Alternating Direction Explicit Methods

for Zero-coupon Bond Pricing in the

Cox-Ingersoll-Ross Model

Fei Lu
Daniel J. Duffy
MSc of Mathematical Finance (2014)
1326736

Dissertation Submitted in Fulfilment of the degree of

MSc of Mathematical Finance (2014)
 Abstract

Alternating Direction Explicit method is an unconditionally stable

and second-order accurate finite difference method, which com-
bines two sweeps marching from opposite directions. It is widely
applicable and can be used in financial pricing problems. However,
this method is relatively unknown compared with the Crank Nicol-
son method, which seems to be one of the most popular numerical
methods in computational finance.

A number of applications to price financial products are the prob-

lem to solve some specific partial difference equations, such as
the Black Scholes equation and the Cox-Ingersoll-Ross interest rate
model, the latter of which is the PDE we focus in this case. In this ar-
ticle, we introduce some basic factors about the CIR model related
to our works. Also, we report some review of the application of finite
difference methods in computational finance. After that, We intro-
duce the ADE method in details to show how this scheme works on
the diffusion terms and convection terms of partial differential equa-
tions. To this end, we apply the ADE method to price a zero-coupon
bond in three steps: preparing the PDE by domain transformation,
deciding the appropriate boundary conditions of the problem under
the Fichera theory, and finally assembling each terms discretized
by the ADE method and get the whole explicit scheme. As we have
transformed the original PDE, we discuss the well-posedness of the
modified initial boundary value problem. We compare the approxi-
mations of zero coupon bond under CIR model using ADE method
with well-known exact affine solution and the approximations using
implicit Euler method and Crank Nicolson method. At last, we sum-
marize the advantages of the ADE method compared with other
finite difference schemes.

Key Words: Alternating Direction Explicit (ADE) method; Cox-Ingersoll-

Ross (CIR) model; finite difference method; well-posedness
Contents

Contents iii

1 Introduction 1
1.1 A Review of Finite Difference Methods . . . . . . . . . . . . . . . 3
1.2 The Cox-Ingersoll-Ross Model . . . . . . . . . . . . . . . . . . . 4

2 Alternating Direction Explicit Method 7

2.1 Background to ADE . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.2 ADE for Diffusion Equations . . . . . . . . . . . . . . . . . . . . . 8
2.3 ADE for Convection Equations . . . . . . . . . . . . . . . . . . . 12
2.4 General Operator Form of the ADE Method . . . . . . . . . . . . 13

3 ADE for Zero-Coupon Bond Pricing Problem 16

3.1 Preparing the PDE: Domain Transformation . . . . . . . . . . . . 16
3.1.1 Domain Transformation . . . . . . . . . . . . . . . . . . . 16
3.1.2 Conservative Form . . . . . . . . . . . . . . . . . . . . . . 19
3.2 Boundary Conditions . . . . . . . . . . . . . . . . . . . . . . . . . 20
3.2.1 The Fichera Theory . . . . . . . . . . . . . . . . . . . . . 21
3.2.2 Boundary Conditions for CIR Problem . . . . . . . . . . . 22

iii
 CONTENTS

3.3 Applying the ADE Scheme . . . . . . . . . . . . . . . . . . . . . 24

4 Well-posedness of the Transformed CIR PDE Problem 25

5 Numerical Results 30
5.1 Example 1: Pricing a Zero-coupon Bond . . . . . . . . . . . . . . 30
5.2 Example 2: Stress Test . . . . . . . . . . . . . . . . . . . . . . . 31

6 The Advantages of ADE Method 33

7 Conclusions 35

References 36

iv
Chapter 1

Introduction

Partial differential Equations (PDEs), such as Black Scholes PDE, are widely
used to price financial derivatives in computational finance. A number of fi-
nite difference schemes are raised to approximate the PDEs numerically. The
Alternating Direction Explicit (ADE) (Saul’ev et al., 1964) method is a finite dif-
ference method (FDM), the applicability of which in computational finance has
been discussed in recent years. It is explicit with unconditional stability and
second-order accurate, and it is extensively applicable: it can be applied to not
only one-factor pricing problems but also multi-factor problems; besides, it is
applicable to both linear and non-linear PDEs (Duffy, 2009).
The main aim of this article is to discuss the application of the ADE method
in approximating time-dependent partial differential equations (PDEs) arising
in financial derivatives pricing problem. The application of ADE method in the
evaluation of equity options under Black Scholes model has been deeply dis-
cussed in Duffy (2009) and Duffy and Germani (2013). In this article, we focus
on using ADE method to price a zero-coupon bond under the Cox-Ingersoll-

1
 CHAPTER 1. INTRODUCTION

Ross (CIR) interest model (Cox et al., 1985), which is to solve a one-factor
time-dependent partial differential equation, although this method is more gen-
erally applicable.
The ADE method has been used in engineering and scientific cases af-
ter its publication. However, its first application to computational finance was
discussed nearly half a century later in Duffy (2009) and is still relatively ob-
scure in computational finance, compared with its competitor, Crank Nicolson
method (Crank and Nicolson, 1947). We report some advantages of the ADE
methods in our article.
The thesis is organized as follows: Chapter 2 introduces the ADE scheme
and shows how to approximate the diffusion and convection terms of partial
differential equations by ADE method. The Chapter to follow is to price a zero-
coupon bond under the CIR model using ADE method in three steps, including
preparing the PDE using domain transformation, determining the correspond-
ing boundary conditions, and applying the ADE method to the transformed
PDE to get the discrete problem and assembling the artifacts to get a final
explicit algorithm. In Chapter 3, we discuss the well-posedness of the initial
boundary value problem. In Chapter 4, we compare the approximations of
zero coupon bond under CIR model using ADE method with well-known exact
affine solution and the approximations using implicit Euler method and Crank
Nicolson method. Chapter 5 summarizes the advantages of ADE method and
the final chapter goes with the conclusion.
In the rest of this chapter, we give a summary of the application of FDM in
computational finance and provides with the basic introduction to CIR model.

