Applications of Periodic and QuasiPeriodic Expansions to Options Pricing
Dominique Bang ^{1}
^{1} Bank of America Merrill Lynch, London Dominique.Bang@baml.com
Abstract. We present a new formulation of the call payoﬀ as a convergent trigonometric series, where the corresponding frequencies are selected accord ing to a minimum variance algorithm. When the characteristic function of the logmoneyness is available, this provides an eﬃcient alternative to trans form methods for option valuation (such as Fourier Integral), reducing the frequency spectrum from a continuum to a discrete set.
1 
Introduction 
A 
standard approach to pricing vanilla options is based on integral representations 
(such as the Fourier integral) of a call payoﬀ, requiring the characteristic function
of 
the logmoneyness to be known in a closed form, as is the case for many models 
of 
interest (e.g. Black&Scholes, Heston, Stein&Stein, Cox process, Levy processes 
etc
Fourier Integral, which can be computationally intensive. Moreover, the related integral being highly oscillatory and thus prone to inaccuracy, care needs to be
taken in the way the integral is truncated and discretized. In particular, in the case of Heston dynamics, a number of tricks can be used to improve the accuracy
of the numerical integration while keeping reasonable the number of evaluations of
the characteristic function as described comprehensively in [2]. Alternatively, an
interesting idea has been developped in Fang and Oosterlee [4] ^{1} where the call price
is approximately expanded in a Fourier Series using an approximate density based
on integral truncation; the authors demonstrate the eﬃciency of their approach compared with Carr and Madan [3] brute force integration in the case of Heston Dynamics. In this note, we develop a diﬀerent approach, seeking for an exact series representation of a call payoﬀ in term of trigonometric functions. The idea is to ﬁnd (recursively) the combination of trigonometric functions that is closest(in a sense to
be speciﬁed later) to the call price and then, as for the Fourier Integral, to apply the expectation operator. In a sense, this approach amounts to performing a Principal Components Analysis of the Call option payoﬀ itself, using trigonometric functions (for which the expectation is known in a closed form via the characteristic function
of the logmoneyness). We demonstrate constructively the existence of such a series,
show its convergence toward the call payoﬀ in a strong sense (for the chosen norm)
).
These methods generally rely on a numerical integration of the (inverse)
^{1} Thanks to Leif Andersen for pointing out this reference and for constructive conversations.
1
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and give an error estimate when the call price is computed using a truncation of the series. Finally, as an illustration, we apply this method to option pricing under Heston dynamics. Additionnally, we provide in passing a simple (approximate but arbitrarily accurate) representation of a call option in terms of Fourier series, similar to Fang and Oosterlee’s cosine expansion, but with an improved rate of convergence.
2 Notations and General Framework
The payoﬀ of a call struck at K maturing at T on the underlying S _{T} is given by:
(S _{T} − K) ^{+}
=
K(e ^{x} − e 2 e
x = ln( ^{S} ^{T} )
x
K
∆
_{−} x
2
)
From contour integral theory, we have that:
∆
φ(x) = e
_{−} x
2
=
π ^{} +∞
1
0
f _{λ} (x) λ ^{2} +
1
4
dλ,
∆
f _{λ} (x) = cos(λx)
yielding
(1)
