THE ANALYSIS OF PDES ARISING IN

NONLINEAR AND NON-STANDARD
OPTION PRICING
A thesis submitted to the University of Manchester
for the degree of Doctor of Philosophy
in the Faculty of Engineering and Physical Sciences
2008
Kristoffer John Glover
School of Mathematics
Contents
Abstract 11
Declaration 12
Copyright Statement 13
Acknowledgements 14
Dedication 15
1 Introduction 16
1.1 Evidence of increased interest in liquidity . . . . . . . . . . . . . . . . 17
1.2 A brief history . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
1.3 Derivative pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
1.3.1 European options . . . . . . . . . . . . . . . . . . . . . . . . . 21
1.3.2 Arbitrage pricing . . . . . . . . . . . . . . . . . . . . . . . . . 22
1.3.3 The Feynman-Kac representation theorem . . . . . . . . . . . 24
1.3.4 From Feynman-Kac to Black-Scholes . . . . . . . . . . . . . . 25
1.3.5 American options . . . . . . . . . . . . . . . . . . . . . . . . . 27
1.3.6 Optimal stopping problems . . . . . . . . . . . . . . . . . . . 29
1.3.7 Free-boundary problems . . . . . . . . . . . . . . . . . . . . . 30
1.4 Supply and demand economics . . . . . . . . . . . . . . . . . . . . . . 32
1.5 Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
1.5.1 Defining liquidity . . . . . . . . . . . . . . . . . . . . . . . . . 35
1.5.2 Measuring liquidity . . . . . . . . . . . . . . . . . . . . . . . . 36
1.6 Price formation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
2
1.7 Option pricing in illiquid markets: a literature review . . . . . . . . . 40
1.8 Introduction to perturbation methods . . . . . . . . . . . . . . . . . . 45
1.9 Layout of the thesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
2 The Modelling Framework 48
2.1 Technical asides . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
2.1.1 Markovian processes . . . . . . . . . . . . . . . . . . . . . . . 53
2.1.2 Applicability of Itˆ o’s formula . . . . . . . . . . . . . . . . . . . 54
2.2 Alternative models . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
2.2.1 Transaction-cost models . . . . . . . . . . . . . . . . . . . . . 56
2.2.2 Reaction-function (equilibrium) models . . . . . . . . . . . . . 57
2.2.3 Reduced-form SDE models . . . . . . . . . . . . . . . . . . . . 58
2.3 A unified framework . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
2.3.1 Cetin et al. (2004) . . . . . . . . . . . . . . . . . . . . . . . . 59
2.3.2 Platen and Schweizer (1998) . . . . . . . . . . . . . . . . . . . 59
2.3.3 Mancino and Ogawa (2003) . . . . . . . . . . . . . . . . . . . 60
2.3.4 Lyukov (2004) . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
2.3.5 Sircar and Papanicolaou (1998) . . . . . . . . . . . . . . . . . 61
3 First-order Feedback Model 64
3.1 Analysis close to expiry: European options . . . . . . . . . . . . . . . 67
3.2 Analysis close to expiry: American put options . . . . . . . . . . . . . 72
3.3 The vanishing of the denominator . . . . . . . . . . . . . . . . . . . . 77
4 Full-feedback Model 83
4.1 Put-call parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
4.2 A solution by inspection . . . . . . . . . . . . . . . . . . . . . . . . . 87
4.3 Similarity solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
4.4 Perturbation expansions . . . . . . . . . . . . . . . . . . . . . . . . . 90
4.5 Numerical solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92
4.6 Analysis close to expiry . . . . . . . . . . . . . . . . . . . . . . . . . . 93
4.7 Numerical results - full problem . . . . . . . . . . . . . . . . . . . . . 97
4.7.1 A second solution regime . . . . . . . . . . . . . . . . . . . . . 99
3
5 Smoothed Payoffs - Another Breakdown 102
5.1 Local analysis about the singularities . . . . . . . . . . . . . . . . . . 106
5.1.1 Asymptotic matching . . . . . . . . . . . . . . . . . . . . . . . 108
5.1.2 Properties of the inner solution . . . . . . . . . . . . . . . . . 110
5.1.3 Introduction to phase-plane analysis . . . . . . . . . . . . . . 111
5.1.4 Deriving an autonomous system . . . . . . . . . . . . . . . . . 114
5.1.5 Behaviour of the fixed points . . . . . . . . . . . . . . . . . . 116
5.1.6 Structure of the phase portrait . . . . . . . . . . . . . . . . . 120
5.1.7 Other fixed points . . . . . . . . . . . . . . . . . . . . . . . . . 122
6 Perpetual Options 127
6.1 Analytic solutions and perturbation methods . . . . . . . . . . . . . . 131
7 Other Models 137
7.1 Frey (1998, 2000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
7.2 Frey and Patie (2002) . . . . . . . . . . . . . . . . . . . . . . . . . . . 139
7.3 Sircar and Papanicolaou (1998) . . . . . . . . . . . . . . . . . . . . . 140
7.4 Bakstein and Howison (2003) . . . . . . . . . . . . . . . . . . . . . . 141
7.4.1 Non-smooth solutions to the Bakstein and Howison (2003) model146
7.4.2 New non-smooth solutions to the Black-Scholes equation . . . 147
7.5 Liu and Yong (2005) . . . . . . . . . . . . . . . . . . . . . . . . . . . 149
7.5.1 Vanishing of the denominator . . . . . . . . . . . . . . . . . . 150
7.6 Jonsson and Keppo (2002) . . . . . . . . . . . . . . . . . . . . . . . . 152
7.6.1 Connections with the other modelling frameworks . . . . . . . 154
8 Explaining the Stock Pinning Phenomenon 155
8.1 Linear price impact . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
8.2 Nonlinear price impact . . . . . . . . . . . . . . . . . . . . . . . . . . 159
8.3 A new nonlinear price impact model . . . . . . . . . . . . . . . . . . 161
9 The British Option 164
9.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
9.2 The no-arbitrage price . . . . . . . . . . . . . . . . . . . . . . . . . . 167
4
9.2.1 The gain function . . . . . . . . . . . . . . . . . . . . . . . . . 170
9.3 Numerical treatment . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
9.4 Free boundary analysis far from expiry . . . . . . . . . . . . . . . . . 175
9.5 Analysis close to expiry . . . . . . . . . . . . . . . . . . . . . . . . . . 180
9.6 Financial analysis of the British put option . . . . . . . . . . . . . . . 186
9.7 The British call option . . . . . . . . . . . . . . . . . . . . . . . . . . 193
9.7.1 Analysis far from expiry . . . . . . . . . . . . . . . . . . . . . 196
9.7.2 Analysis close to expiry . . . . . . . . . . . . . . . . . . . . . 198
9.8 Integral representations of the free boundary . . . . . . . . . . . . . . 198
9.8.1 The American put option . . . . . . . . . . . . . . . . . . . . 198
9.8.2 The British put option . . . . . . . . . . . . . . . . . . . . . . 201
10 Conclusions 204
A Maximum Principles 223
A.1 Nonlinear equations . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226
A.2 Uniqueness of PDEs . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
A.2.1 The linear Black-Scholes equation . . . . . . . . . . . . . . . . 228
A.2.2 The nonlinear (illiquid) Black-Scholes equation . . . . . . . . . 229
A.3 Monotonicity in λ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
B Non-dimensionalisation of the British Put 232
C The Probability Density Function 233
Word count 69834
5
List of Figures
3.1 Value of European call options with first-order feedback (T = 1, r =
0.04, σ = 0.2, K = 1) for λ = 0, 1, 2, 5, 10; the variation with λ
appears to be monotonic. . . . . . . . . . . . . . . . . . . . . . . . . . 66
3.2 Value of European put options with first-order feedback (T = 1, r =
0.04, σ = 0.2, K = 1) for λ = 0, 1, 2, 5, 10; the variation with λ
appears to be monotonic. . . . . . . . . . . . . . . . . . . . . . . . . . 66
3.3 Asymptotic Matching. . . . . . . . . . . . . . . . . . . . . . . . . . . 70
3.4 Inner solution minus the payoff for put and call options, r = 0.04,
σ = 0.2, K = 1 and for λ = 0.1, 0.15, 0.2, . . ., 0.4. . . . . . . . . . . . 72
3.5 Value of American put options, T = 1, r = 0.04, σ = 0.2, K = 1 and
for λ = 0, 1, 2, 5, 10; the variation with λ appears to be monotonic. . 73
3.6 First-order feedback put (with early exercise), location of free bound-
ary (as τ →0) with λ, K = 1, r = 0.04, σ = 0.2. . . . . . . . . . . . . 76
3.7 Location of the vanishing of the denominator of (2.9) with λ = 0.1,
K = 1, r = 0.04 and σ = 0.2. . . . . . . . . . . . . . . . . . . . . . . 78
3.8 The first derivative (∆) of the Black-Scholes equation (3.2) (dotted
line) and the first order feedback PDE (2.9) (solid line) for τ = 0.01,
0.015, . . ., 0.05. Compare the location of the vanishing denominator 3.7. 79
3.9 The second derivative (Γ) of the Black-Scholes equation (3.2) (dotted
line) and the first order feedback PDE (2.9) (solid line) for τ = 0.01,
0.015, . . ., 0.05. Compare the location of the vanishing denominator 3.7. 79
6
3.10 First-order feedback put option value for two different values of λ at
various times to expiry; τ = 0.0125, 0.0375, 0.075. For r = 0.04,
σ = 0.2, K = 1 and λ = 0.09 (solid line) and λ = 0.1 (dotted line).