2
 CHAPTER 1. INTRODUCTION

1.1 A Review of Finite Difference Methods

The finite difference method has been applied in a great number of computa-
tional finance problems including the pricing of equity options, commodity, fixed
income products and interest rate problems. In this section, we give some gen-
eral comments on the application of FDM in computational finance:

• Implicit method is stable but it is computationally expensive: a matrix

system is needed to solve at each time level to arrive at the final solution.
A stable and explicit scheme would be nice as it can keep the balance
between the accuracy and the efficiency.

• One of the most popular finite defference method in approximating the

Black Scholes equation is the Crank Nicolson method. However, it suf-
fers spurious oscillations and loses the second-order accuracy in some
situations (deeply discussed in Duffy 2004).

• Generally, the original PDEs using in computational finance tend to be

defined on the semi-infinite interval. For example, stock price cannot be
negative in nature when we price equity options in Black Scholes PDE.
However, FDM only works with PDEs defined on a bounded interval. As
a result, we need to find a new interval and the corresponding boundary
conditions. Numerous articles and books are trying to solve this problem
and most of the methods are to truncate the semi-infinite interval (see
Windcliff et al. 2004). Duffy (2009) resolves this problem on the unit
interval by transformation instead of truncation and gives the method to
define the corresponding boundary conditions of the transformed PDE by

3
 CHAPTER 1. INTRODUCTION

appealing to the Fichera theory (Fichera, 1956).

1.2 The Cox-Ingersoll-Ross Model

In 1985, Cox, Ingersoll and Ross proposed a model (Cox et al., 1985), named
as CIR model later, in which the behaviour of the instantaneous interest rate
follows the following equation:

p
dr(t) = k(θ − r(t))dt + σ r(t)dW (t) (1.1)

where k, θ and σ are non-negative with 2kθ > σ 2 , which is known as the Feller
condition for the CIR process. W (t) in this case is a Brownian motion under
the risk-neutral measure.
Under the no-arbitrage assumption, the exact solution of the price of a zero-
coupon bond in the CIR model (see Cox et al. 1985) at time t ∈ [0, T ] with
maturity T is given by

P (t, T ) = A(t, T )e−r(t)B(t,T ) , (1.2)

where
2kθ/σ2
2he(h+k)(T −t)/2

A(t, T ) = (1.3)
2h + (h + k)(eh(T −t) − 1)

and
2(eh(T −t) − 1)
B(t, T ) = (1.4)
2h + (h + k)(eh(T −t) − 1)

with
√
h= k 2 + 2σ 2 (1.5)

4
 CHAPTER 1. INTRODUCTION

The price of a zero-coupon bond B(r, t), which is assumed as a function

of the current time t and the interest rate r, satisfies the following equation
(Tavella and Randall, 2000):

∂B 1 2 ∂ 2 B ∂B
+ σ r 2 + (a − br) − rB = 0 (1.6)
∂t 2 ∂r ∂r

whit B = 1 at maturity, t = T . In this model, the interest rate cannot be

√
negative, which makes σ < 2a. The inequality in this case is consistent with
the Feller Condition.
The upper boundary condition is theoretically B = 0 as r → ∞, which
should be transformed into a bounded interval when applied to finite difference
method. The lower bound at r = 0 is not a Dirichlet boundary condition: the
bond price B is not given at r = 0 and it satisfies the following hyperbolic partial
differential equation:
∂B ∂B
+a =0 (1.7)
∂t ∂r

In general, we need to solve the boundary condition either numerically or ana-

lytically in this case.
In a summary, the original initial boundary value problem to solve a one-
factor zero-coupon bond in the CIR model with time to maturity t is given by:


∂B 1 2 ∂2B



 − ∂t
+ 2
σ r ∂r2 + (a − br) ∂B
∂r
− rB = 0, r > 0, t > 0


 B(∞, t) = 0, t > 0

(1.8)



 − ∂B
∂t
(0, t) + a ∂B
∂r
(0, t) = 0, t > 0



 B(r, 0) = 1, r > 0

5
 CHAPTER 1. INTRODUCTION

where t represents the time to maturity and the equations have been rewritten
from forward time into backward time.
Apart from pricing the zero-coupon bond, the CIR model can also be ap-
plied to other interest rate based financial products pricing problems, such as
coupon-bearing bonds and bond options.

6
Chapter 2

Alternating Direction Explicit

Method

2.1 Background to ADE

The ADE method was introduced by Saul’ev et al. (1964), a scientist from the
former Soviet Union. It combines an explicit calculation with a particular im-
plicit formulation , which, unlike the implicit Euler method and Crank-Nicolson
method, makes it free from the restriction of a high computational demand per
time step. In general, ADE method can be easily parallelized. In addition, it
has a impressive character: it is not only easily implemented like an explicit
method, but it is also unconditional stable in a way similar to an implicit method
and it is of second-order accuracy.
Although it has been adopted in a considerable number of scientific and
engineering applications after its publication, it is still relatively unknown when
compared with other finite difference methods. It seems that most of the PDE

7
 CHAPTER 2. ALTERNATING DIRECTION EXPLICIT METHOD

methods in computational finance are based on the Alternating Direction Im-

plicit (ADI) method and Crank-Nicolson method, even though ADE method pre-
dates the ADI methods and has a large potential for improvement in computa-
tional time.
The application of ADE method to computational finance was first con-
ducted by Duffy (2009) and the results to date look promising. There are a
number of potential application area in computational finance for ADE method.
For more examples which could be discovered, see Duffy and Germani (2013).