This decomposition formula shows how to recover the call payoﬀ using a con tinuum of frequencies in the Fourier space. Applying the expectation operator to this equality yields a valuation formula for the call option, provided that the char acteristic function of the logmoneyness at maturity, χ(s) = E ^{T} (e ^{(} 2 ^{+}^{i}^{s}^{)}^{x} ), is known in closed form. As pointed out above, this integral, being highly oscillatory, needs particular care in the way it is discretized and/or truncated. More over, as a Fourier transform of an unsmooth fonction, and per Heisenberg principle, the integrand de cays slowly to zero, or, in other terms high frequencies are necessary to describe well the underlying payoﬀ function. The aim of this note is to develop an alternative to this approach by providing a trigonometric series representation of φ(x) rather than an integral, that is to project the function φ on a discrete set of frequencies rather than a continuum. More precisely, we aim to write
(S _{T} − K) ^{+} = S _{T} − Ke ^{x} φ(x)
2
1
φ =
∞
n=1
φ n e n
where φ _{n} is a scalar and e _{n} is a function such that e _{n} ∈ span f
the diﬀerentiation is performed w.r.t λ (the element
polynomial of degree p times a sin() or a cos() depending on the parity of p). The frequencies λ _{j} are selected through a minimum variance algorithm (which, in our case, is formulated as a maximization of a normalized scalar product ^{2} to be deﬁned
_{p} f _{λ} (x) corresponds to a
_{1}_{≤}_{j}_{≤}_{n} , where
(p _{j} )
λ
j
∂ ^{p}
∂λ
^{2} This approach is comparable to the one developped by Laskar [5] in the context of KAM theory. The latter proved to be very successful in areas as diverse as Celestial Mechanics and High Energy Particles Dynamics.
2
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later on) and can be seen as a PCA. Next, we introduce the framework in which this analysis takes place, which is naturally Hilbert space. More precisely, consider the weighted space H ^{µ} of integrable functions (w.r.t the weight µ) and the associated scalar product:
^{} +∞
0
g, h
g
µ(x)
x ^{p} µ(x)dx
=
=
>
<
g, h _{µ} = +∞ g(x)h(x)µ(x)dx
0
g _{µ} = ^{} g, g
0
∞, p ≥ 0
where the last technical condition is designed to ensure that for any λ ≥ 0, the elements f _{λ} remains in H ^{µ} through diﬀerentiation of arbitrary order; we note that this condition is almost always satisﬁed in practice. We plan to build an orthonormal family (e _{n} ) _{n}_{∈}_{N} ∗ in H ^{µ} (using GramSchmidt construction) based on the free family (f _{λ} ) _{λ}_{≥}_{0} , satisfying some optimal constraints and complete w.r.t φ. To gain further intuition about the forthcoming construction, we emphasize the following statement:
Lemma 1. let g _{λ} denote a parametric family of non zero elements in H ^{µ} and ξ denote a ﬁxed element in H ^{µ} . Then the two following problems are equivalent
• Find ^{}
λ, ν = arg min ξ − νg _{λ}  ^{2} .
• Find ^{}
λ = arg max ξ,
_{λ} _{} ^{2} , ν = ^{}  ^{ξ}^{,}^{g} g  ^{} ^{2} ^{.}
g
λ
g
λ
λ
Proof 1. From ∇ ξ − νg _{λ}  ^{2} = 0 we must have ν = ^{} ^{ξ}^{,}^{g} ^{λ} ^{} , so that
g _{λ}  ^{2}
ξ − νg
_{λ}  ^{2}
=
=
ξ ^{2} −
2 ν ξ, g _{λ} + ν ^{2} g _{λ}  ^{2}
ξ ^{2} − ξ,
λ  2
g
λ
g
_{} (the
which shows that minimizing ξ − νg _{λ}  ^{2} is equivalent to maximizing ξ,
lemma is also clear from a Lagrange Multipliers perspective). The ﬁrst formulation amounts to ﬁnding the element g _{λ} which captures the max imum variance of ξ, and can be essentially regarded as a Principal Component Analysis. However, for practical computation, we opt for the second one, which is well adapted to the iterative procedure we intend to use. From eq.1 we see that the success of any approach based on characteristic function relies on the ability to represent φ in an eﬃcient manner. The main idea of this paper is to apply the mini mum variance (maximum scalar product) strategy to φ on a recursive basis: ﬁnd the
ﬁrst element f _{λ} _{1} which maximizes φ,
_{} _{f} _{λ} 1 _{} and
g
λ
g
_{λ}
_{} , set e _{1} =
f
λ
f _{λ}
φ,
_{} _{f} _{λ} 1 _{} and φ _{1} =
^{f}
^{λ} 1
^{λ} 1
^{f}
3