Compare with figure 3.7. . . . . . . . . . . . . . . . . . . . . . . . . . 81
4.1 The leading order correction term V
1
(S, τ) to the Black-Scholes (i.e.
λ = 0) European put option for various time to expiry. K = 1,
r = 0.04, σ = 0.2, T = 1 and τ = 0.1, 0.2, . . . , 1. . . . . . . . . . . . . 92
4.2 Deltas for full-feedback (European) put, K = 1, r = 0.04, σ = 0.2,
λ = 0.1 and T = 1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
4.3 Local (τ →0) solution of a full-feedback put, K = 1, λ = 0.1, r = 0.04
and σ = 1, 0.95, . . ., 0.15. . . . . . . . . . . . . . . . . . . . . . . . . 96
4.4 Full feedback put, K = 1, r = 0.04, σ = 0.2 and λ = 0.1; modified
numerical scheme. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
4.5 Full feedback put, K = 1, r = 0.04, σ = 0.2 and λ = 0.1; modified
numerical scheme. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
4.6 Full feedback call, K = 1, r = 0.04, σ = 0.2 and λ = 0.1; modified
numerical scheme. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
4.7 Full feedback put, smoothed payoff, K = 1, r = 0.04, σ = 0.1, λ = 0.1
and τ = 0.01. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
5.1 Phase portrait of the autonomous system (5.24). Note the fixed point
at u =
_
243
80
_1
3
, v = 0 and the field direction lines. The dotted line rep-
resents an analytic envelope for the phase portrait close to the singular
line v =
5u
3
, cf. equation (5.31). . . . . . . . . . . . . . . . . . . . . . 120
6.1 Full feedback American put, K = 1, r = 0.04, σ = 0.2, λ = 0.25,
ρ = 0.15 (smoothed payoff), τ = 0, 1, . . . , 10. Note that we are in the
regime λ < 2ρ and so we should expect no singular behaviour. . . . . 128
6.2 Perpetual full-feedback American put, K = 1, r = 0.04, σ = 0.2,
λ = 0, 0.1, 0.2, . . . , 1.1; free-boundary location as indicated. . . . . . . 130
7
6.3 The first order correction to the Black-Scholes perpetual American put
option (solid line) compared to the difference of the fully numerical
option value with the Black-Scholes (dotted line). K = 1, r = 0.04,
σ = 0.2 and λ = 0.1. . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
6.4 The first order correction to the Black-Scholes perpetual American put
option (solid line) compared to the difference of the fully numerical
option value with the Black-Scholes (dotted line) for various values of
λ. K = 1, r = 0.04, σ = 0.2 and λ = 0.1, 0.5, 1. . . . . . . . . . . . . 136
7.1 Location of the vanishing of the denominator of the Frey (1998, 2000)
(solid line) and Sch¨ onbucher and Wilmott (2000) (dotted line) model
with λ = 0.1, K = 1, r = 0.04 and σ = 0.2. . . . . . . . . . . . . . . 139
7.2 Local (τ → 0) call solution of the Sircar and Papanicolaou (1998)
model K = 1, r = 0.04, σ = 0.2, and
ˆ
λ = 0, 0.05, . . . , 0.2. . . . . . . . 141
7.3 Local (τ → 0) put solution of the Sircar and Papanicolaou (1998)
model K = 1, r = 0.04, σ = 0.2, and
ˆ
λ = 0 0.05, . . ., 0.3. . . . . . . . 142
7.4 Solution to equation (7.9) for a put option with λ = 0.01, 0.5, 1, . . .,
5, σ = 0.2, r = 0.04, K = 1, and α = 1.5. . . . . . . . . . . . . . . . . 144
7.5 Local (τ →0) put solution of the Bakstein and Howison (2003) model
K = 1, r = 0.04, σ = 0.2, α = 1.5, and
ˆ
λ = −5, -4.75, . . ., 5. . . . . . 147
7.6 Local (τ →0) call solution of the Bakstein and Howison (2003) model
K = 1, r = 0.04, σ = 0.2, α = 1.5, and
ˆ
λ = −5, -4.75, . . ., 5. . . . . . 148
7.7 Non-smooth solution of the Black-Scholes equation. K = 1, r = 0.04,
σ = 0.2. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149
7.8 Location of the vanishing of the denominator for the Liu and Yong
(2005) model for various value of β. K = 1, r = 0.04, σ = 0.2,
λ = 0.1, and β = 1 10
5
, 2 10
5
, . . ., 1 10
6
. . . . . . . . . . . . . . 151
7.9 Local (τ → 0) call solution of the Jonsson and Keppo (2002) model
K = 1, σ = 0.2, and a = −1, -0.9, . . ., 1. . . . . . . . . . . . . . . . . 153
7.10 Local (τ → 0) put solution of the Jonsson and Keppo (2002) model
K = 1, σ = 0.2, and a = −1, -0.9, . . ., 1. . . . . . . . . . . . . . . . . 153
8
8.1 The pinning probability (8.5) for values of nE = 0.5, 1, . . ., 5. T −t =
0.1, K = 1, and σ = 0.2. . . . . . . . . . . . . . . . . . . . . . . . . . 158
8.2 Comparing the pinning probability associated with (8.6) (solid line)
with the model of Avellaneda and Lipkin (2003) (dotted line) for nE =
0.1, T −t = 0.1, K = 1, σ = 0.2, and r +
1
2
σ
2
= 0. . . . . . . . . . . . 159
8.3 Solution to (8.7) for p = 0.8, 0.9, . . . , 1.2, T − t = 0.1, K = 1, σ = 0.2
and r +
1
2
σ
2
= 0. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161
8.4 Solution to equation (8.8) (solid line) compared to (8.5) (dotted line)
for T = 0.1, K = 1, σ = 0.2, and r +
1
2
σ
2
= 0. . . . . . . . . . . . . . 163
9.1 The British put option free boundary for varying values of the contract
drift. T = 1, K = 1, σ = 0.4, r = 0.1, D = 0, and µ
c
= 0.11, 0.115,
0.12, . . ., 0.16. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
9.2 The British put option free boundary for varying volatilities. T = 1,
K = 1, µ
c
= 0.125, r = 0.1, D = 0, and σ = 0.05, 0.1, . . ., 0.5. . . . . 173
9.3 The zero of the H-function, i.e. S
h
(t), for varying values of the contract
drift. µ
c
= 0.102, 0.104, . . . , 1. T = 50, K = 1, r = 0.1, D = 0, and
σ = 0.4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
9.4 The asymptotic approximation for the British put option free bound-
ary close to expiry, i.e. (9.27) (dotted line) compared with fully nu-
merical value (solid line). T = 0.01, σ = 0.4, r = 0.1, µ
c
= 0.125, and
D = 0. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186
9.5 Location of the free boundary for the British (solid line) and American
(dotted line) put option under investigation in figures 9.6, 9.7 and 9.8.
T = 1, K = 1, σ = 0.4, r = 0.1, µ
c
= 0.125, and D = 0. . . . . . . . . 189
9.6 The difference in the percentage return of the British put option and
the American put option at every possible stopping location. The solid
lines denote contours at increments of 10% from -10% to 60%. The
dotted line represents the zero contour. S
0
= 1, T = 1, K = 1, σ = 0.4,
r = 0.1, D = 0, and µ
c
= 0.125. . . . . . . . . . . . . . . . . . . . . . 190
9
9.7 The difference in the percentage return of the British put option and
the European put option. Again the solid lines denote contours at
increments of 10% from 0% to 70%. The dotted line represents the
zero contour. S
0
= 1, T = 1, K = 1, σ = 0.4, r = 0.1, D = 0, and
µ
c
= 0.125. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190
9.8 The difference in the percentage return of the American put option and
the European put option. The solid lines denote contours at increments
of 10% from -70% to 30%. The dotted line represents the zero contour.
S
0
= 1, T = 1, K = 1, σ = 0.4, r = 0.1, and D = 0. Note the change
of orientation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191
9.9 Schematic representation of the regions in which at-the-money Eu-
ropean, American and British put option would provide the greatest
return on an investment. The dotted lines represent the free bound-
aries of the American and British put option for reference. T = 1,
K = 1, σ = 0.4, r = 0.1 and D = 0. . . . . . . . . . . . . . . . . . . . 192
9.10 Figures representing the region in which American put options would
provide a greater expected return that its British option counterpart,
for increasing moneyness. T = 1, K = 1, σ = 0.4, r = 0.1 and D = 0. 194
9.11 The British call option free boundary for varying values of the contract
drift. T = 1, K = 1, σ = 0.4, r = 0.1, D = 0, and µ
c
= 0.05, 0.055,
0.06, . . ., 0.09. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195
9.12 The British call option free boundary for varying volatilities. T = 1,
K = 1, µ
c
= 0.08, r = 0.1, D = 0, and σ = 0.05, 0.1, . . ., 0.5. . . . . . 195
9.13 The asymptotic approximation for the British call option free bound-
ary close to expiry, i.e. (9.32) (dotted line) compared with fully nu-
merical value (solid line). T = 0.01, K = 1, σ = 0.4, r = 0.1, µ
c
= 0.08
and D = 0. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199
10
The University of Manchester
Kristoffer John Glover
Doctor of Philosophy
The Analysis of PDEs Arising in Nonlinear and Non-standard Option
Pricing
October 23, 2008
This thesis examines two distinct classes of problem in which nonlinearities arise in
option pricing theory. In the first class, we consider the effects of the inclusion of fi-
nite liquidity into the Black-Scholes-Merton option pricing model, which for the most
part result in highly nonlinear partial differential equations (PDEs). In particular,
we investigate a model studied by Sch¨ onbucher and Wilmott (2000) and furthermore,
show how many of the proposed existing models in the literature can be placed into
a unified analytical framework. Detailed analysis reveals that the form of the nonlin-
earities introduced can lead to serious solution difficulties for standard (put and call)
payoff conditions. One is associated with the infinite gamma and in such regimes
it is necessary to admit solutions with discontinuous deltas, and perhaps even more
disturbingly, negative option values. A second failure (applicable to smoothed payoff
functions) is caused by a singularity in the coefficient of the diffusion term in the
option-pricing equation. It is concluded in this case is that the model irretrievably
breaks down and there is insufficient ‘financial modelling’ in the pricing equation.