2.2 ADE for Diffusion Equations

In this section, we give a simple initial boundary value problem to show how the
ADE method works on solving partial difference equation. We take a one-factor
diffusion equation as an example with the boundary conditions of the Dirichlet
type, which means the values of the unknown solution at the boundary points
are given:

∂u ∂ 2u
= a 2 , 0 < x < L, t > 0
∂t ∂x
u(x, 0) = f (x), 0 ≤ x ≤ L (2.1)

u(0, t) = A, u(L, t) = B, (A, B constant), t > 0

where we assume f (0) = A and f (L) = B for convenience. We discretize the

interval (0; L) into J subintervals with h the constant step size in the x direction
and similarly discretize the interval (0; T ) into N subintervals with k the constant
step size in t direction.

8
 CHAPTER 2. ALTERNATING DIRECTION EXPLICIT METHOD

Let us first consider one of, if not the most basic numerical method, the
explicit Euler method, to approximate the solution of equation (2.1):

un+1
j − unj a
= 2 (unj+1 − 2unj + unj−1 ), 1 ≤ j ≤ J − 1, n ≥ 0
k h
u0j = f (jh), 0 ≤ j ≤ J (2.2)

un+1
0 = A, un+1
J = B, n ≥ 0.

Since the method is explicit and is a one-step marching scheme, the solution
at time n + 1 can be directly solved in terms of the solution at time n. The
disadvantage of this scheme, however, is that it could be unstable unless the
step size is small enough, which makes this method inefficient in some case.
Let us consider the implicit Euler method as follows:

un+1
j − unj a
= 2 (un+1 − 2un+1 + un+1
j−1 ), 1 ≤ j ≤ J − 1, n ≥ 0
k h j+1 j

u0j = f (jh), 0 ≤ j ≤ J (2.3)

un+1
0 = A, un+1
J = B, n ≥ 0.

which, unlike the explicit Euler method, is an unconditionally stable first-order

accurate scheme. The disadvantage of this method is that a tridiagonal system
of equations is required to be solved at each time level.
When it comes to the Crank-Nicolson method, it is a combination of the
explicit Euler method at time n and the implicit Euler method at time n + 1. The

9
 CHAPTER 2. ALTERNATING DIRECTION EXPLICIT METHOD

scheme is as follows:

un+1
j − unj a
= 2 ((un+1 n+1
j+1 − 2uj + un+1 n n n
j−1 ) + (uj+1 − 2uj + uj−1 )),
k 2h
1 ≤ j ≤ J − 1, n ≥ 0
(2.4)
u0j = f (jh), 0 ≤ j ≤ J

un+1
0 = A, un+1
J = B, n ≥ 0.

This scheme has second-order accuracy and is unconditionally stable. How-

ever, since it is a implicit method, it, like the implicit Euler method, is also re-
stricted by a high computational demand at each time level. Besides, it suffers
the spurious oscillations in some case (for more discussion, see Il’in 1969).
We now introduce the ADE method, which could be seen as a combination
of a modified implicit formulation and an explicit method of calculation. The
procedure of the calculation of the ADE method contains two oppositely di-
rected marching schemes and the resulting solutions are averaged to get the
final approximation at each time level. We approximate the solution of equation
(2.1) in the following steps (Barakat and Clark, 1966):

1. For j = 1, 2, . . . , J, we create a sub-solution U :

Ujn+1 − Ujn a n
= 2 (Uj+1 − Ujn − Ujn+1 + Uj−1
n+1
), n ≥ 0. (2.5)
k h

2. For j = J, J − 1, . . . , 1, we create another sub-solution V :

Vjn+1 − Vjn a n+1

= 2 (Vj+1 − Vjn+1 − Vjn + Vj−1
n
), n ≥ 0. (2.6)
k h

10
 CHAPTER 2. ALTERNATING DIRECTION EXPLICIT METHOD

3. Compute the final solution as an average of these two sub-solutions at

each time level:

1
unj = (Ujn + Vjn ), 0 ≤ j ≤ J, n ≥ 0. (2.7)
2

Notice that in Step 1 and Step 2, both un+1

j and vjn+1 can be computed
explicitly. When we calculate un+1
j in step 1, as the equation (2.5) marches
from the left boundary to the right boundary and the index is in the ascending
order, the value of un+1
j−1 on the right hand side is always known. Hence, we can

calculate un+1
j explicitly. In a similar manner, when we calculate vjn+1 in step 2,
as the equation (2.6) marches from the right boundary to the left boundary and
n+1
the index is in the descending order, the value of vj+1 on the right hand side
is again always known. The value of vjn+1 can be consequently determined
explicitly. The scheme can be rewritten into a computational form:

Ujn+1 (1 + λ) = Ujn (1 − λ) + λ(Uj+1

n n+1
+ Uj−1 ), (2.8)

and
Vjn+1 (1 + λ) = Vjn (1 − λ) + λ(Vj+1
n+1 n
+ Vj−1 ), (2.9)

k
with λ = h2
. As a result, this whole method is a fully explicit scheme.
In addition to its explicitness, the ADE method has another satisfying prop-
erty: it is unconditionally stable and has a second-order accuracy. The local
truncation error of this scheme is O(h2 + k 2 ) and hence it is second-order ac-
curate (Duffy, 2009).

