3.2.

3 Practical implementation

It requires the discretization of (X x , rX x ). One may use the usual Euler scheme, setting:

- (X0⇡ , rX0⇡ ) = (x, 1)

- and on ⇡:

d
X
Xt⇡i+1 = Xt⇡i + b(Xt⇡i )(ti+1 ti ) + .j
(Xt⇡i )(Wtji+1 Wtji )
j=1
d
X
rXt⇡i+1 = rXt⇡i + rb(Xt⇡i )rXt⇡i (ti+1 ti ) + r .j
(Xt⇡i )rXt⇡i (Wtji+1 Wtji )
j=1

Remark: simplification if d = 1.

110
3.3 Greek weights

• We are interested in computing the sensitivity of

⇥ ⇤
u(✓) = E g(XT✓ )

with respect to the parameter ✓ at ✓ = ✓0 .

Example 3.3. (i) If ✓ = x, and x is the starting point of X then we are computing the ’Delta’.

(ii) If X follows a BS model and ✓ = the volatility of X then we are computing the ’vega’.

111
• We are interested in finding random variable ⇧ s.t.

h i
@✓ u(✓0 ) = E g(XT✓0 )⇧

for a large class of payoff function g.

• Precisely, we consider

h i
W := {⇧ 2 L2 | @✓ u(✓0 ) = E g(XT✓0 )⇧ , for all bounded measurable function g}

• Often in practice, this will lead to

h i
@✓ u(✓0 ) = E g(XT✓0 )⇧✏ + E(✏)

where ⇧✏ is an approximation of such greek weight and E(✏) is the associated error.

112
3.3.1 Likelihood Ratio Method

• Assuming that XT✓ has a differentiable positive probability density (✓, x):

⇥ ⇤ h i
✓0 ✓0
@✓ E g(XT✓ ) = E g(XT )s(✓0 , XT ) with s(✓, x) = @✓ ln( (✓, x)) .
✓=✓0

s is called the score function.

We compute
Z
⇥ ⇤
@✓ E g(XT✓ ) = @✓ g(x) (✓, x)dx
Z Z
@✓ (✓, x)
= g(x)@✓ (✓, x)dx = g(x) (✓, x)dx
(✓, x)

113
• If s✓0 := s(✓0 , XT✓0 ) 2 L2 , then
h i
W := {⇧ 2 L2 | E ⇧ | XT✓0 = S ✓0 }

• We observe also that V ar[g(XT✓0 )⇧] V ar[g(XT✓0 )S ✓0 ]

h i
V ar[g(XT✓0 )⇧] = E (g(XT✓0 )⇧)2 (@✓ u)2
h h ii
= E E (g(XT✓0 )⇧)2 |XT✓0 (@✓ u)2
h h i i
E (E g(XT✓0 )⇧|XT✓0 )2 (@✓ u)2

= V ar[g(XT✓0 )s✓0 ]

114
Example: Black Scholes delta In the Black-Scholes setting, we have

WT
@x u(0, x) = e rT E g(Xtx ) .
x T

The density h of XTx is lognormal and given by

1 2
1 log(y/x) (r 2 )T
h(y) = p '(⇣(y)), ⇣(y) = p
y T T

And we compute

1 2
log(y/x) (r 2 )T
@x h(y)/h(y) = ⇣(y)@x ⇣(y) =
x 2T

115
Similar computations lead to the following form for the vega,

W2 1
@ u(0, x) = e rT E g(Xtx ) T WT .
T

Higher order derivatives Assuming that XT✓ has a twice differentiable positive probability density (✓, x):

2
⇥ ⇤ 2
✓ @✓✓ (✓, XT )
✓
@✓✓ E g(XT✓ ) = E g(XT ) .
(✓, XT✓ )

Example 3.4. (Black Scholes Gamma)

 2
2 rT 1 x WT 1
@xx u(0, x) =e E g(Xt ) WT .
x2 T T

116
3.3.2 Integration by part

• We consider the delta in the Black Scholes setting (r = 0), the payoff function is Cb1 .