The repercussions for American options are also considered.
In the second class of problem, we investigate the properties of the recently intro-
duced British option (Peskir and Samee, 2008a,b), a new non-standard class of early
exercise option, which can help to mediate the effects of a finitely liquid market,
since the contract does not require the holder to enter the market and hence incur
liquidation costs. Here we choose to focus on the interesting nonlinear behaviour of
the early-exercise boundary, specifically for times close to, and far from, expiry.
In both classes, detailed asymptotic analysis, coupled with advanced numerical tech-
niques (informed by the asymptotics) are exploited to extract the relevant dynamics.
11
Declaration
No portion of the work referred to in this thesis has been
submitted in support of an application for another degree
or qualification of this or any other university or other
institute of learning.
12
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13
Acknowledgements
I am extremely grateful to my supervisors Professor Peter W. Duck and David P.
Newton for their expert guidance and continued support throughout the course of
this Ph.D. In particular, I thank Peter for his boundless knowledge, enthusiasm and
efficiency, and David for his caring supervision and his confidence in my abilities. In
addition, EPSRC funding is gratefully acknowledged.
I thank my parents for their love and unwavering support for which these mere
expressions of gratitude do not suffice. Thank you to my colleagues and friends
for their invaluable advice and numerous enlightening discussions. In particular, to
Goran Peskir for his time and enthusiasm for the subject, and to Erik Ekstr¨ om for
his insight and friendship.
To my close friends, both old and new, and in particular to Jonathan Causey, Helen
Burnip, Philip Haines, John Heap, Sebastian Law and Vicky Thompson, I thank you
for creating the good times and for being there through the bad. I hope, despite
the distances between us, our friendships can continue to flourish. Finally, I thank
Hannah for everything, I hope we both find what we’re looking for.
14
Dedication
To Gran, in loving memory.
15
Chapter 1
Introduction
Nowadays people know the price of everything and the value of nothing.
- Oscar Wilde (1854-1900)
The Picture of Dorian Gray (1891)
Mathematical finance is not a branch of the physical sciences. There are no laws of
nature just waiting to be discovered; one is not trying to model Mother Nature and
her laws, but the nature of man and his markets. However, this does not preclude
us from trying to quantify the financial markets and to utilise the powerful tools of
mathematics in order to better understand such markets.
Since the definitive papers of Black and Scholes (1973) and Merton (1973), much of
the work undertaken in mathematical finance has been aimed at relaxing a number
of the modelling assumptions. One of the more subtle was that the market in the
underlying asset
1
was infinitely (or perfectly) elastic, such that trading had no impact
on the price of the underlying. If we relax this assumption, then we see some rather
interesting and possibly counterintuitive behaviours. As we shall show later, this is
partly due to the fact that any model incorporating such a feature will inevitably
lead to nonlinear behaviour (feedback). In particular, we shall be concerned for the
most part with nonlinear partial differential equations (PDEs) arising from the study
1
Termed underlying in the sequel.
16
CHAPTER 1. INTRODUCTION 17
of finitely elastic markets. Work that has led to this class of PDEs in finance to
date includes Whalley and Wilmott (1993) in relation to transaction costs, which
was one of the first nonlinear PDEs to arise in the field of mathematical finance.
In addition, there is the so called Black-Scholes-Barrenblatt equation introduced by
Avellaneda et al. (1995) in the study of uncertain volatility models. These models
involve optimisation over all possible values of volatility, and as a result are also
highly nonlinear.
The aim of modelling the behaviour of the underlying is to capture the dynamics
of the observed market prices as faithfully as possible. One approach to incorporate
these dynamics is to find a stochastic process that fits most closely the distribution of
returns of the underlying. This is an exogenous strategy, and as such provides little
insight into which of the many factors affecting the price dynamics are actually the
most important. In addition, the exogenous processes required tend to be difficult to
handle mathematically, for example L´evy processes. An alternative approach (and
that to be followed in this thesis) is to retain one the simplest stochastic process,
geometric Brownian motion, but to provide an endogenous mechanism by which
the dynamics differ from this standard geometric Brownian motion. This provides
much greater insight into how prices are actually formed in the market, and has the
advantage of being consistent with the bulk of the literature over the past thirty-five
years.
In this chapter we introduce the basic ideas and concepts and review the results of
the classical Black-Scholes-Merton option pricing theory used in later chapters. It
is by no means a complete treatment of the relevant theories, just enough for the
unfamiliar reader to understand the contributions of the following chapters.
1.1 Evidence of increased interest in liquidity
Recent worries about the health of the modern financial system have deterred people
from getting involved in the derivatives markets. This has resulted in trading volumes
CHAPTER 1. INTRODUCTION 18
decreasing and hence increased liquidity problems. David Oakley of the Financial
Times
2
warns that
...the sharp slowdown in these [derivative] markets is a serious warning
sign of the growing problems in the financial world as they are usually
highly liquid, turning over vast amounts of trade every day.
Further, Rachel Lomax, the Bank of England’s Deputy Governor goes on to describe
the recent financial turmoil in the wake of the American sub-prime mortgage prob-
lems
3
as
...the largest ever peacetime liquidity crisis.
The current liquidity crisis can be traced back to the collapse of the US sub-prime
mortgage market. In August 2007 the Financial Times is quoted as saying that
4
...as market turmoil rises financial problems are no longer simply confined
to a risky corner of the US mortgage market. This stems from another
key theme now haunting the markets: namely that liquidity is evaporating
from numerous corners of the financial world, as both investors in hedge
funds and the banks that lend to them try to cut and run from recent
losses.
Clearly, in times of crisis, liquidity becomes an ever important issue, motivating
further investigation into the effects of reduced liquidity on all aspects of the financial
markets. In a recent blog entry regarding the sub-prime induced liquidity crisis Paul
Wilmott states that
5
...this should spur on the implementation of mathematical models for
feedback... which may in turn help banks and regulators to ensure that
2
See Derivative liquidity crisis ‘to continue’, David Oakley, FT.com, November 23 2007.
3
Quoted in Bank deputy downbeat on economy, Chris Giles, FT.com, February 27 2008.
4
See Liquidity alarm bells sound, Paul J Davies, Gillian Tett, Joanna Chung and Stacy-Marie
Ishmael, FT.com, August 1 2007.
5
Quoted in Science in Finance IV: The feedback effect Paul Wilmott, blog entry at http://www.
wilmott.com/blogs/paul/, January 29 2008.
CHAPTER 1. INTRODUCTION 19
the press that derivatives are currently getting is not as bad as it could
be.
1.2 A brief history
In 1828 Robert Brown (1773-1858), a Scottish botanist, observed the apparently ran-
dom motion of pollen particles suspended in water and subsequently during the 19th
century it became clear that the pollen particles were being bombarded by a multi-
tude of molecules of the surrounding water, whose aggregate effect was (apparently)
random. In addition, wherever we look we see a random world and therefore Brow-
nian motion (named in honour of Robert Brown) is an invaluable tool for describing
this randomness. In fact, the ubiquitous nature of Brownian motion can be seen as
the dynamic counterpart of the ubiquitous nature of the normal distribution, which
rests ultimately on the Central Limit Theorem.
6
The origins of much of financial mathematics trace back to a dissertation (entitled
Th´eorie de la sp´eculation
7
) published in 1900 by Louis Bachelier (1870-1946). In
it he proposed to model the movement of stock prices with a diffusion process or
Brownian motion. Note that this was five years before Einstein’s seminal paper
outlining the theory of Brownian motion, and it was not until the 1920s that the
rigorous mathematical underpinnings of the theory of Brownian motion was provided
by Norbert Wiener (1894-1964).
Meanwhile, as quantum mechanics emerged in the 1920s it began to become clear
that the quantum picture is both inescapable at the subatomic level and intrinsically
probabilistic. The work of Richard P. Feynman (1918-1988) in the late 1940s on quan-
tum mechanics using path integrals, introduced the Wiener measure into the heart
of quantum theory. Feynman’s work was made mathematically rigorous by Mark
Kac (1914-1984) and the so-called Feynman-Kac formula, which gives a stochastic
6
See for example Jacod and Protter (2003).
7
For a translated version with commentary and a foreword by Paul Samuelson see Davis and
Etheridge (2006).
CHAPTER 1. INTRODUCTION 20
representation for the solution to certain classes of PDEs, was introduced (see section
1.3.3).