11
 CHAPTER 2. ALTERNATING DIRECTION EXPLICIT METHOD

2.3 ADE for Convection Equations

Apart from the diffusion equation discussed in the previous section, a convec-
tion equation following is also of interest to us:

∂u ∂u
=b (2.10)
∂t ∂x

Many of the partial difference equations of great concern in computational fi-

nance are specific cases of convection-diffusion equations, which, as the name
implies, are the combination of convection and diffusion equations. Further-
more, the boundary condition of the CIR model when the interest rate is zero
is a pure convection equation as the equation (2.10). As a result, we apply the
ADE method to the equation (2.10) in this section.
There are several methods to approximate the convection equation. Towler
and Yang (1976) have approximated the convection term as follows:

Ujn+1 − Ujn b n+1

= (U n − Uj−1 ), for j = 1, 2, . . . , J − 1
k 2h j+1
Vjn+1 − Vjn b (2.11)
= (V n+1 − Vj−1
n
), for j = J − 1, J − 2, . . . , 1
k 2h j+1
1
unj = (Ujn + Vjn ).
2

This scheme has been proved unconditionally stable (Campbell and Yin, 2007).
The truncation error of the approximation in each sweep in the equation (2.11)
is O(k/h). However, the truncation error for the two-step approximation is
O(k 2 /h) after we average the solutions of each sweep.
Another approximation is a variation of the Towler-Yang method, which was

12
 CHAPTER 2. ALTERNATING DIRECTION EXPLICIT METHOD

discovered by Roberts and Weiss (1966):

Ujn+1 − Ujn b
= (Ujn+1 + Uj+1
n n+1
− Uj−1 − Ujn ), for j = 1, 2, . . . , J − 1
k 2h
Vjn+1 − Vjn b n+1
= (Vj+1 + Vjn − Vjn+1 − Vj−1
n
), for j = J − 1, J − 2, . . . , 1
k 2h
1
unj = (Ujn + Vjn ).
2
(2.12)

Again, the Roberts-Weiss method is unconditionally stable and the truncation

error of each sweep is O(k) (Campbell and Yin, 2007). We use the Roberts-
Weiss method in this article.

2.4 General Operator Form of the ADE Method

In the previous sections, we apply the ADE method to a simple one-factor dif-
fusion equation and a pure convection equation to see the essence of the
scheme. In this section, we introduce the general formulation of the ADE
method, which can be applied to a wider class of linear equations in higher
dimensions (Leung and Osher, 2005).
Consider a linear system of time-dependent equations:

∂T
= L(T ) ≡ AT + b. (2.13)
∂t

The matrix A can be decomposed into three matrices L + D + U , where D is

the diagonal part of A, L is the strictly lower triangular part of A and U is the

13
 CHAPTER 2. ALTERNATING DIRECTION EXPLICIT METHOD

strictly upper triangular part of A, which implies

∂T
= (L + D + U )T + b. (2.14)
∂t

The next step is to construct two schemes marching in opposite direction:

T1n+1 − T1n D D
= LT1n+1 + T1n+1 + T1n + U T1n + b, n ≥ 0 (2.15)
k 2 2

and

T2n+1 − T2n D D
= LT2n + T2n+1 + T2n + U T2n+1 + b, n ≥ 0. (2.16)
k 2 2

We can approximate the final solution by averaging the solutions of equation

(2.15) and (2.16), which implies:

1
T n = (T1n + T2n ), n ≥ 0. (2.17)
2

Further, if we define B and C by

1 1
B = L + D and C = U + D, (2.18)
2 2

we can rewrite the ADE method as follows:

(I − kB)T1n+1 = (I + kC)T1n + kb (2.19a)

(I − kC)T2n+1 = (I + kB)T2n + kb (2.19b)

14
 CHAPTER 2. ALTERNATING DIRECTION EXPLICIT METHOD

1 1
T n+1 = [(I−kB)−1 (I+kC)+(I−kC)−1 (I+kB)]T n + k[(I−kB)−1 +(I−kC)−1 ]b.
2 2
(2.19c)
This system is easy to solve. One reason is that the whole scheme is totally
explicit. From the equation (2.19c), we can see that the value of T at time level
n + 1 can be directly computed in terms of the solution at time level n. Another
reason is that the inverses of matrices (I ± kB) and (I ± kC) can be found
easily, since they are either lower triangular matrix or upper triangular matrix.
In the rest of this section, we report some properties of the ADE method
about the accuracy and the stability, which have been proved by Leung and
Osher (2005).

Theorem 1. The ADE scheme (2.19c) has a second-order accuracy in time

if all the diagonal elements of the matrix A in the equation (2.13), which in
other words are all the elements of the matrix D in the equation (2.14), are
non-positive.

Theorem 2. The ADE scheme (2.19c) is unconditionally stable if the matrix A

in the equation (2.13) is symmetric negative definite.

Theorem 3. The ADE scheme (2.19c) is unconditionally stable if the matrix A

in the equation (2.13) is lower-triangular with all diagonal elements negative,
which in other words means that all the elements of the matrix L in the equation
(2.14) are zero and all the elements of the matrix D in the equation (2.14) are
negative.

15
Chapter 3

ADE for Zero-Coupon Bond

Pricing Problem

In this chapter, we execute three steps when setting up the ADE method for
pricing a zero-coupon bond under the CIR model, including preparing the PDE
using domain transformation, determining the corresponding boundary condi-
tions, and applying the ADE method to the transformed PDE to get the discrete
problem and assembling the artifacts to get a final explicit algorithm.

3.1 Preparing the PDE: Domain Transformation

3.1.1 Domain Transformation

As we report previously, because of the nature of underlying assets, many

PDEs in computational finance are defined on semi-infinite intervals. For ex-
ample, in the CIR PDE (1.6), the variable t represents time to maturity and

16
 CHAPTER 3. ADE FOR ZERO-COUPON BOND PRICING PROBLEM

the variable r represents the interest rate. We need to specify the boundary
price of a zero-coupon bond when r = 0 and r = ∞. Since we are interested
in solving these PDEs using the ADE method, we need to replace the semi-
infinite intervals with a interval bounded on both sides. A popular method in
computational finance is the domain truncation. Although substantial discus-
sion has been made about how to decide the artificial boundary, however, we
still cannot discover a general theory. There are some problems with domain
truncation methods, such as the complexity of these methods, the less-than
optimal solutions and the tendency to be firmly based upon specific PDEs.
As a result, we distant ourselves from domain truncation methods and apply
domain transformation (Duffy, 2009), which can help us avoid the problems
mentioned previously and is a more general method for dealing with infinite
domains.
The main idea of domain transformation is to replace the original variable,
which is defined on the semi-infinite interval, with a new variable which is cor-
respondingly defined on the unit interval (0, 1). In this article, we define the
new variable as follows:
r
y= (3.1)
r+α

where α is a free scale factor the value of which depends on different cases
and can be chosen by the user. Note that for different PDEs, there are other
transformation formulas that are useful for the applications (see Duffy 2009).
In this case, we use the transformation (3.1) and choose α = 1. The CIR
PDE (1.6) in the coordinates (r, t) can be rewritten in the new coordinates (y, t).
Some simple mathematical manipulation needs to be made in order to get the