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restart the same procedure with φ ^{1} = φ−φ _{1} e _{1} and so forth. In section 4, we provide a rigorous formalization of this algorithm, stating the main result of this note, that is the existence of (e _{n} ) _{n}_{∈}_{N} ∗ along with the convergence of the series ^{} _{i}_{=}_{1} φ _{i} e _{i} to wards φ., but prior to that, in section 3 we give a selfcontained result which allows for (approximate) call pricing in a very eﬃcient and simple manner. This result is based on Fourier Series expansion of a periodization of φ.
∞
3 Periodic decomposition of a Quasicall payoﬀ
The following result ^{3} gives a proxy for the call price using the characteristic function
χ(s) = E ^{T} (e ^{(} ^{1} 2 ^{+}^{i}^{s}^{)}^{x} ) of the
Theorem 3.1 Let A be a real positive number. Consider the 2A− periodic function φ _{A} (x) such that φ _{A} (x) = φ(x) on x ≤ A, and C _{A} (F, K) the (approximate) call price by replacing φ with φ _{A} in eq.1. Then we have:
logmoneyness.
C _{A} (F, K)
_{c} _{l}
=
_{=}
F − K
∞
l=0
c _{l} χ l
_{4}_{A} 1 − (−1) ^{l} e ^{−} ^{A} A ^{2} + (2πl) ^{2}
2
,
π
A
c _{0} = 2 ^{1} ^{−} ^{e} ^{−} A
2
A
and the following error estimates hold:
• Error in prices:
C(F, K) − C _{A} (F, K) ≤ ^{√} FK ^{} N (K exp ^{−}^{A} ) + 1 − N (K exp ^{A} )
• Error in normal ( ^{N} ) and Black ( ^{B} ) vol for an atthemoney option:
σ ^{N} − σ
σ ^{B} − σ
N
A
B
A
_{}
_{}
_{≤}
_{≤}
^{} 2π
T
^{} 2π
T
F ^{} N (K exp ^{−}^{A} ) + 1 − N (K exp ^{A} )
^{} N (K exp ^{−}^{A} ) + 1 − N (K exp ^{A} )
(≈)
where N () is the cumulative distribution function of S _{T} . Proof: see Appendix A. Remark 3.i The idea of using Fourier Series rather than Integral has been ﬁrst exploited by Fang and Oosterlee in [4]. Though, the approach is slightly diﬀerent in their paper, as it is the integral representation of the density itself which is truncated, leading eventually to a cosine series. We note that their approach involves a total of three levels of approximations whereas ours only involves two(in the choice for the threshold A and the truncation of the Fourier Series) with an improved decay rate of the Fourier coeﬃcients. The latter being rescaled by χ (.) which usually vanishes exponentially fast, this shouldn t make too much of a diﬀerence in practice, except
^{3} The idea to directly periodize φ originates from a conversation with Alex Lipton. We wish to thank him in passing for his interest in this work.
4
when the distribution of the underlying is close to singular (e.g. when the option maturity is very small) and where the call is close to its intrinsic value. Also, our Formula is simpler, and the error estimate for the choice of A quite transparent (N (x) can be easily estimated for small/large x). The previous formula has been mentioned in passing, as the core subject of this paper is to provide an exact series expansion, rather than a proxy. However, its great simplicity compared to the forthcoming quasiperiodic expansion sometimes outweights the fact that it is only an imperfect representation of the call.
4 QuasiPeriodic decomposition of a call payoﬀ
The next theorem is the main result of this note: it proves constructively the exis tence of a countable trigonometric family (e _{n} ) _{n}_{∈}_{N} ∗ satisfying some optimality criteria and on which φ can be decomposed, in a Hilbert sense.
with asso
ciated frequencies (λ _{n} ≥ 0) _{n}_{∈}_{N} _{∗} , indices (p _{n} ≥ 0) _{n}_{≥}_{1} and scalars (φ _{n} ≥ 0) _{n}_{∈}_{N} _{∗} such
that:
N ^{∗}
Theorem 4.1 There exists an orthonormal family (e _{n} ) _{n}_{∈}_{N} ∗ ∈ H
µ
φ
e _{i}
=
∈
∞
i=1
φ i e i
φ
span f
i
∆
=
φ, e _{i}
(p _{j} )
λ
j
1≤j≤i
where the convergence of the series should be understood as a strong convergence in H _{µ} . The algorithm to compute (e _{n} ) _{n}_{∈}_{N} ∗ is performed recursively as follows: initial
ization for
n = 1 according to step(1) and iteration of step(2).
1. ﬁnd λ _{1} such that:
λ
1
∆
= arg max Ω _{0} (λ) where
λ≥0
set and store:
e
1
∆ ^{f} ^{λ} ^{1}
=
^{}
0
+∞
cos ^{2} (λ _{1} x)µ(x)dx
2. ﬁnd λ _{n}_{+}_{1} for n > 1 such that:
λ n+1
= ∆ arg max Ω _{n} (λ) where
λ≥0
Ω _{n} (λ) = φ,
∆