In 1944 Kiyoshi Itˆ o (1915-) went on to develop stochastic calculus, the machinery
needed in order to use Brownian motion to model stock prices successfully, and which
would later become an essential tool of modern finance. However, it was not until 1965
that economist Paul Samuelson (1915-) resurrected Bachelier’s work and advocated
Itˆ o’s geometric Brownian motion model as a suitable model for stock price movements.
After this it was not long until Black, Scholes and Merton wrote down their famous
equation for the price of a European call and put option in 1969, work for which the
surviving members (Scholes and Merton) received the Nobel Prize for economics in
1997.
A more comprehensive overview of the early years of mathematical finance can be
found in Jarrow and Protter (2004).
1.3 Derivative pricing
When we discretise a problem it becomes easier to define or understand but much
harder to solve without the use of continuous time calculus; this thesis deals solely
with continuous time models. In continuous-time modelling there are two main ap-
proaches to calculating the price of a given derivative security, the so-called martin-
gale approach and the PDE approach. In the former, a stochastic process for the
underlying is specified and an equivalent probability measure is found that turns the
discounted underlying into a martingale. The price of the derivative is then defined
as the conditional expectation of its discounted payoff under this new (risk-neutral)
measure. Alternatively, in the PDE approach, a stochastic process for the underlying
is likewise specified and then Itˆ o’s formula for a function of the underlying stochastic
process is used to derive a PDE involving the coefficients of the underlying process.
The two approaches are deeply linked via the famous Feynman-Kac formula (outlined
in section 1.3.3) and it should be noted that both approaches can be used for complete
CHAPTER 1. INTRODUCTION 21
and incomplete markets. In the latter case, arriving at a unique price for a derivative
requires additional assumptions. If one is using the martingale approach, then this
arbitrariness is reflected in the choice of equivalent martingale measure, whereas using
the PDE approach the choice of martingale measure is analogous to specifying the
so-called market price of risk of the non-traded variable. Since the models introduced
in this thesis result in complete markets,
8
i.e. all sources of risk are traded, both the
martingale approach and the PDE approach should arrive at the same price.
The fair price of a derivative security (and all other financial instruments) is de-
termined by the expected discounted value of some future payoff, which is itself
dependent on the future value of the underlying asset. Of course, the future value
of the underlying is not known a priori, and price processes are often modelled by
stochastic processes. Therefore, an understanding of the behaviour of such stochastic
processes is a valuable prerequisite for the study of derivative pricing; this section
attempts to provide such an understanding. The derivative securities studied in this
thesis, without exception, are options contracts. A brief overview of the types of
contracts referred to in the main body of the thesis will be considered next.
1.3.1 European options
European options are the simplest type of options contract and within this class the
most common are call options and put options. The holder of a call option written
on a certain underlying asset (usually a stock) has the right, but not the obligation,
to buy the underlying at some pre-determined date, denoted T, and at some pre-
determined price, denoted K. If the underlying at time t = T, S
T
, is worth more
then K then the (rational) holder would exercise the option and make a profit S
T
−K.
Alternatively, if S
T
is less than K, then the holder would not exercise, resulting in
the option expiring worthless. Thus, the value of the call option at expiry (T) is
given by
V
C
(S
T
, T) = (S
T
−K)
+
:= max¦S
T
−K, 0¦. (1.1)
8
Under suitable restrictions, see chapter 2.
CHAPTER 1. INTRODUCTION 22
Similarly, the holder of a put option has the right to sell the underlying for the
exercise price K, resulting in the value of the put option:
V
P
(S
T
, T) = (K −S
T
)
+
:= max¦K −S
T
, 0¦. (1.2)
The functions (1.1) and (1.2) are called payoff profiles and will be referred to as such
throughout this thesis. There are, of course, many different options contracts with
more general payoff profiles, h(S
T
) say. For an option to be described as European,
its contract must specify that exercise is only possible at a single maturity time, T.
Note that these contracts dependent only on the price of the underlying at expiry,
S
T
, and not on the path of the price prior to maturity; this results in tractability in
many situations. Options that allow exercise at times prior to expiry are said to have
an early-exercise feature. More specifically if the option allows exercise at any time
prior to expiry such an option is referred to as an American option. These options
are very popular in practise, and will play an important role in much of this thesis.
Indeed we shall return to them shortly in section 1.3.5.
1.3.2 Arbitrage pricing
An arbitrage opportunity corresponds to a risk-free profit. More formally, it is the
opportunity to construct a trading strategy (i.e. buying and selling financial instru-
ments) in such a way that the initial investment (at t = 0) is zero and the wealth at
time T is non-negative with a non-zero probability of a strictly positive wealth. In
an efficient market there should be no such arbitrage opportunities and indeed the
seminal work by Black and Scholes (1973) and Merton (1973) used the no-arbitrage
principle to arrive at a unique price for the fair value of an option contract. To state
their results, we have a market consisting of a bank account which grows according
to the (deterministic) dynamics
dB = rBdt,
and one risky asset, with stochastic price dynamics
dS
t
= µS
t
dt +σS
t
dW
P
t
, (1.3)
CHAPTER 1. INTRODUCTION 23
where r is the positive (constant) interest rate, µ the drift and σ the volatility of
the underlying price process. W
P
t
denotes a standard Brownian motion under the
probability measure P. The fair value or price of a European option contract V (S, t)
with payoff profile h(S
T
) can be shown to be given by
V (S, t) = E
Q
S,t
_
e
−r(T−t)
h(S
T
)
¸
, (1.4)
in words, the expected discounted future payoff. The indices indicate that the pro-
cess for S
t
is started at S at time t and also that the expectation is calculated under
the so-called risk-neutral probability measure, Q, as opposed to the real world mea-
sure, P, defined by the process (1.3).
9
The risk-neutral measure is defined as the
unique measure equivalent to P under which the discounted price process is a mar-
tingale. Consequently, the stock price process (1.3) can then be described in terms
of a standard Q-Brownian motion W
Q
t
as
dS
t
= rS
t
dt +σS
t
dW
Q
t
. (1.5)
Note that the dynamics of S
t
under the risk-neutral measure Q are the same as
the dynamics under the real-world measure P, except that the drift of S
t
under Q
is equal to the interest rate r instead of µ. Consequently the drift parameter µ
does not appear anywhere in the pricing formula for European options; this fact
undoubtedly contributed to the widespread application of the Black-Scholes-Merton
pricing methodology in the years subsequent to its publication, since in practise
the drift parameter is notoriously difficult to measure from past time series of the
underlying process.
10
The model analysed above is an example of a complete market model. The simplest
definition of a complete market is one in which every derivative security can be repli-
cated by a self-financing trading strategy in the stock and bond. In this model, any
security whose payoff h(S
T
) is known at time T (where h(S
T
) is any T
T
-measurable
9
This subtlety was the main innovation of option pricing research in the 1970s. Prior to this,
expectations had been taken under the real world measure P.
10
In fact, Liptser and Shiryaev (2001) show that the expected waiting time to obtain an estimate
of the drift (via the naive approximation S
t
/t) that is within of the true drift is proportional to

−2
. For example if = 0.01 it would take ∼ 10, 000 years to obtain such an estimate.
CHAPTER 1. INTRODUCTION 24
random variable with E[h
2
(S
T
)] < ∞) can be replicated by some unique self-financing
trading strategy. Finally, we note that in a complete market, a characterisation of
the arbitrage-free principle is that there exists a unique equivalent martingale mea-
sure Q, under which the discounted prices of traded securities are martingales. For
more on this characterisation see the original works of Harrison and Kreps (1979)
and Harrison and Pliska (1981, 1983).
Expected values of solutions to stochastic differential equations (SDEs), such as the
pricing equation (1.4), are linked to the solution of (linear) parabolic partial differen-
tial equations (PDEs) via the famous Feynman-Kac representation theorem. Thus,
the price of a European option can be studied using both stochastic methods and
parabolic PDE methods; this thesis focuses primarily on the latter. In the following
section we describe the Feynman-Kac representation theorem.
1.3.3 The Feynman-Kac representation theorem
Suppose we are given the PDE for the unknown function u(S, t)
∂u
∂t
+
1
2
σ
2
(S, t)

2
u
∂S
2
+µ(S, t)
∂u
∂S
= 0, (1.6)
subject to the final condition
u(S, T) = h(S),
where µ(S, t), σ(S, t) and h(S) are known functions and T a parameter. This equation
is sometimes called the Kolmogorov backward equation. The Feynman-Kac formula
tells us that the solution can be written as an expectation,
u(S, t) = E
P
S,t
[h(S
T
)]
where S
t
is a stochastic process given by the equation
dS
t
= µ(S
t
, t)dt +σ(S
t
, t)dW
P
t
. (1.7)
The indices on the expectation indicates that the process S
t
is started at S at time t
and in addition the superscript indicates that the expectation is taken under the prob-
ability measure P, corresponding to the stochastic process (1.7), with a P-Brownian
CHAPTER 1. INTRODUCTION 25
motion W
P
t
. This useful representation allows us to solve deterministic PDEs via
stochastic methods and, conversely, expectations of functions of stochastic processes
via deterministic PDEs.
Proof. The proof of the Feynman-Kac representation is fairly straightforward and so
we shall outline the basic idea here. Consider an unknown function u(S, t). Applying
Itˆ o’s formula we have
du =
_
∂u
∂t
+µ(S, t)
∂u
∂S
+
1
2
σ
2
(S, t)

2
u
∂S
2
_
dt +σ(S, t)
∂u
∂S
dW
P
t
.