17
 CHAPTER 3. ADE FOR ZERO-COUPON BOND PRICING PROBLEM

transformed PDE. First, we have the inverse transformation:

y
r= (3.2)
1−y

and furthermore:

dy 2 d2 y
= (1 − y) , 2
= −2(1 − y)3
dr dr
∂B ∂B dy ∂B
= × = (1 − y)2
∂r ∂y dr ∂y
2
   
∂ B ∂ ∂B ∂ 2 ∂B
= = (1 − y) (3.3)
∂r2 ∂r ∂r ∂r ∂y
dy ∂B ∂ 2 u dy
= −2(1 − y) × + (1 − y)2 2 ×
dr ∂y ∂y dr
2
∂B ∂ B
= −2(1 − y)3 + (1 − y)4 2
∂y ∂y

To this end, we substitute the terms with y for the terms with r in the original
CIR PDE (1.6) to get the transformed PDE:

∂B ∂ 2B ∂B
= α(y, t) 2 + β(y, t) + ρ(y, t)B, 0 < y < 1, 0 < t < T (3.4)
∂t ∂y ∂y

where
1
α(y, t) = − σ 2 y(1 − y)3 , (3.5)
2

β(y, t) = −a(1 − y)2 + by(1 − y) + σ 2 y(1 − y)2 , (3.6)

and
y
ρ(y, t) = . (3.7)
1−y

Now we can see that the new PDE is defined on the unit interval which is

18
 CHAPTER 3. ADE FOR ZERO-COUPON BOND PRICING PROBLEM

bounded on both sides and we can apply the ADE method on the transformed
PDE.
Note that y cannot equal to 1 as the denominator cannot equal to 0. As a
result, we modify the problem a little bit by defining the far field boundary value
as 0, not at y = 1 but at a point close to 1 to the left. For example, in this case
J
we take the interval [0, J+1 ] instead, where J is the number of steps in space.
Since we are using uniform meshes in y, domain transformation will lead
to non-uniformly spaced solutions in our original variable, which is the interest
rate r in this case. The corresponding meshes in r would be finer around the
near field and would be rougher at the far field, which in a way consist with our
study interest of the behaviour of interest rate.

3.1.2 Conservative Form

We have already introduce the domain transformation of PDEs in non-conservative

form. Another way is to first modify the original PDE into the conservative form
using the integrating factor method (Duffy and Germani, 2013). In this case,
the CIR PDE (1.6) can be modified as:

 
∂B ∂ ∂B
= α(r, t) β(r, t) + rB (3.8)
∂t ∂r ∂r

with
1 2a 2br 2a 2br
α(r, t) = − σ 2 r1− σ2 e σ2 , and β(r, t) = r σ2 e− σ2 (3.9)
2

After this modification, we can use domain transformation to the new PDE (3.8)
on the semi-infinite interval to one on the unit interval. The transformed PDE

19
 CHAPTER 3. ADE FOR ZERO-COUPON BOND PRICING PROBLEM

could be different, as using different transformation formulas. However, the

transformed PDE is in the same basic form as the equation (3.8), which in
other words is still a conservative PDE.
Here we report several advantages of this scheme have been summarised
in Duffy and Germani (2013):

• This scheme admits non-uniform meshes. When we evaluate a bond,

we could be interested in the bond price at particular interest rate. This
scheme allow us to create finer meshes at critical points and rougher
meshes at regions of less interest.

• This scheme is still applicable even if the diffusion coefficient β(r, t) in the
equation (3.8) is discontinuous or non-linear, which is right the case.

• This scheme removes the convection term from the original PDE, which
can have benefits in some cases.

3.2 Boundary Conditions

In the previous section, we have already define a numerical boundary by do-

main transformation. The only problem left is to define the boundary conditions
associated with the new PDE. In this section, we introduce the Fechera Theory
(Fichera, 1956; Radkevic and Olejnik, 1973) and show how to find the corre-
sponding boundary condition under this theory.

20
 CHAPTER 3. ADE FOR ZERO-COUPON BOND PRICING PROBLEM

3.2.1 The Fichera Theory

Here we recall some basic matters about the Fichera theory which we use in
the subsection to follow to decide the boundary condition to our PDE problem.
The Fichera theory can help us find the boundary conditions for a wide
range of partial difference equations. Consider the second order equation:

n n
X ∂ 2u X ∂u
Lu ≡ aij + ci + du = f in Ω (3.10)
i,j=1
∂x i ∂x j i=1
∂x i

with the condition

n
X
aij ξi ξj ≥ 0 in Ω (3.11)
i,j=1

for any ξ = (ξ1 , . . . , ξn ) ∈ Rn . According to the inequality (3.11), ∂Ω, which

denotes the boundary of Ω, can be divided into two parts of sub-boundaries.
We focus on the characteristic boundary, which by definition is:
( n
)
X
Γ≡ x ∈ ∂Ω : aij νi (x)νj (x) = 0 (3.12)
i,j=1

where νi (x) denotes the ith component of the unit inward normal vector ν(x)
to Ω at x ∈ ∂Ω. The Fichera function is defined as

n n
!
X X ∂aik
F(x) ≡ ci − νi (x) : Γ → R. (3.13)
i=1 k=1
∂xk

After computing the value of the Fichera function, we can divided the charac-
teristic boundary into two subsets:

Γ+ = {x ∈ Γ : F(x) ≥ 0}, Γ− = {x ∈ Γ : F(x) < 0}. (3.14)

21
 CHAPTER 3. ADE FOR ZERO-COUPON BOND PRICING PROBLEM

The classical Fichera theory (Fichera, 1956) says no boundary condition is

necessarily imposed on Γ+ and we need to define a boundary condition on Γ−
to lead to a well-posed problem. It was shown in Radkevic and Olejnik (1973)
that the sign of the Fichera function on the characteristic boundary Γ does not
change under smooth non-singular of independent variables in the equation.
As a result, we can apply the Fichera theory to the transformed PDE and find
the corresponding boundary conditions to define.