Ω _{0} (λ) = φ,
∆
f _{λ}  2
f
λ
,
∆
φ _{1} = φ, e _{1} ,
∆
p _{1} = 0
f _{λ} − ^{} ^{n}
i=1
f _{λ} , e _{i} e _{i}  2
f
λ
, e
i
e
i
^{n}
f _{λ} − ^{} _{i}_{=}_{1}
(2)
(3)
5
set and store:
e
n+1
p n+1
∆
=
lim
λ→λ
+
n+1
f _{λ} − ^{} _{i}_{=}_{1} ^{n} f _{λ} , e _{i} e _{i}
f _{λ} − ^{} ^{n}
_{i}_{=}_{1} f _{λ} , e _{i} e _{i} 
= ∆ min p such that f
(p)
λ n+1 ^{−}
n
i=1
^{φ} ^{n}^{+}^{1}
∆
=
φ, e _{n}_{+}_{1}
f
n+1 ^{,} ^{e} i ^{e} i
(p)
λ
= 0
Moreover (for completeness and practical interest) we have for any n ≥ 1 :
lim
λ→λ _{n}
Ω _{n} (λ) = 0
Proof: see Appendix B. As for the existence of the family (e _{n} ) _{n}_{∈}_{N} ∗, see B.1, for
the convergence of the associated series toward φ, see B.2 and for the last statement
Ω _{n} (λ _{n} ) = 0, it comes directly from a second order Taylor expansion associated with
a maximality argument.
Remark 4.i In (b) the limit is taken from above lim _{λ}_{→}_{λ} _{n}_{+}_{1} . This choice is made
to resolve the intrinsic ambiguity on e _{n}_{+}_{1} (which can be replaced by −e _{n}_{+}_{1} without any disruption). Remark 4.ii The fact that Ω _{n} (λ _{n} ) = 0 is useful in practice, providing informa
tion about the zeros of Ω _{n} (λ _{n} ) when solving for λ _{n}_{+}_{1} (in particular, λ _{n}_{+}_{1}
moreover λ _{n}_{+}_{1} should be fairly far from λ _{n} ). In practice, one can observe a persis tence of the zeros of Ω _{n} () that is Ω _{n} (λ _{i} ) = 0 not only for i = n but also for i ≤ n (or at least it remains small). However, this is not necessarily the case for all n. Thus, a frequency λ _{j}_{<}_{n}_{−}_{1} may reappear when solving for arg max Ω _{n} (λ). When this
occurs, there is an indeterminacy in lim _{λ}_{→}_{λ}
and denominator collapse, involving naturally the derivatives of the elements f _{λ} (see L’Hopital’s rule). The integer p _{n} can be seen as a counter of the visits of the fre quency λ _{n} before time n and also corresponds to the order of diﬀerentiation in f _{λ} _{n}
when λ _{n}
number of visits n. Remark 4.iii We insist that, by construction, once e _{n} has been computed and stored, only one additional frequency is necessary to generate e _{n}_{+}_{1} . This means that the algorithm can be used on an adaptative basis with a low computational cost (the numbers used to compute e _{n} can be stored and reused for e _{n}_{+}_{1} ). This is of prime importance in option pricing, where the expectation operator will be applied to the elements e _{n} and thus, will lead to evaluations of the characteristic function, which is generally computationnally intensive. In our case, the evaluations of the characteristic function will be stored to be possibly reused when/if incrementing n.
= 0. For the special case λ _{n} = 0 the degree of diﬀerentiation is twice the
both numerator
λ _{n} , and
+
=
f _{λ} − ^{} ^{n}
i=1
f
λ
,e
i
e
i
^{n} _{} f _{λ} − ^{} _{i}_{=}_{1}
_{} _{f} _{λ} _{,}_{e} _{i} _{} _{e} _{i}_{}
+
n+1
^{,} ^{a}^{s}
5 Option Pricing
5.1 Valuation Formula and Error Estimate
We apply the previous approach to the pricing of a call option in a model for which the characteristic function of the logmoneyness χ(λ) = E ^{T} (e ^{(} ^{1} 2 ^{+}^{i}^{λ}^{)}^{x} ) is known, as
6
suming that (λ _{j} ) _{j}_{≥}_{1} , (p _{j} ) _{j}_{≥}_{1} , (e _{j} ) _{j}_{≥}_{1} and (φ _{j} ) _{j}_{≥}_{1} have been found following the procedure in 4 such that:
_{−} x
e 2
=
∞
i=1
φ _{i} e _{i} ,
e _{i} =
F
∆
= E(S _{T} )
i
j=1
C ij ∂ p j f ^{λ}
∂λ ^{p} j
^{} λ j
for some constants C _{i}_{,}_{j} . Also we introduce ρ (.), the density function of the log
= ∆ ρ(s) + ρ(−s). We
moneyness x = log ^{} ^{F} ^{T} ^{} , along with its symmetrization ρ (s)
deﬁne the exact and approximate (truncated) price of the call option by
K
∆
C(F, K) = E (S _{T} − K) ^{+}
C _{n} (F, K) = F − KE e
∆
x
2
n
i=1
φ i e i
and assume that the norm  _{µ} dominates the norm  _{ρ} _{} , that is: there exists C _{µ} > 0 such that f  _{ρ} _{} < C _{µ} f _{µ} for any f ∈ H ^{µ} ⊂ H ^{ρ} ^{} . Theorem 5.1 Under the previous assumptions, the following results hold:
• Option Valuation
For the exact price we have
C(F, K) = F − K
∞
i=1
φ
i
i
j=1
_{C} ij ∂ ^{p} ^{j} χ(λ) ∂λ ^{p} j
 λ=λ _{j}
and for the proxy:
C _{n} (F, K) = F − K
n
j=1
Γ
n
j
∂ ^{p} ^{j} χ(λ) ∂λ ^{p} j
 λ=λ _{j} Γ
n
j
n
i=j
∆
=
C ij φ i
2
i
• Error Estimate
We have the following bound for the truncation error:
n
i=1
2
i
φ
C(F, K) − C _{n} (F, K) ≤ C _{µ} ^{√} FK ^{} φ, φ −
n
φ
i=1
^{} ≤ C _{µ} F ^{√} 2π ^{} φ, φ −
and for the normal implied vol error atm we have:
^{} σ ^{N} − σ
N
n
and for the lognormal vol atm approximately
^{} σ ^{B} − σ
B
n
n
φ
2
i
i=1
^{} ≤ C _{µ} ^{√} 2π ^{} φ, φ −
7
Proof: See appendix C Remark 5.i As for the standard Fourier approach, this formula allows a strip
of options for diﬀerent strikes to be priced at once since
E exp ( _{2} + iz)x = exp −( ^{1} _{2} + iz) ln(K) E exp ( ^{1} _{2} + iz) ln(F _{T} )
1
and the evaluations of the characteristic functions can be stored and reused for dif ferent strikes. Remark 5.ii We emphasize that the computation of C _{n} (F, K) requires exactly n evaluations of the characteristic function χ (or its derivatives); moreover, as already stated above, one increment of n will result in a single new evaluation of χ, pro vided the past evaluations have been stored, which makes an adaptative procedure possible. Remark 5.iii The error estimate shows clearly the impact of the norm  _{µ} on the deviation of the proxy from the exact price. Obviously C _{µ} should be reasonable so that the series converge suﬃciently rapidly.
5.2 How to choose the truncation level n?
From the last section, it is clear that the error depends directly on the product
C _{µ} ^{} φ, φ − ^{} ^{n}
. Once µ has been chosen, the number of terms necessary to
2
i=1 ^{φ} i
achieve a given accuracy η can be easily inferred by setting
n
φ
2
i
i=1
C _{µ} ^{√} FK ^{} φ, φ −
< η
when C _{µ} is known or at least is known to be reasonable. As an illustration, let us consider a tractable example with BlackScholes dynamics:
x
ρ(s)
=
=
σ ^{√} T Z, Z ∼ N (0, 1)
ρ(−s) =
^{1} 2πT exp(−
σ ^{√}
^{s} ^{2}
2σ ^{2} T ^{)}
where N (0, 1) denotes the standard normal distribution. For µ, we use an exponen tial weight
µ(s) = ν exp(−νs)
A few calculations show that f  _{ρ} _{} < C _{µ} f _{µ} with the optimal choice ν =
1
σ ^{√} T
≈ 1. 147 This means that if the variance of our process is
σ ^{2} T = 1, a good choice for our proxy distribution will be µ(s) = exp(−s). In that case, our experiments suggests that values n ≈ 15 − 20 produce very good results, not only when the terminal distribution of the underlying is lognormal, but also for richer dynamics such that stochastic volatility, as long as the variance of the
yielding C _{µ} = ^{2}^{e}
π
8
process is reasonnably in line with the one implied by µ. When C _{µ} is not known a priori, another possible strategy is to evaluate the elements (e _{i} ) _{1}_{≤}_{i}_{≤}_{1}_{0}_{0} once and for all, and then increment the number of elements used within this family until convergence is achieved (e.g the results do not change by more than some given quantity). This adaptative procedure is made possible as the evaluations of the characteristic functions are stored and reused. In the next section we examine the choice for the weight µ.
5.3 Example of Weights
In this section we provides useful quantities related to the practical implementation when the weights are either gaussian or exponential. We recall that the scalar product in H ^{µ} is deﬁned by:
g, h _{µ} = +∞ g(x)h(x)µ(x)dx
0
where, without loss of generality, we impose ^{}
0
+∞
µ(x)dx = 1.
5.3.1 Gaussian Weight
This case corresponds to Black&Scholes dynamics for the underlying, thus, for an at themoney option, the logmoneyness can be assumed to be gaussian (and centered for simplicity). This results in the following table:
distribution 
Gaussian 

