some function f .

can serve as basis for simulation to estimate I .

X and X a are called antithetic variates.

So, it would be nice if ρ (X , X a ) were (strongly) negative.

1 Pricing exotic options by simulation

2 Variance reduction—the big picture (§21.2)

Analysis: the normal case (§21.6)

Suppose I = E [f (Z )] for Z ∼ N (0, 1) and some f .

Var(Y ) = Var(X ) · 21 [1 + ρ (X , X a )].

If ρ < 0 we always win something.

1 Pricing exotic options by simulation

2 Variance reduction—the big picture (§21.2)

When do antithetic variates reduce the variance?

This lemma can help us:

If they are monotone in the opposite direction, then:

Proof: (on board).

§21.7 Multivariate version of the lemma

Cov(f (X1 , . . . , Xn ), g (X1 , . . . , Xn )) ≥ 0.