3.2.2 Boundary Conditions for CIR Problem

In this case, we show how the Fichera theory works to find the mathematically
and financially appropriate boundary conditions for the transformed CIR PDE
in bond pricing.
Consider the transformed CIR PDE (3.4), the Fichera function is given by:

∂α
F(y) =(β − )ν(y)
∂y
 
2 2 2 1 2 2 3

= a(1 − y) − by(1 − y) − σ y(1 − y) − σ −3y(1 − y) + (1 − y) ν(y)
2
(3.15)

where y = 0 is the only characteristic boundary and ν(y) is the inward unit
normal with ν(0) = 1. Since the equation above uses the backward time, the
signs are contrary in this case. On the characteristic boundary, we have

1
F(0) = a − σ 2 . (3.16)
2

We can see that the requirement of boundary conditions depends on the rela-

22
 CHAPTER 3. ADE FOR ZERO-COUPON BOND PRICING PROBLEM

tive sizes of the parameters a and σ:

√
σ≤ 2a : F(0) ≥ 0, r = 0 ∈ Γ+ , no boundary condition needed
√ (3.17)
σ > 2a : F(0) < 0, r = 0 ∈ Γ− , boundary condition needed

The inequality in the latter case is called the Feller condition for the CIR pro-
cess. Therefore, the boundary condition is:

∂B ∂B
+a =0 (3.18)
∂t ∂y

at y = 0 assuming Feller condition holds. This is consistent with the conclu-

sions showed in Duffy (2009), where the Fichera theory has been applied to
the original CIR PDE as an example.
We need to solve the boundary condition either numerically or analytically.
We use the Thomée scheme (Thomée, 1962) in this article, which is uncondi-
tionally stable and second order accurate. The scheme is as follows:

n+1 n n+1/2 n+1/2

Bj+1/2 − Bj+1/2 Bj+1 − Bj
+a =0 (3.19)
k h

where
n 1 n
Bj+1/2 ≡ (Bj+1 + Bjn ) (3.20)
2

and
n+1/2 1
Bj ≡ (Bjn+1 + Bjn ). (3.21)
2

By solving a 2 × 2 system, we get the value of B0n+1 and B1n+1 . We then treat
the numerical solution of B1n+1 as the Dirichlet type boundary condition of the

23
 CHAPTER 3. ADE FOR ZERO-COUPON BOND PRICING PROBLEM

IBVP and apply it to the standard ADE scheme.

3.3 Applying the ADE Scheme

Although the CIR PDE in conservative form admits non-uniform meshes, it is

much more complex than uniform ones. In this article, we apply the uniform
meshes to the transformed CIR PDE (3.4) in non-conservative form and ap-
proximate each term as we mentioned in the previous chapter. The upward
sweep is given by:

Ujn+1 (1+Lj −Mj −Nj ) = Ujn (1−Lj −Mj )+Uj−1

n+1 n
(Lj −Mj )+Uj+1 (Lj +Mj ) (3.22)

The downward sweep is given by:

Vjn+1 (1+Lj +Mj −Nj ) = Vjn (1−Lj +Mj )+Vj−1

n n+1
(Lj −Mj )+Vj+1 (Lj +Mj ) (3.23)

where

k k
Lj = 2
α(yj , t), Mj = β(yj , t), Nj = kρ(yj , t), 1 ≤ j ≤ J − 1 (3.24)
h 2h

and {yj }Jj=0 is the set of mesh points in the y direction. To this end, we can get
our final bond price by averaging the solutions of these two sweeps, which is
Bjn = 21 (Ujn + Vjn ), 0 ≤ j ≤ J, n ≥ 0. We can see that the two sweeps are
independent, which means we can compute the approximation of each sweep
separately. This will certainly help us improve the efficiency.

24
Chapter 4

Well-posedness of the
Transformed CIR PDE Problem

When we have a initial boundary value problem (IBVP), we are wondering

whether the solution of the IBVP is unique and whether the behaviour of the
solution changes continuously with the input, namely the boundary conditions,
the initial conditions and the coefficients in the PDE. The initial boundary value
problem which has the above property is called the well-posedness problem
by definition. After we transform the original PDE, we need to find out whether
the new IBVP is a well-posedness problem. In this section, we employ the
methods discussed in Kreiss and Lorenz (1989) to check the well-posedness
of the corresponding IBVP.
Let us consider the transformed CIR PDE. We rewrite the equation from
forward time into backward time as the follows:

 
∂B 1 2 ∂ 2 ∂B ∂B ∂B y
= σ y(1−y) (1 − y) +a(1−y)2 −by(1−y) − B (4.1)
∂t 2 ∂y ∂y ∂y ∂y 1 − y

25
 CHAPTER 4. WELL-POSEDNESS OF THE TRANSFORMED CIR PDE
PROBLEM

We examine its well-posedness by realizing the following steps:

1. Multiply both sides of the equation (4.1) by B to give:

 
∂B 1 2 ∂ 2 ∂B
B = σ y(1 − y)B (1 − y)
∂t 2 ∂y ∂y
(4.2)
∂B ∂B y
+ a(1 − y)2 B − by(1 − y)B − B2
∂y ∂y 1−y