µ (x) 
2 x 
^{2} 
T ^{)} 

σ ^{√} T √ _{2}_{π} exp(− 2σ ^{2} 

f _{λ} , f _{µ} 
exp − ^{λ} ^{2} ^{+}^{µ} ^{2} σ ^{2} T cosh (λµσ ^{2} T) 2 

f _{λ}  ^{2} 
_{2} 1 [1 + exp (−2λ ^{2} σ ^{2} T )] 

φ, f _{λ} 
[exp(m ^{2} )erf c(m)] , m = ^{} _{2} − λi ^{} σ ^{T} 1 2 

φ, φ 
2N(−σ ^{√} T ) exp( ^{σ} ^{2} ^{T} ) 2 
Remark 5.ivThe Gaussian distribution is not necessary appropriate when the un derlying’s distribution has fat tails, which is the case in stochastic volatility models.
5.3.2 Exponential Weight
The last remark suggests that we might consider a more slowly decaying density, and a good tractable candidate is the exponential density for which we will analyze
9
in more details.
distribution 
Exponential 

µ (x) 
ν exp(−νx) 

f _{λ} , f _{µ} 
_{ν} _{2} 
ν ^{2} +λ ^{2} +µ ^{2} 
_{(} ν ^{2} +(λ+µ) ^{2} _{)}_{(} ν ^{2} +(λ−µ) ^{2} _{)} 

f _{λ}  ^{2} 
ν ^{2} +2λ ^{2} 

ν ^{2} +4λ ^{2} 

φ, f _{λ} 
ν _{(} ν+ 2 ) 1 

_{(} ν+ ^{1} _{2} _{)} ^{2} +λ ^{2} 

φ, φ 
ν 

1+ν 
In this case, we can work out the ﬁrst term in the expansion. A short calculation leads to:
for ν = 1 this becomes:
λ 
√ 
^{√} 65−5 
≈ . 4374 

1 
4 

φ 
24 
√ 8959+737 ^{√} 65 
≈ . 6942 

1 
1777+303 ^{√} 65 

e _{1} (x) 
_{c}_{o}_{s} ^{} ^{√} ^{√} 65−5 4 x 


√
31+ √ 65
≈ 1. 1299 cos (0. 4374 x) 