Now, by assumption the O(dt) terms above are zero if u(S, t) is assumed to be the
solution of the PDE (1.6). Integrating the above equation we obtain
_
T
t
du = u(S
T
, T) −u(S
t
, t) =
_
T
t
σ(S, t)
∂u
∂S
dW
P
t
.
Next, taking expectations and reorganising a little we arrive at
u(S, t) = E
P
S,t
[u(S
T
, T)] −E
P
S,t
__
T
t
σ(S, t)
∂u
∂S
dW
P
t
_
.
Finally, it can be shown that the expectation of an Itˆ o integral with respect to a
Brownian motion is zero (see, for example, prop. 4.4 of Bj¨ ork, 2004) resulting in the
required result
u(S, t) = E
P
S,t
[u(S
T
, T)] = E
P
S,t
[h(S
T
)] .
1.3.4 From Feynman-Kac to Black-Scholes
Having satisfied ourselves of the validity of the Feynman-Kac representation theorem,
we can now use it to represent the expectation given in (1.4), representing the price
of a European option, as the solution to a second-order linear parabolic PDE. The
first point to note is that (1.4) involves discounting and so it is useful to make the
transformation
V (S, t) = e
−r(T−t)
u(S, t)
CHAPTER 1. INTRODUCTION 26
in equation (1.6) to obtain the PDE
∂V
∂t
+
1
2
σ
2
(S, t)

2
V
∂S
2
+µ(S, t)
∂V
∂S
−rV = 0,
which we have shown can be represented as the conditional expectation
V (S, t) = E
P
S,t
_
e
−r(T−t)
h(S
T
)
¸
.
However, note that the expectation in (1.4) is taken under the risk-neutral measure
Q and so the corresponding PDE representation of (1.4) is given by
∂V
∂t
+
1
2
σ
2
S
2

2
V
∂S
2
+rS
∂V
∂S
−rV = 0, (1.8)
with the following condition
V (S, T) = h(S), (1.9a)
V (0, t) = h(0)e
−r(T−t)
, (1.9b)
V (S, t) →h(S)e
−r(T−t)
as S →∞, (1.9c)
where we have used the risk-neutral process (1.5). Note that in what follows this
shall be referred to as in the Black-Scholes equation (which should also be credited
to Merton). Moreover, if we assume a stochastic process of the much more general
form (1.7), then the corresponding (generalised) Black-Scholes equation obtained via
the Feynman-Kac formula is given by
11
L
BS
(V ) =
∂V
∂t
+
1
2
σ
2
(S, t)

2
V
∂S
2
+rS
∂V
∂S
−rV = 0, (1.10)
with the same boundary conditions as previously, i.e. (1.9).
However, it can be shown that standard Feynman-Kac type results only hold under
(quite restrictive) analytic conditions on the coefficients of the SDE and PDE, as-
sumptions that are often not satisfied by many models used in practise. Remarkably,
this problem is often glossed over or simply not mentioned in the literature. What
follows is a brief overview of the some of these analytic conditions. In some sense the
11
Again note the independence of the real-world drift µ(S, t).
CHAPTER 1. INTRODUCTION 27
behaviour of the models presented in this thesis can be attributed to the failure of
the coefficients of the relevant equations to satisfy the conditions outline below.
In order for the conditional expectation (1.4) to be the unique classical solution to the
Black-Scholes equation (1.10) with the conditions (1.9) then the diffusion coefficient
σ(S, t) must be sufficiently regular. More precisely, it must be locally Lipschitz, i.e.
[σ(S
1
, t) −σ(S
2
, t)[ ≤ C[S
1
−S
2
[
for some C > 0, and also satisfy a linear growth condition in S, i.e.
[σ(S, t)[ ≤ D(1 +[S[)
for some constant D > 0.
12
Another condition is that the operator L
BS
must be
uniformly elliptic, meaning (in this one-dimensional situation) that the coefficient
σ(S, t) must be strictly positive at every point in the solution domain (S, t) ∈ Ω
[0, T], where Ω is the domain of the process S
t
, for example Ω = ¦S > 0¦ for geometric
Brownian motion. In other words, we have the restriction that
σ
2
(S, t) > 0 ∀(S, t),
i.e. the diffusion coefficient σ
2
(S, t) cannot degenerate be zero. Note that even in the
simplest cases, such as geometric Brownian motion where σ(S, t) = σS, the volatility
term degenerates in certain regions of state space. Specifically lim
S→0
σ(S, t) = 0.
We can avoid this difficulty here (and also in many other more general situations)
by making the change of variable x = log S giving σ(x, t) = σ which is no longer
degenerate.
1.3.5 American options
Unlike European options discussed in section 1.3.1, American options have the extra
feature that they can be exercised at any time prior to expiry, T. The time γ at which
12
The stochastic process derived in chapter 2 can be seen to exhibit singular behaviour and, as
such, these conditions are no longer satisfied. Hence, we are no longer in a regime where standard
results from SDE and PDE theory can be applied. In addition, here the non-Lipschitz nature of the
coefficients means that the solutions to the corresponding SDE need no longer remain continuous;
jumps may be seen at the location where the diffusion coefficient becomes singular.
CHAPTER 1. INTRODUCTION 28
the option is exercised is called the exercise time and because the market cannot be
anticipated, the holder of the option needs to decide whether to exercise at each
point in time based only on the information up to time t ≤ T (i.e. the information
contained in the filtration T
t
).
The terms European and American were first coined in Samuelson (1965) and the
story behind their naming is noteworthy. According to a private communication
with Robert C. Merton, Samuelson visited many practitioners on Wall Street prior to
writing his paper. One of his industry contacts explained to him that there were two
types of options available, one more complex (that could be exercised early) and one
much simpler (that could only be exercised at expiry). The practitioner commented
that only the more sophisticated European mind (as opposed to the American mind)
could understand the former. In response, when Samuelson (an American) wrote the
paper, he used the European and American prefixes but reversed the ordering.
If the payoff profile is given by h, and the holder of the American option decides to
exercise early then she receives the amount h(S
γ
) at time γ. Using the theory of
optimal stopping (cf. Peskir and Shiryaev, 2006), the unique no-arbitrage price of an
American option can be shown to be given intuitively by
V (S, t) = sup
t≤γ≤T
E
Q
S,t
_
e
−r(γ−t)
h(S
γ
)
¸
, (1.11)
i.e. the supremum of the expected value of the discounted payoff over all random times
γ that are stopping times with respect to the filtration generated by the Brownian
motion used to specify the dynamics of the underlying process for S
t
. This is a rather
intuitive definition of the American option price.
Immediately from the definition (1.11) we have the inequality
V (S, t) ≥ h(S) (1.12)
since the stopping time γ = t is included in the supremum. This is a natural condition
since if V (S, t) < h(S) then there would be an obvious instant arbitrage at time t.
CHAPTER 1. INTRODUCTION 29
In addition, choosing γ = T gives the further inequality
V (S, t) ≥ V
E
(S, t),
where V
E
(S, t) is the corresponding European option price. Again, this is intuitive,
since an American option gives its holder more rights than the corresponding Euro-
pean option with the same payoff function and expiration date.
Another point to note is that when pricing American options we cannot, without
loss of generality, set the interest rate to zero, which can be done for their European
counterparts. Pricing American derivatives is mathematically more involved than
the European case and closed-form expressions for American option prices are rarely
obtained. However, it can be shown by no-arbitrage arguments that, for nonnegative
interest rates and no dividends, the price of an American call option is the same as
its corresponding European option (see, for example, prop. 7.14 of Bj¨ ork, 2004). In
other words, the supremum in expression (1.11) is attained for the stopping time
γ = T when considering the payoff function of a call option. Thus, the price of an
American call reduces to the price of a European call, which does have an explicit
formula, first derived by Black and Scholes (1973).
It can also be shown that the price of an American put option is, in general, strictly
higher than the price of the corresponding European put option. Indeed it can be
seen (directly from its well-known analytic expression) that the European put option
price crosses below the payoff function (1.2) for sufficiently small S, violating the
condition (1.12). Hence the value of the American contract cannot coincide with
that of its European counterpart. We therefore use a put option as our canonical
example of an American option throughout the remainder of this thesis.
1.3.6 Optimal stopping problems
The observant reader may have noticed already that there is a strong link between
pricing American options and optimal stopping problems. When faced with an optimal
CHAPTER 1. INTRODUCTION 30
stopping problem, there are two facets of the solution that we are most interested
in. The first is to determine the price of the option V (called the value function in
optimal stopping terminology) and the second to determine the optimal strategy for
the option holder, in other words to determine the stopping time that realises the
supremum in (1.11). Determining the value function will be discussed shortly, but
first we state a key result from the theory of optimal stopping. If the function h is
continuous, in addition to some other technical conditions,
13
then the supremum is
attained for the stopping time
γ

:= inf¦u ≥ t : V (S
u
, u) = h(S
u
)¦,
i.e. the first time that the price of the American option drops down to the value of
its payoff. Alternatively, and more practically, the optimal stopping time γ

can be
formulated as the first exit time from the continuation region defined by
( := ¦(S, t) : V (S, t) > h(S)¦,
i.e. as
γ

:= inf¦u ≥ t : (S
u
, u) / ∈ (¦.