2. Integrate the equation (4.2) between 0 and 1 in space. The first term on
the right hand side can be integrated by parts as follows:

Z 1  
1 ∂ 2 ∂B
I1 = σ 2 y(1 − y)B (1 − y) dy
2 0 ∂y ∂y
( 1 Z 1 )
1 2 ∂B ∂ ∂B
= σ y(1 − y)B(1 − y)2 − [y(1 − y)B](1 − y)2 dy
2 ∂y 0 0 ∂y ∂y
1 2 1
Z  
∂B ∂B
=− σ (1 − 2y)B + y(1 − y) (1 − y)2 dy
2 0 ∂y ∂y
Z " 2 #
1 2 1

∂B ∂B ∂B
=− σ (1 − y)2 B − 2y(1 − y)2 B + y(1 − y)3 dy
2 0 ∂y ∂y ∂y
1 2 1 1 2 1
Z Z  
2 ∂B 2 ∂ 1 2
≤− σ (1 − y) B dy + σ 2y(1 − y) B dy
2 0 ∂y 2 0 ∂y 2
1 2 1
Z
∂B
=− σ (1 − y)2 B dy
2 0 ∂y
 Z 1 
1 2  2 2 1
 ∂ 2 2
+ σ y(1 − y) B 0 − [y(1 − y) ]B dy
2 0 ∂y
1 2 1 1 2 1 ∂
Z Z
2 ∂B
=− σ (1 − y) B dy − σ [y(1 − y)2 ]B 2 dy
2 0 ∂y 2 0 ∂y
(4.3)

The second term is:

Z 1
∂B
I2 = a (1 − y)2 B dy (4.4)
0 ∂y

26
CHAPTER 4. WELL-POSEDNESS OF THE TRANSFORMED CIR PDE
PROBLEM

and the third term is:

Z 1
∂B
I3 = − b y(1 − y)B
dy
0 ∂y
Z 1  
∂ 1 2
=−b y(1 − y) B dy
0 ∂y 2
 1 Z 1 (4.5)
1 2 1 ∂
= − b y(1 − y)B + b [y(1 − y)]B 2 dy
2 0 2 0 ∂y
Z 1
1 ∂
= b [y(1 − y)]B 2 dy.
2 0 ∂y

The fourth term is:

Z 1
y
I4 = − B 2 dy. (4.6)
0 1−y

To this end, the right hand side becomes:

RHS =I1 + I2 + I3 + I4
1 2 1 1 2 1 ∂
Z Z
2 ∂B
≤− σ (1 − y) B dy − σ [y(1 − y)2 ]B 2 dy
2 ∂y 2 ∂y
Z 10 Z 1 0 Z 1
2 ∂B 1 ∂ 2 y
+a (1 − y) B dy + b [y(1 − y)]B dy − B 2 dy
0 ∂y 2 0 ∂y 0 1−y
 Z 1
1 ∂B
≤ a − σ2 (1 − y)2 B dy
2 0 ∂y
1 2 1 ∂
Z Z 1
2 2 1 ∂
− σ [y(1 − y) ]B dy + b [y(1 − y)]B 2 dy
2 0 ∂y 2 0 ∂y
  ( 1 Z 1 )
1 2 1 1 ∂
= a− σ (1 − y)2 B 2 − [(1 − y)2 ]B 2 dy
2 2 0 2 0 ∂y
Z 1 Z 1
1 ∂ 1 ∂
− σ2 [y(1 − y)2 ]B 2 dy + b [y(1 − y)]B 2 dy
2 ∂y 2 0 ∂y
 0   Z 1
1 1 2 2 1 1 2 ∂
=− a − σ B (0, t) − a− σ [(1 − y)2 ]B 2 dy
2 2 2 2 0 ∂y
1 2 1 ∂
Z Z 1
1 ∂
− σ [y(1 − y)2 ]B 2 dy + b [y(1 − y)]B 2 dy
2 0 ∂y 2 0 ∂y
(4.7)

27
 CHAPTER 4. WELL-POSEDNESS OF THE TRANSFORMED CIR PDE
PROBLEM

√
Assume the Feller condition holds, which implies σ < 2a. Therefore,
a − 21 σ 2 > 0. We have:

   Z 1
1 1 2 2 1 1 2 ∂
RHS = − a − σ B (0, t) − a− σ [(1 − y)2 ]B 2 dy
2 2 2 2 0 ∂y
1 2 1 ∂
Z Z 1
1 ∂
− σ [y(1 − y)2 ]B 2 dy + b [y(1 − y)]B 2 dy
2 ∂y 2 ∂y
 0  Z 1 0
1 1 2 1
≤− a − σ B 2 (0, t) + M B 2 dy
2 2 2 0

(4.8)

The term on the left hand side becomes:

Z 1 Z 1
∂B 1 ∂ 2
B dy = B dy. (4.9)
0 ∂t 2 0 ∂t

To this end, we have:

Z 1   Z 1
∂ 2 1 2 2
B dy ≤ − a − σ B (0, t) + M B 2 dy, (4.10)
0 ∂t 2 0

where M > 0 is a constant.

3. Integrate the inequality (4.10) in time between 0 and ξ with 0 < ξ ≤ T to

give:

 Z ξ Z ξ
2 1 2
2 2
kBk (ξ) ≤ kBk (0)− a − σ |B(0, t)| dt+M kBk2 (t)dt, (4.11)
2 0 0

where
Z 1
2
kBk (t) ≡ B 2 (y, t)dy. (4.12)
0

28
 CHAPTER 4. WELL-POSEDNESS OF THE TRANSFORMED CIR PDE
PROBLEM

4. Apply Gronwall’s lemma on the inequality (4.11) to give the desired ap-
proximation of the solution to the initial boundary value problem:

  Z ξ 
1
2 2
kBk (ξ) ≤ kBk (0) − a − σ 2 2
|B(0, t)| exp(M ξ), 0 < ξ ≤ T.
2 0
(4.13)

To this end, we have proved the well-posedness of the IBVP assuming the
Feller condition.