^{√} 65−1 
The ﬁrst element e _{1} capture φ ^{2} ≈ . 48198 of the total variance φ, φ = 0.5. That is, in relative terms approximatively 96.4% of the total variance. The 20 ﬁrst frequencies have been computed numerically:
Λ =
1
0.4374, 1.6489, 0.0000, 0.8941, 2.9970, 4.6829, 2.3117, 6.5990, 3.7550, 1.2114, 8.7081, 5.5708, 10.997, 7.5851, 13.455, 9.7852, 16.074, 18.836, 12.160, 0.0000
_{Φ} _{=} ^{}
69.42%, 10.61%, 5.202%, 4.034%, 3.963%, 1.910%, 1.077%, 1.056%, 0.800%, 0.663% 0.645%, 0.474%, 0.423%, 0.306%, 0.293%, 0.212%, 0.211%, 0.158%, 0.153%, 0.138%
Note that the twentieth term is the ﬁrst occurrence of a frequency revisit. Using the
ﬁrst three terms covers 99.2% of the variance etc to Heston Dynamics.
Next, we apply this methodology
10
5.4
An application to Heston Dynamics
In this section we assume that the underlying follows Heston dynamics, that is, using similar notations than in Lipton[1]:
dS _{t}
S
t
dv _{t}
ρdt
=
=
=
σ ^{√} v _{t} dW
t
(S)
κ (1 − v _{t} ) dt + ε ^{√} v _{t} dW
dW
(v)
t
(S)
t
(v)
dW
t
,
v _{0} = 1
From now on we consider an initial spot S _{0} = 5% and the base case: σ = 40%, ε = 100%, ρ = 0, κ = 10% and T = 5y. The standard deviation in the base case is 80% justifying the use of an exponential weight with a caracteristic constant ν = 1. In the tables in Appendix D, we vary individually the diﬀerent model parameters and compare a 20 terms quasiperiodic expansion with a benchmark brute force integration, reporting the errors between the two. The results suggest that a very good accuracy is reached with 20 terms, for a large spectrum of model parameters.
6
Conclusion
The contribution of this paper is two folds: ﬁrst we have slightly simpliﬁed and im proved an original idea developped in [4] and second we have developped a new exact decomposition of the call payoﬀ in a polynomialtrigonometric series. Existence and convergence results have been established in a rigorous framework, yielding a val uation formula along with error estimates when truncation is applied for practical purpose. The expansion has been tested under Heston dynamics, demonstrating the robustness and excellent accuracy of the approach for a number of terms as low as 20. The method could, in principle, be applied to other dynamics whenever the caracteristic function of the logspot is known in a closed form. We plan, in a near future, to apply this technique to close to singular distribution (such as those appearing for very short term maturity) known to pose challenging problems when used in a Fourier Transform framework.
Aknowledgements
I am indebtful to Cyril Grunspan for initial motivating conversations, to Yann Ticot for his insights through out this work and to Professor Peter Hawkes for useful suggestions. Also I want to thank my colleagues in Bank Of America Merrill Lynch, and more specially Leif Andersen, Alex Lipton and Henrik Rasmussen for useful comments and support. Last, i am grateful to prof. Cornelius W. Oosterlee and prof. Fang Fang for interesting feed back and discussion.
11
A
Proof of Theorem 3.1
φ _{A} (x) being 2A− periodic, even, piecewise C ^{1} and C ^{0} , can be decomposed into its Fourier (cosinus) Series:
φ _{A} (x)
_{c} l>0
=
_{=}
Thus, we have that:
C _{A} (F, K)
∞
l=0
c _{l} cos l
π
A ^{x}
_{4}_{A} 1 − (−1) ^{l} e ^{−} ^{A} A ^{2} + (2πl) ^{2}
2
,
c _{0} = 2 ^{1} ^{−} ^{e} ^{−} A
2
A
=
E ^{T} ^{} S _{T} − Ke ^{x} φ _{A} (x) ^{}
2
= F − K
∞
l=0
c _{l} E ^{T} e
x
2
cos l
A x
π
yielding
By CauchySchwartz,
C _{A} (F, K) = F − K
∞
l=0
c _{l} χ l
π
A
C(F, K) − C _{A} (F, K)
=
≤
≤
=
K ^{} ^{} E ^{T} ^{} e
K ^{} E ^{T} [e ^{x} ] E ^{T} ^{} (φ(x) − φ _{A} (x)) ^{2} ^{} ds
(φ(x) − φ _{A} (x)) ^{}^{} ^{}
x
2
K ^{} E ^{T} [e ^{x} ] E ^{T} ^{} 1 x>A ^{} ds
^{√} FK ^{} N
(K exp ^{−}^{A} ) + 1 − N (K exp ^{A} )
At the money K = F , we have, in term of normal volatilities:
^{} σ ^{N} − σ
_{} _{≤} ^{} 2π
N
A
T
F ^{} N (K exp ^{−}^{A} ) + 1 − N (K exp ^{A} )