• From the tangent process approach, we know that:

1 0 x x
@x u(0, x) = E[g (XT )XT ] .
x

• Using an IBP argument, we compute

1
@x u(0, x) = E[g(XTx )WT ] .
x T

We have
Z p p
2 2
@x u(0, x) = g 0 (xe T /2+ Ty
)e T /2+ Ty
'(y)dy

117
which rewrites
Z p
1 2
T /2+ Ty
@x u(0, x) = p @y [g(xe )]'(y)dy
x T
Z p
1 2
T /2+ Ty
= p g(xe )y'(y)dy
x T

118
3.3.3 Bismut’s formula

Theorem 3.2.
 Z T
1
@x u(0, x) = E g(XTx ) (Xsx ) 1 rXsx dWs . (3.4)
T 0
RT
(Here we have ⇧ = 1
T 0 (Xsx ) 1 rXsx dWs ).

Proof. We observe that for 0  s  T ,

@x u(0, x) = E[@x u(s, Xsx )rXsx ]

and then
Z T
1
@x u(0, x) = E[@x u(s, Xsx )rXsx ] ds
T 0

119
 Z T Z T Z T
E @x u(s, Xsx )rXsx ds = E @x u(s, Xsx ) (Xsx )dWs (Xsx ) 1 rXsx dWs
0 0 0

And via the martingale representation theorem, since u is solution to the pde,
Z T
@x u(s, Xsx ) (Xsx )dWs = g(XTx ) u(0, x)
0

Remark 3.1. If Xt := x + bt + Wt then rXt = 1 and we have


Wt
@x E[ (Xt )] = E (Xt ) . (3.5)
t

120
4 U.S. options in complete market

4.1 Definition and first properties

• An option that can be exercised at anytime until its maturity T > 0.

• Setting: Interest rate r constant, X solution on [0, T ], to

Z t Z t
Xt = X0 + rXs ds + (s, Xs )dWs
0 0

W is a standard BM under the risk neutral probability, the market is complete ( is invertible).

Upon exercise, the option pays to the owner g(Xt ) (g exercise payoff, Lipstchitz continuous).

121
• Super-hedging price:

y,
0 := inf{y 2 R | 9 ; admissible financial strategy s.t. Vt
pus g(Xt ) 8 t 2 [0, T ]}

• Dual representation of the price (optimal stopping problem):

,! at time 0:

⇥ ⇤
pus
0 = sup E e
r⌧
g(X⌧ )
⌧ 2T[0,T ]

⇥ r⌧ ?
⇤
=Ee g(X⌧ ? )

,! at time t 2 [0, T ]:

h i
pus
t = esssup⌧ 2T[t,T ] E e r(⌧ t)
g(X⌧ )|Ft

122
 The discounted price is a super-martingale

One proves easily that pus

0 sup⌧ 2T[0,T ] E[e r⌧
g(X⌧ )]

123
 ⇥ ⇤
• (non-linear) PDE representation: pus (t, x) = sup⌧ 2T[t,T ] E e r(⌧ t)
g(X⌧t,x ) is solution3 to

min{ LX u ru , u g} = 0 on [0, T ) ⇥ R

u(T, .) = g(.)

• This comes from the Dynamic programming principle: For all stopping time t  ✓  T

h i
us
p (t, x) = sup E e r(⌧ t)
g(X✓t,x )1{✓>⌧ } +p us
(✓, X✓t,x )1{✓⌧ }
⌧ 2T[t,T ]

(see e.g. chapter 5 in [68])

3
in some sense... e.g. viscosity sense.

124
4.2 Bermudan option

• An option that can be exercised at a discrete set of time (<) during its life.

< = {0 =: s0 , . . . , sj , . . . , s := T } .

• Super-hedging price:

pb0 := inf{y 2 R | 9 ; admissible financial strategy s.t. Vsy, g(Xs ) 8 s 2 <}

125
• Dual representation of the price:

,! at time 0:

⇥ ⇤
pb0 = sup E e r⌧
g(X⌧ )
<
⌧ 2T[0,T ]

⇥ r⌧ ⇤
⇤
=Ee g(X⌧ ⇤ )

,! at time t 2 <:

h i
pbt < E e
= esssup⌧ 2T[t,T ]
r(⌧ t)
g(X⌧ )|Ft

126
• Backward Programming Algorithm: (denoting G := g(X) )

Definition 4.1. (i) at T , set YT = GT

(ii) For j < , compute

h i
Ysj = max Csj , Gsj where Csj := E e r(sj+1 sj )
Ysj+1 |Fsj (Continuation value)

We have Yt = pbt , t 2 <.