The continuation region is so named due to the fact that in this region it is not
optimal to exercise the option. Clearly, if the value V (S, t) at some time t is strictly
larger than the payoff profile h(S), then it is not optimal to exercise the option.
1.3.7 Free-boundary problems
Analogous to the Feynman-Kac representation theorem for European options (out-
lined in section 1.3.3), the price of American options can be shown to satisfy partial
differential inequalities. For a nonnegative payoff function h, the price of an American
13
See, for example, Peskir and Shiryaev (2006)
CHAPTER 1. INTRODUCTION 31
option as defined in (1.11) is given by the solution to the following linear complemen-
tarity problem:
V (S, t) ≥ h(S, t), (1.13a)
L
BS
(V ) =
∂V
∂t
+
1
2
σ
2
S
2

2
V
∂S
2
+rS
∂V
∂S
−rV ≤ 0, (1.13b)
L
BS
(V ).
_
h(S, t) −V (S, t)
_
= 0, (1.13c)
to be solved in the entire domain ¦(S, t) : S > 0, 0 ≤ t ≤ T¦ with the final condition
V (S, T) = h(S).
Further to this, it can be shown that the Black-Scholes equation holds at all points in
the continuation region and that at the boundary of the continuation region, we must
apply the smooth pasting or smooth fit principle.
14
This principle states that the value
function V (S, t) must be at least C
1,1
differentiable,
15
not only in the continuation
regions, but also over the boundary of the continuation regions, denoted by ∂(. It
also transpires that for a standard American put option there is an increasing function
S
f
(t), the free boundary, separating the continuation region from the stopping region,
compare Jacka (1991). As such the linear complementarity problem (1.13) can be
formulated as the free-boundary problem
16
∂V
∂t
+
1
2
σ
2
S
2

2
V
∂S
2
+rS
∂V
∂S
−rV = 0, (1.14a)
V (S
f
, t) = K −S
f
, (1.14b)
V
S
(S
f
, t) = −1, (1.14c)
V (S, T) = (K −S)
+
, (1.14d)
V (S, t) →0 as S →∞, (1.14e)
to be solved in the domain ¦(S, t) : 0 ≤ t ≤ T, S > S
f
(t)¦, in other words the
boundary of the domain is to be solved as part of the problem. This implies that for
S > S
f
(t) the value V (S, t) must satisfy V (S, t) > (K − S)
+
, and for S ≤ S
f
(t) the
14
In fact the principle of smooth fit in probability, the principle of no arbitrage in finance and the
conservation of energy law in the physical sciences can be seen as different formulations of the same
principle. This is alluded to in Peskir (2005b).
15
At least for points at which the payoff profile h(S, t) is C
1,1
differentiable.
16
See for example Karatzas and Shreve (1998)
CHAPTER 1. INTRODUCTION 32
value satisfies V (S, t) = (K−S)
+
. Furthermore, the existence and uniqueness of the
free-boundary problem (1.14) can be proved. In addition, for put options without
dividends, Chen et al. (2008) have recently proved the convexity of the resulting free
boundary.
Explicit solutions to parabolic free-boundary problems are rare, however it can be
shown (cf. Jacka, 1991) that the American put option free boundary S
f
(t) is a mono-
tonically increasing function and that it approaches K as t approaches T. The asymp-
totic behaviour of S
f
(t) for times close to expiry can also be determined and indeed
this shall be expounded upon in further detail in chapter 9.
1.4 Supply and demand economics
Many of the models presented in this thesis make assumptions about the structure
of the markets and the intentions of the participants of these idealised markets. This
motivates a brief discussion of how prices are actually formed in these markets, in
short a discussion of supply and demand, the backbone of a market economy.
Starting with the basics, a market is a place where buyers (providing demand) and
sellers (providing supply) meet. In a free market, prices are determined solely by
the interaction of demand and supply; nothing more, nothing less. In addition, all
being equal, there will be more demand for an asset at a lower price than at a
higher price and, hence, we should expect an inverse relationship between price and
quantity demanded. Conversely, an increase in price will usually lead to an increase
in the number of people wishing to sell at that price, hence we should expect a
positive relationship between price and supply. In the economics literature, these
relationships are often called the law of demand and the law of supply. In a market,
the price at which supply matches demand is often called the equilibrium price or
market clearing price, so called because it is at this price that all the surpluses are
cleared from the market and the forces of demand and supply are not acting to change
this equilibrium. If disequilibrium exists, then the forces of demand and supply will
CHAPTER 1. INTRODUCTION 33
automatically adjust the market to equilibrium. With excess demand, prices will be
forced upwards due to the shortage that exists, and with excess supply, prices will be
forced downwards, due to the surplus that exists.
An important concept crucial to the models discussed in this thesis is that of elasticity.
At its heart this concept is a purely mathematical one which aims to measure the
responsiveness of one variable to a change in another variable. More specifically given
any functional relationship y = f(x) the point elasticity, , is defined as
=
dy/y
dx/x
=
dy
dx
x
y
=
d(log y)
d(log x)
,
i.e. the ratio of percentage changes. Similarly, given a function of more than one
variable y = f(x
1
, x
2
, . . . , x
n
) the partial point elasticities are given by

i
=
∂y
∂x
i
x
i
y
=
∂(log y)
∂(log x
i
)
.
Applied to the economics of supply and demand the price elasticity of demand (PED)
is defined as
PED =
dq/q
dp/p
=
dq
dp
p
q
,
where q is the quantity demanded of an asset and p is the price per unit of that asset.
The PED measures the responsiveness of the quantity demanded to the change in
price. PED > 1 implies that the good is price elastic, PED < 1 implies that the
good is price inelastic and when PED = 1 we have unit elasticity. The limiting cases
PED = 0 and PED = ∞ imply that the asset is perfectly price inelastic and elastic
respectively. The price elasticity of supply (PES) is defined similarly.
An important point to note at this stage is that elasticity and liquidity are not the
same, though there is a tendency to confuse the two. Elasticity defines a relationship
between price and the quantity demanded (as defined above), whereas liquidity is
concerned with the availability to trade the underlying asset at a given price. How-
ever (unlike elasticity) liquidity is not a well-defined concept, hence there is much
ambiguity in the connection between the two concepts. The next section explores the
concepts of liquidity in much more detail.
CHAPTER 1. INTRODUCTION 34
1.5 Liquidity
Risk can be classified into the following categories
17
• Market risk,
• Credit risk,
• Model risk,
• Operational risk,
• Liquidity risk.
The standard models implicitly assume that the only risk experienced by a trader
is that due to the uncertain nature of the market. More relevant to this thesis,
these standard models assume that the trader will not experience any liquidity risk,
implicitly assuming a level of liquidity that is without limits. Liquidity risk arises
in situations where a party interested in trading an asset cannot do so because she
cannot find a willing counter-party to that trade. Liquidity risk becomes particularly
important to parties who are about to hold or currently hold an asset, since it affects
their ability to trade. In fact one of the most important attributes of financial markets
is to provide immediate liquidity to investors. Of course, some markets are more liquid
than others, and the liquidity of a given market varies over time and in addition can
dramatically dry up in times of crisis.
Recent crises in the financial markets have triggered studies on the subject of market
liquidity. For example, the stock market crises in October 1987 and 1989, the Asian
crisis in 1997 and the problems at Long-Term Capital Management Fund (LTCM)
led the Committee on the Global Financial System to conduct several studies dis-
cussing the importance of liquid financial markets, including Bank for International
Settlements (1999) and Bank for International Settlements (2001).
17
See Protter (2006).
CHAPTER 1. INTRODUCTION 35
1.5.1 Defining liquidity
Market liquidity is often associated with the ability to quickly buy or sell a particular
item without causing a significant movement in the price. However, the concept
of liquidity is multifaceted and ill-defined. Many researchers have attempted to do
so but the best that can be done is to classify its many dimensions. Kyle (1985)
describes market liquidity in terms of three attributes, namely the tightness, depth
and resilience of the market. Liu (2006) identifies four dimensions to liquidity, namely,
trading quantity, trading speed, trading cost, and price impact. Alternatively, Sarr
and Lybek (2002) state that liquid markets exhibit five characteristics: tightness, i.e.
having low transaction costs, such as a small bid-ask spread as well as other implicit
costs; immediacy, i.e. the speed with which orders can be executed, reflecting the
efficiency of the trading, clearing and settlement systems; depth, i.e. the existence of
abundant orders both above and below the price at which an asset currently trades;
breadth, i.e. orders are both numerous and large in volume with minimal impact on
prices; and finally resiliency, i.e. new orders flow quickly to correct order imbalances.
Clearly, liquidity is a tricky concept to define (let alone measure), and due to this
multidimensional nature comparing individual assets liquidities is also problematic,
since one asset could be more liquid along one dimension of liquidity while the other
is more liquid in a different dimension. One particular interpretation of liquidity in
the literature fits nicely with the philosophy of this thesis; Howison (2005) states
that market liquidity can manifest itself in three possible forms. First, there is a
difference between the prices for buying and selling the asset, the so-called bid-ask
spread. Second, the price paid for trading the asset depends on the quantity traded,
due to limited availability of a stock at the quoted price. In fact, even for a highly
liquid market, trading beyond the quoted depth of the market usually results in a
higher purchase price (or a lower selling price) for part, if not all, of the trade; this
is often termed the liquidation cost. Third, and most relevant to this thesis, is that
the action of a large trade may itself impact the price, independent of all the other
factors affecting the price dynamics; this is termed price impact.