and in term of lognormal volatility, approximately:
^{} σ ^{B} − σ
B
A
_{} _{≤} ^{} 2π
T
^{} N (K exp ^{−}^{A} ) + 1 − N (K exp ^{A} )
B Proof of Theorem 4.1
B.1
Existence result
In this section we show that the recursive construction described in 4 is valid at any order
12
Proof: We prove the result by induction. For n = 1, we have that
f _{λ}  
= 
φ, f _{λ} 
= 
+∞ cos ^{2} (λx)µ(x)dx > 0
0
+∞ cos(λx)φ(x)µ(x)dx
0
Ω _{0} (λ) =
∆
0
+∞
cos(λx)φ(x)µ(x)dx ^{2}
+∞
0
cos ^{2} (λx)µ(x)dx
, λ ≥ 0
which shows that Ω _{1} is a positive continous function of λ. Moreover, using Lebesgue’s Lemma, we see that:
λ→∞ +∞
lim
0
cos ^{2} (λx)µ(x)dx = ^{1} _{2} +∞ µ(x)dx
0
λ→∞ +∞
lim
0
cos(λx)φ(x)µ(x)dx
=
0
so that:
_{λ}_{→}_{∞} Ω _{0} (λ) = 0
Relying now on the continuity of Ω _{1} associated with a compacity argument, we can
ensure that there exist
lim
λ ≥ 0 such that
λ≥0 ^{φ}^{,}
λ = arg max
ξ ^{λ}  2
ξ
λ
we now let
λ
e
_{1}
_{1}
=
=
^{}
λ
^{f} ^{λ} ^{1}
^{}
0
+∞
cos ^{2} (λ _{1} x)µ(x)dx
and assume now a valid construction of (e _{i} ) _{1}_{≤}_{i}_{≤}_{n} and (λ _{i} ) _{1}_{≤}_{i}_{≤}_{n} up to the rank n. We proceed as for the ﬁrst term, considering
e _{λ} =
=
λ
^{n} ^{f} ^{λ} ^{−} ^{} _{i}_{=}_{1}
f _{λ} , e _{i} e _{i}
f _{λ} − ^{} _{i}_{=}_{1} ^{n} f _{λ} , e _{i} e _{i} 
λ _{i} , i = 1
n
which is well deﬁned since
λ _{i} , i = 1,
Let us consider now λ _{j} ≥ 0, j ≤ n. We have trivially f _{λ} _{j} − ^{} _{i}_{=}_{1} so that we can consider
f _{λ}  ^{2} > ^{} _{i}_{=}_{1}
^{n}
f _{λ} , e _{i} ^{2} as
f _{λ} ∈/ Span(e _{1} ,
^{n}
,
,
n.
e _{n} ) when λ
=
f _{λ}_{j} , e _{i} e _{i} = 0
p = max l ≥ 0/∀ 0 ≤ k ≤ l, ^{∂} ∂λ ^{k} ^{f} ^{k}
^{} λ j ^{=}
n
i=1
^{} ∂ ^{k} f ∂λ ^{k}
 _{λ} _{j} , e _{i} e _{i}
13
then, using Taylor expansion up to order p, we have that:
f _{λ} −
so that
n
i=1
f _{λ} , e _{i} e _{i} = ^{(}^{λ} (p ^{−} + ^{λ} ^{j} 1)! ^{)} ^{p}^{+}^{1}
^{} _{∂} p+1 _{f}
_{∂}_{λ} p+1
^{} λ j ^{−}
n
^{} _{∂} p+1 _{f}
i=1
_{∂}_{λ} p+1
 _{λ} _{j} , e _{i} e _{i} + o(1)
_{e} λ _{=} (λ − λ _{j} ) ^{p}^{+}^{1} λ − λ _{j}  ^{p}^{+}^{1}
_{∂} p+1 _{f}
_{∂}_{λ} p+1
^{} λ j ^{−} ^{} ^{n}
i=1 ∂ p+1 f
_{∂}_{λ} p+1
 _{λ} _{j} , e _{i} e _{i}
_{∂} p+1 _{f}
_{∂}_{λ} p+1
^{} λ j ^{−} ^{} ^{n}
i=1 ∂ p+1 f
_{∂}_{λ} p+1
 _{λ} _{j} , e _{i} e _{i}
is well deﬁned and Ω _{n} (λ) can be continously extended on λ ≥ 0. Similar argument
as previously shows that Ω _{n} (∞) = 0 and thus λ _{n}_{+}_{1} = arg max _{λ}_{≥}_{0} Ω _{n} (λ) < ∞. Also, in virtue of what preceed,
Thus, we can perform this
construction at any order.
∆
e _{n}_{+}_{1} = lim _{λ} _{→}_{λ}
+
n+1
f _{λ} − ^{} _{i}_{=}_{1} ^{n} f _{λ} ,e _{i} e
_{} f _{λ} − ^{} _{i}_{=}_{1} ^{n} f _{λ} ,e _{i} e
_{i}_{} is well deﬁned.
i
B.2
Convergence result
Φ _{n} =
n
i=1
φ i e i
(e _{i} ) _{1}_{≤}_{i} being orthonormal, we have:
φ, φ ≥ Φ _{n} , Φ _{n} =
n
i=1
2
φ i
As an increasing bounded sequence, Φ _{n} , Φ _{n} is convergent with limit l ≥ 0 (this also yields φ _{∞} = 0) . Per
Φ _{n}_{+}_{p} − Φ _{n}  ^{2} =
=
Φ _{n}_{+}_{p} − Φ _{n} , Φ _{n}_{+}_{p} − Φ _{n}
n+p
φ
2
i
i=n+1
≤
∞
φ
2
i
i=n+1
Let us
denote its limit by Φ. We want to prove that Φ = φ. Let us assume momentarily
= 0. (λ _{j} ) _{j}_{≥}_{1} being a discrete
family, there exists ^{}
that this condition is violated, that is:
we see that Φ _{n} is a Cauchy sequence in H ^{µ} and therefore is convergent.
ψ
=
φ − Φ
λ such that:
[ ψ, e _{∞} ] ^{2}
e _{∞}
=
=
η > 0
^{f}
^{}
λ
− ^{}
∞
i=1 ^{f}
λ
, e _{i} ^{} e _{i}
^{} ^{} f
λ
^{} ^{2} − ^{}
∞
i=1 ^{f}
λ
,
e _{i} ^{} ^{2}
by orthogonality, we have that:
ψ, e _{∞} = φ, e _{∞}
14
and from φ _{∞} = 0, there exists N _{1} such that ∀n ≥ N _{1} we have φ have that:
n 2 ^{<}
^{η}
2 .
Also, we
n→∞ ^{e} ^{}
lim
n = e ∞
e _{n} =
^{f}
^{}
λ
_{−} ^{} n−1
i=1
^{} f
λ
, e _{i} ^{} e _{i}
^{} ^{} f
λ
_{} 2 _{−} ^{} n−1
i=1
^{} f
λ
,
e _{i} ^{} ^{2}
such that there exists N _{2} > 0 verifying ∀n ≥ N _{2} , φ, e ^{2} > ^{η} . Considering now
N
2
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