• We now set r = 0 and prove the above results.

127
Proposition 4.1. (i) Y is the smallest super-martingale above G = g(X).

(ii) The optimal stopping time ⌧ ? is given by

⌧ ? = inf{t 2 < | Yt = Gt } ^ T ,

i.e. Y0 = E[G⌧ ? ].

(iii) Martingale decomposition theorem: Yt = Y0 + Mt? A?t .

(iv) Y is the super-hedging price.

Proof.

(i) by induction

128
(ii) Since Y is a super-martingale above Z on <, we observe that Y0 E[Y⌧ ] E[Z⌧ ] for all ⌧ 2 T[0,T
<
].

Let us define ⌧ ? = inf{t 2 < | Yt = Zt }. We compute

" 1 #
X
E[Y⌧ ? Y0 ] = E (Ysj+1 Ysj )1{⌧ ? >sj }
j=0
" 1 #
X ⇥ ⇤
=E E (Ysj+1 Ysj )1{⌧ ? >sj } |Fsj
j=0
" 1 #
X ⇥ ⇤
=E (E Ysj+1 |Fsj Ysj )1{⌧ ? >sj }
j=0

=0

This proves that Y0 = sup⌧ 2T[0,T

<
]
E[G⌧ ].

(iii) For t 2 <, we have that Yt = Y0 + Mt? A?t where M ? is a martingale and A? is an increasing process given

129
recursively by (M0 , A0 ) = (0, 0) and

⇥ ⇤
Ms?j+1 = Ms?j + Ysj+1 E Ysj+1 |Fsj
⇥ ⇤
A?sj+1 = A?sj + Ysj E Ysj+1 |Fti

⇥ ⇤
We notice that Ysj E Ysj+1 |Fti = [Gsj Csj ] +

(iv) Denotes

:= {y 2 R | 9 ; admissible financial strategy s.t. Vsy, g(Xs ) 8 s 2 <}

a. Note that for y 2 , V y, is a super-martingale above G and thus – in particular –

y = V0y, Y0

which leads to inf Y0 .

130
b. Denote ⌘ ? = Y0 + M ? , we have that

Y0 = E[⌘⌧?? ] == E[⌘T ] .

In our setting, this means that we can replicate ⌘T with an initial wealth of Y0 i.e. there exists an admissible strategy

s.t.

⌘t = UtY0 , and then UtY0 , Yt Gt , t 2 ⇡.

Thus Y0 2 . 2

131
Proposition 4.2. Set |<| = max0<j (sj sj 1 ), then the following holds:

⇥ ⇤
sup E |pbt pus
t | 2
 C|<|↵
t2[0,T ]

where ↵ = 1 if g is Lipschitz continuous and ↵ = 2 if g 2 Cb2 .

Proof. We first observe that

0  pus
t pbt

132
Let ⌧¯, be the projection on the grid < of ⌧ ⇤ (optimal stopping time for the US option), we have
h i
pus
t pbt = E g(X⌧ ⇤ ) Ft pbt
h i
 E[g(X⌧ ⇤ )|Ft ] E g(X⌧¯ ) Ft
h i
 CE |X⌧ ⇤ X⌧¯ | Ft
p
C |<|

If g 2 Cb2 , we apply Ito formula to obtain

 Z ⌧¯
pus
t pbt  CE | LX g(Xs )ds| Ft
⌧⇤

 C|<|

133
4.2.1 Discretisation of the forward process

• We now introduce a discretization grid ⇡:

⇡ = {0 =: t0 < · · · < ti < . . . tn := T } ,

such that < ⇢ ⇡.

• We define the bermudan option associated to the exercise payoff g(X ⇡ ).

⇥ ⇤
p⇡0 = sup E e r⌧
g(X⌧⇡ )
<
⌧ 2T[0,T ]

⇥ r⌧ ⇤
⇤
=Ee g(X⌧⇡⇤ )

134
Proposition 4.3. In our setting, we have

1
|pb0 p⇡0 |  C|⇡| 2 .

when g is Lipschitz continuous.