CHAPTER 1. INTRODUCTION 36
1.5.2 Measuring liquidity
Because there are many dimensions of liquidity, there is no single method for mea-
suring it. Measures which are often used in the empirical literature on liquidity and
asset pricing include the bid-ask spreads, various measures of the price impact of
order flow, and various measures of order flow. Measures of the price impact of or-
der flow include price changes regressed on signed volume, or absolute price changes
regressed on absolute volume, or daily changes regressed on daily volume. Measures
of volume include numbers of trades and daily volume measured in dollars. Of all
these measures, the price impact of order flow is perhaps the most widely used, the
advantage of this measure being that it is based on the actual observed price changes
associated with trades. However, despite the advantages of using the price impact of
order flow as a measure of liquidity, tricky econometric issues, such as measurement
error, selection bias and simultaneity bias are involved when using this measure.
Sarr and Lybek (2002) classify the existing liquidity measures into four categories.
18
The first is transaction cost measures that capture the costs of trading financial
assets and trading frictions in secondary markets. One particularly intuitive measure
of transaction costs is the percentage bid-ask spread, defined as
BAS = 2
_
P
A
−P
B
P
A
+P
B
_
,
where the ask price P
A
and bid price P
B
can be calculated from the quotes on the
market or using a weighted average of actual executed trades over a period of time,
the latter being a better estimate of the actual transaction costs since trades may not
take place at the actual quoted prices, in this case the spread is called the realised
spread. In the second category are volume-based measures that attempt to distinguish
liquid markets by the volume of transactions compared to the price variability, this
is primarily used to measure the breadth and depth of the market. Trading volume
is traditionally used to measure the existence of numerous market participants and
transactions and is defined as
Vol =
n

i=1
P
i
Q
i
(1.15)
18
See Sarr and Lybek (2002) for a good review of many examples of each class of liquidity measure.
CHAPTER 1. INTRODUCTION 37
where Vol is the dollar volume traded, P
i
and Q
i
are prices and quantities of the i-th
trade during a specified period. This can be given more meaning by relating it to
the outstanding volume of the asset. The resulting turnover rate gives an indication
of the number of times the outstanding volume of the asset changes hands. The
turnover can thus be defined as
TO =
Vol
NP
where Vol is the trading volume defined in (1.15), N is the outstanding stock of the
asset and P is the average price of the n trades in (1.15). There are many other
volume-based measures. The third category of liquidity measures are equilibrium
price-based measures that try to capture orderly movements towards equilibrium
prices; in the main these attempt to measure resiliency of the market. The fourth
and final category, and the most relevant to the focus of this thesis, are market-impact
measures that attempt to differentiate between price movements due to the degree
of liquidity from other factors, such as general market conditions or arrival of new
information; these attempt to measure both elements of resiliency and speed of price
discovery.
However, clearly no single measure can manage to fully capture the multifaceted na-
ture of liquidity, and as such there is no universally accepted measure of liquidity.
Most of the existing literature attempting to measure liquidity has focused on the
different dimensions of liquidity individually. In fact this problem of no universal liq-
uidity measure has resulted in many unanswered questions in market microstructure
theory, which focuses on determining the processes by which information is incorpo-
rated into prices. One such question is whether liquidity is priced in asset returns.
For example Amihud and Mendelson (1986) (who simply use the bid-ask spread)
and Datar et al. (1998) (who instead use the turnover rate) argue that liquidity is
priced, whereas others, such as Chalmers and Kadlec (1998), Chen and Kan (1995)
and Eleswarapu and Reinganum (1993) suggest that it is not.
More recently Liu (2006) introduced a new measure of liquidity (called the standard-
ised turnover-adjusted number of zero trading volumes over the prior 12 months) that
CHAPTER 1. INTRODUCTION 38
aims to capture multiple dimensions of liquidity. Using this measure Liu (2006) out-
lines a two-factor, liquidity risk adjusted capital asset pricing model (CAPM) that
well explains the cross-section of stock returns, (possibly) answering the question
whether liquidity is priced. In addition, the new two-factor CAPM model is able to
account for the book-to-market effect, which the Fama and French (1996) three-factor
model fails to explain.
1.6 Price formation
We have alluded to the fact that the price of financial instruments may be considered
as entirely dependent on supply and demand. However knowledge about how these
prices are actually formed in the market are of great interest, since we wish to see ex-
actly whereabouts in the price formation process liquidity issues become important.
From a market microstructure perspective, price movements are caused primarily
through the arrival of information. The dynamics by which this information is incor-
porated into the current price is addressed in the market microstructure literature,
where many models of price formation have been proposed; for an overview of this
topic see O’Hara (1995). Such models are not referred to specifically in this thesis
and so it suffices to describe briefly the role of some of the more important market
participants.
One of the most important members of any financial market are the so-called market
makers. These are individuals or firms that will take both long and short positions
in a given security in order to facilitate trading, and thus add to the liquidity and
depth of the market. The market-maker accepts a certain level of risk in holding the
financial instrument or commodity but hopes to be compensated by making a profit
on the bid-ask spread.
In the United States, many markets have official market makers for each given se-
curity, known as specialists. Their main function being to provide the other side of
trades when there are short-term buy-and-sell-side imbalances in customers orders.
CHAPTER 1. INTRODUCTION 39
In return, the specialist is granted various informational and trade execution advan-
tages. On the London Stock Exchange (LSE) there are official market makers for
many securities (except for the largest and most heavily traded companies, which
instead use an automated system called SETS). On the LSE one can always buy and
sell stock; each stock always has at least two market makers and they are obliged to
deal. This is in contrast with much smaller order driven markets in which it can be
extremely difficult to determine at what price one would be able to buy or sell any
of the many illiquid stocks.
In traditional exchange floor markets the burden of providing liquidity is given to
market makers or specialists. Nowadays, however, most financial markets have be-
come fully electronic and operate on what is called a matched bargain or order driven
basis. In these markets, when a buyer’s bid price meets a seller’s offer price the stock
exchange’s matching system will decide that a deal has been executed. In an order-
driven market there are numerous types of orders that can be placed, each catering to
the different needs of different market participants. The two main type of orders are
the market order, which is an order to buy or sell immediately at the best available
price, and as such gives no guarantee on the price but is guaranteed to be executed
immediately. Alternatively we have limit orders which are not to be executed unless
the specified price is met (or bettered) by current bids or asks. Here, we are not
guaranteed execution but we are guaranteed price. It should, however, be noted that
limit orders often incur higher commission fees. Further, in these order-driven mar-
kets liquidity now becomes self-organised, in the sense that any agent can choose, at
any instant of time, either to provide or to consume liquidity; providing liquidity by
posting limit orders or consuming liquidity by issuing a market order.
The introduction of electronic markets has seen a sharp increase in another type of
market participant, the program trader. A program trader is one who uses a computer
to automate his trades. This may be to exploit arbitrage opportunities such as index
arbitrage (the misalignment of the price of an index and the sum of its constituent
stocks) or to perform portfolio insurance, the automated execution of a deterministic
CHAPTER 1. INTRODUCTION 40
hedging strategy. Program traders are thought to have been a contributing factor
of the October 19, 1987 market crash
19
and to be responsible for an increased stock
market volatility, since they quickly dump large orders on the market at critical times.
These large orders can contribute to the existing momentum of the market, thereby
increasing market volatility. This shall be seen in a more mathematical framework
in chapter 3.
1.7 Option pricing in illiquid markets: a literature
review
Authors such as Kreps (1979) and Bick (1987, 1990) have placed the classical Black-
Scholes-Merton formulation into the framework of a consistent model for market
equilibrium with interacting agents having very specific investment characteristics
(see section 1.6). Moreover Bick (1987, 1990) showed how geometric Brownian mo-
tion, one of the fundamental assumptions of the Black-Scholes-Merton model, can be
derived in a general equilibrium model with price-taking agents.
Furthermore F¨ ollmer and Schweizer (1993) were the first to use a microeconomic
approach to construct diffusion models for asset price movements. They define in-
formation traders who believe in a fundamental value of the asset, and noise traders
whose demands are from hedging requirements. They derived equilibrium diffusion
models for the asset price based on interaction between the two. Many of the models
discussed in this thesis such as Platen and Schweizer (1998), Sircar and Papanicolaou
(1998) and Sch¨ onbucher and Wilmott (2000) were inspired by the temporary equi-
librium approach of F¨ ollmer and Schweizer (1993). Starting from a microeconomic
equilibrium and deriving a diffusion model for stock prices which endogenously in-
corporates the demand due to hedgers and in particular delta hedgers.
19
Jacklin et al. (1992) argue that one of the causes was actually information about the extent
of portfolio insurance-motivated trading suddenly becoming known to the rest of the market. This
prompted the realisation that assets had been overvalued because the information content of trades
induced by hedging concerns had been misinterpreted. Consequently, general price levels fell sharply.