29
Chapter 5

Numerical Results

In this chapter, we compare our results with the exact solution of zero-coupon
bonds under CIR model, together with the numerical solutions of the implicit
Euler method and the Crank Nicolson method to get a general feeling of the
accuracy of the ADE method. We take two examples in our article: the first one
is to price a zero-coupon bond for a range of sizes of steps in time k and steps
in space h; the second example it to take a stress test under large volatility.

5.1 Example 1: Pricing a Zero-coupon Bond

In this section, we price a zero-coupon bond with a = 0.048, b = 0.08, r0 = 0.08,

T = 0.25, and σ = 0.4, where the Feller condition holds. The exact bond
price is 0.97896681. Table 5.1, 5.2 and 5.3 show the numerical solutions using
ADE method, implicit Euler method and Crank Nicolson method for a range of
steps in time and space respectively. The absolute differences between the
approximations and the exact solution (×106 ) are given in the parentheses in

30
 CHAPTER 5. NUMERICAL RESULTS

the tables.

NY/NT 100 200 500 1000

50 0.97895070 0.97895013 0.97894951 0.97894926
(16.11) (16.68) (17.30) (17.55)
200 0.978951053 0.97896307 0.978965987 0.978966242
(15.76) (3.74) (0.82) (0.57)
500 0.978858369 0.978940257 0.978962806 0.978965869
(108.44) (26.55) (4.00) (0.94)

Table 5.1: Example 1 in ADE method

NY/NT 100 200 500 1000

50 0.978940202 0.97894459 0.978947226 0.978948106
(26.61) (22.22) (19.58) (18.70)
200 0.97895719 0.97896166 0.978964346 0.978965242
(9.62) (5.15) (2.46) (1.57)
500 0.978957738 0.978962216 0.978964907 0.978965804
(9.07) (4.59) (1.90) (1.01)

Table 5.2: Example 1 in implicit Euler method

5.2 Example 2: Stress Test

In this section, we price a zero-coupon bond with a = 0.048, b = 0.08, r0 = 0.08,

T = 1. We price the bond under large volatility with σ = 1. In this case, the
Feller condition still holds. The exact bond price is 0.97913863. The results of
ADE method, implicit Euler method and Crank Nicolson method are given in
the following tables.

31
 CHAPTER 5. NUMERICAL RESULTS

NY/NT 100 200 500 1000

50 0.978948989 0.978948987 0.978948986 0.978948986
(17.82) (17.82) (17.82) (17.82)
200 0.978966141 0.978966139 0.978966138 0.978966138
(0.67) (0.67) (0.67) (0.67)
500 0.978966705 0.978966702 0.978966702 0.978966702
(0.11) (0.11) (0.11) (0.11)

Table 5.3: Example 1 in Crank Nicolson method

NY/NT 100 200 500 1000

50 0.97909611 0.97911616 0.97912094 0.97912133
(42.53) (22.48) (17.69) (17.30)
200 0.978672553 0.979022093 0.979120014 0.979133745
(466.08) (116.54) (18.62) (4.89)
500 0.976319268 0.978410957 0.979021533 0.97910949
(2819.37) (727.68) (117.10) (29.14)

Table 5.4: Example 2 in ADE method

NY/NT 100 200 500 1000

50 0.97912121 0.979121145 0.979121119 0.979121113
(17.42) (17.49) (17.51) (17.52)
200 0.979137553 0.97913775 0.979137882 0.979137929
(1.08) (0.88) (0.75) (0.71)
500 0.979137996 0.979138247 0.979138412 0.979138469
(0.64) (0.39) (0.22) (0.16)

Table 5.5: Example 2 in implicit Euler method

NY/NT 100 200 500 1000

50 0.979121118 0.97912111 0.979121108 0.979121108
(17.52) (17.52) (17.53) (17.53)
200 0.979137987 0.979137979 0.979137977 0.979137976
(0.65) (0.65) (0.66) (0.66)
500 0.979138538 0.97913853 0.979138528 0.979138528
(0.10) (0.10) (0.11) (0.11)

Table 5.6: Example 2 in Crank Nicolson method

32
Chapter 6

The Advantages of ADE Method

The Alternating Direction Explicit method has several advantages compared

with other finite difference method:

• The ADE method is unconditionally stable and second-order accurate,

which is better than other explicit numerical methods such as the explicit
Euler.

• The ADE method is an explicit method: the solution of this method is the
average of solutions of two explicit schemes. Hence, we do not need to
solve a whole system to get the value of next time step at the current time
level. This certainty improves the efficiency of the approaching.

• The two sweeps of this scheme are independent and can be computed at
the same time separately, which can help use reduce the computational
time.

• This method is widely applicable. It can be applied to not only one-factor

problems but also multi-factor problems. Besides, the ADE method can

33
 CHAPTER 6. THE ADVANTAGES OF ADE METHOD

be also used to solve non-linear partial differential equations. The latter

case is not shared by other finite difference method such as the Crank
Nicolson method.

34
Chapter 7

Conclusions

In this article, we have discussed the Alternating direction Explicit method in

details, including the background, the stability and the accuracy. We also have
showed how to use this method to approximate the diffusion and convection
terms in time-dependent partial differential equations. We take the CIR model
as the example and apply domain transformation to transform the original semi-
definite interval into a bounded unit interval. We examine the Fichera theory
on the transformed problem to help us decide where to define the boundary
conditions. We proved the well-posedness of the transformed initial boundary
value problem assuming the Feller condition holds. We use the ADE method
to approximate the price of zero coupon bond under CIR model, and compare
our solutions with the exact affine solutions and the approximations using im-
plicit Euler method and Crank Nicolson method. Finally we summarize the
advantages of the ADE method.

35
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