Proof. See Exercise ?? 2

135
Extension to the continuous case

• We assume that < = ⇡.

• Combining Proposition 4.2 and Proposition 4.3, we have

p
|pus
0 p⇡0 |  C ⇡ .

136
4.2.2 Longstaff-Schwarz algorithm

• Observe that in Definition (4.1), the optimal stopping time ⌧ˆ0 (from time 0) can be estimated by

1. set ⌧ˆ = T

2. then set ⌧ˆj = sj 1Aj + ⌧ˆj+1 1Acj with Aj = {Ysj  Gsj } .

,! Indeed, one has Y0 = E[G⌧ˆ0 ], namely ⌧ ? = ⌧ˆ0 .

• The Longstaff-Schwartz Algorithm [59] focuses on the sequence of optimal time execution

Definition 4.2. (Longstaff-Schwartz)

1. set ⌧˜ = T

137
 ⇥ ⇤
2. then set ⌧˜j = sj 1Ej + ⌧˜j+1 1Ejc with Ej = {E G⌧˜j+1 |Fsj  Gsj } .

,! Then one has Y0 = E[G⌧˜0 ]

• Note that the value process Y is computed only through its representation in terms of optimal stopping time.

⇥ ⇤
indeed, Ysj = E G⌧˜j+1 |Fsj

138
4.3 Dual approach

• We work in the Bermudan case on the discrete time grid <.

• Let M0 the space of square integrable martingale M such that M0 = 0.

Theorem 4.1. The following holds


Y0 = sup E[G⌧ ] = inf E sup(Gt Mt ) . (4.1)
⌧ M 2M0 t2<

The inf is achieved for M ? the martingale part of the Doob-Meyer decomposition and

Y0 = sup(Gt Mt? ) .
t2<

• The previous representation has been introduced in [71] (for the continuous case) and simultaneously in [47] where

the formula involves supermartingales.

139
Proof. 1. First, observe we observe that

Y0 = sup E[G⌧ M⌧ ]
⌧
 
 E sup(G⌧ M⌧ ) = E sup(Gt Mt ) .
⌧ t2<

2. Recall the Doob-Meyer decomposition theorem: Yt = Y0 + Mt? A?t where A is an increasing predictable process

with A0 = 0. Thus, we have

Gt  Yt = Y0 + Mt? A?t

which leads to

(Gt Mt? )  Y0 A?t  Y0 .

140
• In [71], sub-optimal martingales are constructed in "ad-hoc" way, see Section 4.4.2 for possible systematic ap-

proaches.

• Numerical methods based on the dual formula 4.1 will lead naturally to upper-bounds for the true price.

141
4.4 Implementation using regression techniques

• The regression part is required to estimate the conditional expectation (linear or nonlinear [74, 47])

• Approximation of the Bermudan option price on

< = {0 =: s0 , . . . , sj , . . . , s := T }

• Assume perfect simulation of the underlying and r = 0 (w.l.o.g)

• Use the Backward Algorithm:

(i) at T , set Y = g(XT ).

142
 (ii) For j < , compute

⇥ ⇤
Yj = max E Yj+1 |Fsj , g(Xsj )

,! need to compute continuation value.

4.4.1 Linear Regression-based methods

• An easy backward induction proves Yj = uj (Xsj ), 1  j  . (X is markovian)

⇥ ⇤ ⇥ ⇤
• Denote Cj := cj (Xsj ) := E Yj+1 |Xsj = E Yj+1 | Fsj ( continuation value), we have

Yj = cj (Xsj ) _ g(Xsj )

How to approximate Cj ? (assuming all quantities are square integrable)

143
• Observe that

⇥ ⇤ ⇥ ⇤
Cj = argminZ2L2 (Fsj ) E |Yj+1 Z|2 = argminZ2L2 ( E
(Xsj )) |Yj+1 Z|2

• Denoting L2j the set of PXsj -square integrable function, we observe

⇥ ⇤
cj = argminf 2L2j E |Yj+1 f (Xsj )|2

• L2j is too big! so one considers some basis function ( ` )` 1 and then pick a finite number of them, say K, to get

K
X
`
f' `
`=1

(( ` )1`K depends on f ...)

144
• With this approximation, the minimisation problem can be rewritten
" K
#
X
¯j = argmin 2RK E |uj+1 (Xsj+1 ) `
` (Xsj )|
2
(4.2)
`=1

and one sets

K
X
c̄j := ¯` ` , and cj = c̄j + error
j
`=1
PK
(Cj = C̄j + error where C̄j = `
`=1 c̄j ` (Xsj ))

• The coefficient ¯ is easily calculated, once observed that C̄j is the orthogonal projection of Yj+1 on V =

V ect( 1 (Xj ), . . . , K (Xj )):

145
We denote := ( 1, . . . , K) and set

⇥ ⇤ ⇥ ⇤
B j = E (Xj )> (Xj ) , B j u = E (Xj )> uj+1 (Xj+1 ) ,

we have that

¯j = (B j ) 1 B j ,
u

assuming B j non-singular.

⇥ ⇤
By property of the orthogonal projection on the vector space V, we have E (Yj+1 C̄j )Z = 0, for all Z 2 V

leading to
" K
#
X
E Yj+1 ¯` ` (Xj ) r (Xj ) = 0 ,1  r  K .
`=1

146
• In practice, one has to consider estimated counterparts of B j , B j u ...

N
j 1 X
B = (Xji )> (Xji )
N i=1

where (Xji )1iN are i.i.d copies of Xj .

147
 • Full approximation (Tsitsiklis-Van Roy): observe that in practice one has to estimate ūj = c̄j _ g instead of uj

leading to the following method:

1. Simulate (Xji )1iN i.i.d copies of Xj , j  .

2. at T , set Yi = g(Xi ) and ūˆ = g.

3. for j < , compute ˆ¯ = (B̂ j ) 1 B̂ j ūˆj+1

PK ˆ¯
set c̄ˆj := `=1 ` ` and ūˆj = c̄ˆj _ g.

• One can compute an approximated optimal policy ⌧ˆ⇤ on each path and recompute E[g(X⌧ˆ⇤ )].

Remark 4.1. 1. The choice of the basis functions is key, specially in high dimension.

148
 2. The linear-regression method is used for the Longstaff-Schwartz Algorithm [59].

3. Error analysis (approximation/statistical) is involved, see [25, 39, 36].

4. This is a low-biased estimator of the American option price.

5. The backward scheme is revisited in [?] using non-linear regression.

4.4.2 Implementation of the dual approach

• Based on Theorem 4.1, one should find a "good" martingale. Various approaches beyond "guessing" [71] have

been considered see e.g. [8] and the references therein.

• We recall the method in [47], see also [33, Chapter 8].

149
• The martingale to use in (4.1) is M ? which is given by

⇥ ⇤
Mj? = Ysj+1 E Ysj+1 |Fsj . (4.3)

• To ensure the martingale property, Haugh & Kogan suggest to recompute the previous martingale increment for

each simulated path ) Nested Simulation

– An approximation ūˆ of the us option price has been computed

⇥ ⇤
– Simulate M path of X: for each Xsmj , compute E ūˆ(Xsj+1 )|Xsj by resimulation and set

⇥ ⇤
M̂j+1 = M̂j + ˆ j with ˆ j = ūˆ(Xsj+1 ) E ūˆ(Xsj+1 )|Xsj (4.4)

PM
– Compute 1
M
m
m=1 maxt2< (g(Xsj ) M̂jm )

150
4.5 Quantization based methods

4.5.1 Introduction - cubature formula

See e.g. the review article [62] or Chapter 5 in the book [63]

• Let X be an Rd random variable. Quantization ! find the best approximation of X by discrete random variable

taking at most M different values x := {x1 , . . . , xM }.

• Voronoi tessellation of the M -quantizer x is a (Borel) partition C(x) := (Ci (x))1iM s.t.

Ci (x) ⇢ {⇠ 2 Rd | |⇠ xi |  min |⇠ xj |}
i6=j

151
152
 • Nearest neighbour projection on x: Px : ⇠ 2 Rd 7! xi if ⇠ 2 Ci (x)

• x-quantization of X: X̂ = Px (X) (remark: if X is absolutely continuous any two x quantizations are Pa.s.

equal.)

• pointwise error: |X X̂ x | := d(X, {x1 , . . . , xn }) = min1iM |X xi |

h i 12
• Quadratic mean quantization error : E |X x 2
X̂ | =: kX X̂ x k2

Optimal quantization (this presentation: X has infinite support)

• Proposition 1 in [62] ot Theorem 5.1 in [63]

h i
1. The quadratic distortion function: x 7! E |X X̂ x |2 reaches a minimum at some quantizer x⇤

153
 h i
x⇤ 2
2. The function M 7! E |X X̂ | is decreasing to 0 as M ! +1

• Upper bound on the convergence rate for X 2 L2+✏ for some ✏ > 0: There exists Cd,✏ s.t.

1
8M 1, min kX X̂ x k2  Cd,✏ kXk2+✏ M d (4.5)
x2(Rd )M

This is Zador’s Theorem, see e.g. [60].

• Any L2 -optimal M -quantizer is the best approximation of X by L2 r.v. taking at most M values (least square

approximation) i.e.

⇤
kX X̂ x k2 := min{kX Y k2 | #Im(Y )  M } (4.6)

154
 Proof. Set y := Im(Y ) = {y1 , . . . , yM } and observe that

min |X yi |  |X Y| P a.s.
i

⇤
so that kX Y k2 kX X̂ y k2 kX X̂ x k2 . 2

• Any L2 -optimal M -quantizer x⇤ 2 Rd is stationary in the following sense

h ⇤
i ⇤
E X X̂ x = X̂ x . (4.7)

h i
(in particular E[X] = E X̂ x as soon as the quantizer is stationary which generally does not correspond to

minima)

155
Proof. We compute

h i
x⇤ 2
E |X X̂ |
 h i2 h i h i h i 2
x⇤ x⇤ x⇤ x⇤ x⇤ ⇤
= E X E X X̂ + 2(X E X X̂ )(E X X̂ X̂ ) + E X X̂ X̂ x
 h i2 h i 2
x⇤ x⇤ ⇤
=E X E X X̂ + E X X̂ X̂ x

⇤
where the last inequality is obtained by conditioning w.r.t X̂ x .
h i
x⇤
From the previous point, we also have, as E X X̂ takes almost M different values (this is a measurable function
⇤
of X x ...)

h i  h i
⇤ 2
x 2 x⇤
E |X X̂ | E X E X X̂

156
 This leads to
 h i 2
x⇤ ⇤
E E X X̂ X̂ x =0.

• Two M -quantizer (M = 500) of N (0, I2 ) one of them being (close to be) optimal... [62]

157
For a discussion on how to obtain optimal quantization grid, we refer to Section 5.3 in [63].

158
Cubature formulas

• Below x is an L2 -optimal M -quantizer for X.

• One naturally computes

h i XM
x
E[g(X)] ' E g(X̂ ) = f (xi )P(X 2 Ci (x))
i=1

• If g is Lipschitz,

h i h i
x x
|E[g(X)] E g(X̂ ) |  [g]Lip E |X X̂ |  [g]Lip kX X̂ x k2

• If g is C 1 with Lipschtiz derivative,

h i h i
|E[g(X)] x
E g(X̂ ) |  [Dg]Lip E |X x 2
X̂ | (4.8)

159
 as X̂ x is stationnary.

• Convergence when M ! 1 follows from (4.5).

Conditional expectation

• For X, Y denote their quantized version by X̂, Ŷ

h i
ˆ
• Approximation of ⇥ = E[F (X)|Y ] by ⇥ = E F (X̂)|Ŷ ...

• one needs to compute X̂, Ŷ and the law of (X̂, Ŷ ).

• Say E[F (X)|Y ] = 'F (Y ) with 'F Lipschitz, then:

⇣ ⌘
k⇥ ˆ
⇥k2  C kX X̂k2 + kY Ŷ k2 (4.9)

160
Proof. See Exercises ??. 2

161
4.5.2 Quantization tree for optimal stopping problem

This technique has been introduced in [6, 5], where a complete error analysis is done, see also Section 11.3.2 in [63].

• we are given a discrete-time Markov Chain (Xk )0k on a grid ⇡ (samples of (Xt )0tT or an associated scheme).

• we use the Backward Programming algorithm of Definition 4.1.

• In the Markovian setting, recall that

Yk = uk (Xk ) where uk = ck _ g and ck (Xk ) = E[uk+1 (Xk+1 ) | Xk ].

• For each k, we consider the (optimal) quantization X̂k of Xk on the grid Ck := (Cki )1iMk .

162
 h i
• For any ', we replace E['(Xk+1 )|Xk ] by E '(X̂k+1 ) | X̂k , denote then

⇡ijk = P(X̂k+1 = xjk+1 |X̂k = xik )

• Define the pseudo-Snell envelope:

8
>
>
>
>
<Ŷn = g(X̂n )
. (4.10)
>
> h i
>
>
:Ŷk = max{E Ŷk+1 |X̂k , g(X̂k )}

• A backward induction yields Ŷk = ŷk (X̂k ) where

8
>
>
>
>
<ŷn = g
(4.11)
>
> PMk+1 k
>
>
:ŷk (xik ) = max{ j=1 ⇡ij ŷk (xjk+1 ), g(xik )}

163
 Pn 1
• ’online’ computational cost: ⇠ k=0 Mk Mk+1 .

• note that the grids and (⇡ k ) are computed offline, e.g. by MC method: Note

]{n|X̂kn = xik & X̂k+1

n
= xjk+1 }
⇡ijk = limN !1
]{n|X̂kn = xik }

where (Xkn )1nN,1k are MC simulation of the Markov Chain (Xk )1k .

164
4.5.3 Markovian quantization (grid method)

• given > 0 and  2 N⇤ , we consider the bounded lattice grid:

= {x 2 Zd | |xj | 6  , 1 6 j 6 d} .

Observe that there are (2)d + 1 points in .

• We introduce a projection operator ⇧ on the grid centered in X0 given by, for x 2 Rd ,

8
>
>
>
>
> b 1 j
(x X j
0 ) + 1
2 c + X j
0 , if |xj X0j | 6  ,
>
<
(⇧[x])j =  , if xj X0j >  ,
>
>
>
>
>
>
:  , if xj X0j <  .

165
• we use an optimal quantization of Gaussian random variables ( Wi ):

p Wi
ci :=
W h i GM ( p )
hi

GM denotes the projection operator on the optimal quantization grid for the standard Gaussian distribution with

M points in the support4 .

Moreover, it is shown in [41] that

h i p1 p 1
E | Wi ci |p
W 6 Cp,d hM d . (4.12)
4
The grids can be d ownloaded from the website: http://www.quantize.maths-fi.com/ .

166
 • we introduce the following discrete/truncated version of the Euler scheme,
8
>
> b0⇡ = X0
<X
h i (4.13)
>
>
:Xb⇡ = ⇧ Xb ⇡ + hi b(X
b ⇡ ) + (X
b ⇡) W
ci .
i+1 i i i

b ⇡ is a Markovian process living on

We observe that X b ⇡ | 6 C(|X0 | +  ), for all i 6 n.
and satisfying |X i

Definition 4.3. We denote (Ybi⇡ )06i6n the solution of the backward scheme satisfying

(i) The terminal condition is Ybn⇡ := g(X

bn⇡ )

(ii) for i < n, the transition from step i + 1 to step i is given by

h i
Ybi⇡ = max(Eti Ybi+1
⇡ bi⇡ ))
, g(X (4.14)

167
Proposition 4.4. For all i 2 {0, ..., n}, there exists a function u⇡ (ti , .) : ! R such that

Yb ⇡ = u⇡ (ti , X
bi⇡ )

This function is computed on the grid by the following backward induction: for all i 2 {0, ..., n} and x 2 ,

h ⇣ ⇣ p ⌘⌘i
⇡ ⇡
u (ti , x) = max{E u ti+1 , ⇧ x + hi b(x) + hi (x)GM (U ) , g(x)}

with U ⇠ N (0, 1).

The terminal condition is given by u⇡ (tn , x) = g(x).

168