CHAPTER 1. INTRODUCTION 41
The literature on liquidity falls broadly into two approaches. The first involves the
price impact due to a large trade. In such models the large trader can move the price
by his actions. Jarrow (1992, 1994) provided a discrete-time model which allows
the large trader to impact the market via some reaction function. He showed that
the price of a derivative in this framework must be equal to the hedge cost, but
this cost, and hence the price, is dependent on the large trader’s position in the
underlying and the derivative asset; leading to nonlinearity. However in markets that
allow large traders to impact the price of the asset there is the possibility of price
manipulation and so called market corners and market squeezes. A market corner
is a successful effort of a trader to manipulate the price of a futures contract by
gaining effective control over trading in the futures and the supply of the deliverable
goods. In a market squeeze, the trader achieves control by disruption in the supply of
the cash commodity. Although price manipulation violates the Commodity Exchange
Act, there have been many examples of such activities, especially in (less regulated)
developing markets. An example of a market corner is the Hunt silver manipulation
of 1979-1980, a detailed and readable account of which can be found in Williams
(1995). An example of a market squeeze is the (alleged) soybean manipulation of 1989
for which more details can be found in Pirrong (2004). However in the theoretical
framework proposed by Jarrow (1992, 1994) it was showen that to prevent any such
manipulation the price impact mechanism must not exhibit any delay. In addition a
sufficient condition to exclude profitable market manipulation (in discrete-time) was
given, i.e. that the price mechanism must be independent of the history of the trades,
and only dependent on the current position of the trades. Bank and Baum (2004)
later extended Jarrow’s results to continuous time.
Moreover, in the presence of price impact, it is not clear that an option is still perfectly
replicable; hence it is no longer straightforward how to derive option prices from
the prices of the underlying. Frey and Stremme (1997) studied the perturbation of
volatility induced by a delta hedging strategy for a European option whose price is
given by a classical Black-Scholes formula with constant volatility. They concluded
CHAPTER 1. INTRODUCTION 42
that if a hedging strategy is used which does not take into account the feedback effect
(which we term first-order feedback), then it is not possible to replicate perfectly
an option, and hence there is still risk associated with hedging in illiquid markets.
They did show, however, that increasing heterogeneity of the distribution of hedged
contracts reduces both the level and price sensitivity of this un-hedged risk. Frey
(1998, 2000) then showed that if feedback is taken into account in a more general
hedging strategy (which we term full feedback), then it is possible to replicate an
option perfectly (provided certain conditions on market liquidity and the nonlinearity
of the payoff condition are satisfied). In the discrete-time framework of Jarrow (1994),
the question as to whether options could be perfectly replicated in a finitely elastic
market reduces to solving (recursively) a finite number of equations. In the continuous
time framework of Frey (1998), this can be characterised more succinctly as the
solution of a nonlinear PDE, for which Frey (1998) gave existence and uniqueness
results. These results, however, place a heavy restriction on the amount of market
illiquidity that the model allows and rely on the terminal payoff being sufficiently
smooth, both of which can be seen as undesirable restrictions.
20
Frey and Patie
(2002) extended the work of Frey (2000) with an asset dependent liquidity parameter
which attempts to incorporate so called liquidity drops, whereby market liquidity
drops if the stock price drops, the aim being to reproduce, more effectively, the
volatility smile.
Other continuous time models similar to Frey (1998) include Sch¨ onbucher and Wilmott
(2000), who used a market microstructure equilibrium model to derive a modified
stochastic process under the influence of price impact. The PDEs derived by these
latter authors correspond to those derived in chapter 2 of the present study. Sircar
and Papanicolaou (1998) derived a slightly different nonlinear PDE that depends on
the exogenous income process of the reference traders and the relative size of the
program traders. Platen and Schweizer (1998) proposed a model using an approach
that attempted to explain the volatility smile and its skewness endogenously and
20
For further discussion on these restrictions see chapter 4.
CHAPTER 1. INTRODUCTION 43
Mancino and Ogawa (2003) proposed a very similar model in the same vein. Lyukov
(2004) then extended the model of Platen and Schweizer (1998) with more realistic
assumptions about market equilibrium conditions (taking into account the presence
of a market maker) and also obtained a very similar nonlinear PDE to that derived
in chapter 2. Another ‘tweak’ of these models was made by Liu and Yong (2005) who
attempted to regularise the PDE close to expiry. The majority of these models will
be considered in more detail in chapter 7.
The second approach to liquidity seen in the literature involves the price impact due
to the immediacy provisions of market makers. In these models, supply and demand
are equalised by the market maker in the short-term market. The approach is relevant
if an agent wishes to trade a large amount in a short time. These models have been
considered by Rogers and Singh (2006) and Cetin and Rogers (2007), amongst others,
who propose a series of independent auctions. The main difference with the first class
of models is that these are now local in time models, without long-term effects, i.e.
the actions of the traders do not influence the underlying stochastic process. These
models eliminate the feedback effects discussed above and, as such, they are concerned
more with the liquidation cost than permanent price impact. Bakstein and Howison
(2003) adopted a similar approach to Rogers and Singh (2006) but the former study
leads to feedback effects, which the latter study was trying to avoid. Another model
in this category is the work of Cetin et al. (2004), who modelled the liquidation cost
as dependent on the quadratic variation of the trading strategy which again leads to
a nonlinear PDE when considered in continuous time.
Other notable work in the area of liquidity and price impact includes Agliardi and
Andergassen (2001) who extended the work of Sch¨ onbucher and Wilmott (2000) and
Frey (1998) to include sink transaction costs as an additional source of illiquidity. Mo-
tivated by empirical evidence, Esser and Moench (2003) extended the work of Frey
(2000) to incorporate stochastic liquidity into the price impact framework. More
recently, Henry-Labord´ere (2004) incorporated the feedback model of Sch¨ onbucher
and Wilmott (2000) into the portfolio optimisation of Markowitz (1959) to find that
CHAPTER 1. INTRODUCTION 44
portfolio optimisation has the effect of reducing market volatility and thus the price
of options in that market. Brennan and Schwartz (1989) also analysed the transfor-
mation of market volatility under the impact of portfolio insurance and under the
assumption of CRRA utility. They showed an increase in Black-Scholes implied mar-
ket volatility between 1% and 7% for values for the fraction of the market subject
to portfolio insurance varying between 1% and 20%. Cvitanic and Ma (1996) and
Cuoco and Cvitanic (1998) studied a diffusion model for price dynamics when the
drift and volatility coefficient are functions of the large traders’ trading strategy. Fi-
nally Jonsson and Keppo (2002) derived a somewhat different nonlinear PDE, using
a model with an exogenously defined exponential price effect function.
According to Rogers and Singh (2006) and Cetin and Rogers (2007), the price impact
models of a large trader have numerous shortcomings. The first is the so-called free
round trip phenomenon, which can result in the possibility of market manipulation
by a large agent. Recall that Jarrow (1992, 1994) gave sufficient conditions to ex-
clude profitable market manipulation, but only in the discrete-time framework, for a
detailed discussion of how things can go wrong in continuous time see Sch¨ onbucher
and Wilmott (2000). The second, and by far the most important problem with these
models is that if we allow the action of one large agent to affect the price, then we
must allow the actions of all large agents to affect the price and furthermore the effect
of hedging a multitude of options on the underlying. Clearly this would result in an
impossibly cumbersome problem.
There has also been some recent work using alternative pricing paradigms in place
of portfolio replication, such as that by Bank (2006) who attempted to price options
on illiquid underlyings using the utility indifference of the market maker. This ap-
proach leads to a stochastic optimisation problem and the Hamilton-Jacobi-Bellman
equation, which is also inherently nonlinear.
One of the few attempts to analyse the aforementioned models from an empirical
standpoint was carried out recently by Sanfelici (2007) who considered the model of
CHAPTER 1. INTRODUCTION 45
Mancino and Ogawa (2003) (amongst others) and attempted to calibrate the model to
market data, comparing the results with other popular models. Sanfelici concluded
that the nonlinear models above can contribute to the explanation of the implied
volatility smile but not as well as the other possible explanations, such as jump-
diffusion or stochastic volatility, due in the most part to the models’ limited capability
to reproduce skewed probability distributions. However, the study did find that the
model of Mancino and Ogawa (2003) was more stable through time and consistent
with market data.
Any other relevant literature will be discussed in the body of the thesis where it is
appropriate.
1.8 Introduction to perturbation methods
Perturbation methods, also known as asymptotic methods, are a collection of mainly
analytical techniques that can be used to solve (or simplify) mathematical problems
involving a small or large parameter. They are used extensively throughout this
thesis and so a brief introduction, including their rich history, is outlined below.
Two phases in the history of asymptotics may be identified. The first, often called
classical asymptotics dates back to the work of Poincar´e (1886) on the far-field be-
haviour of linear ordinary differential equations. These techniques are primarily con-
cerned with coordinate expansions, i.e. asymptotic expansions in which the indepen-
dent variable, x say, plays the role of the large or small parameter. Taylor expansions
are the most well known of this class of expansions. Coordinate expansions can also
be used to investigate the behaviour of differential equations near any singular point
x
0
as x −x
0
→0 or for large values of the independent variable, i.e. as x →∞, both
of which we exploit in this thesis. More recent developments in asymptotic theory
have been associated with so called parametric expansions. These ideas have been
developed alongside the theory of fluid dynamics (especially, but not exclusively),
a theory in which the governing equations are highly nonlinear and as such have
CHAPTER 1. INTRODUCTION 46
tractability only in the simplest of situations. Exploiting the smallness of certain
parameters and seeking a power series solution in the smallness parameter can often
reduce the original system of equations to a much simpler asymptotic set of equations,
whose solutions (both analytical or numerical) will often be much easier to find. The
relative simplicity of the asymptotic solution does, however, come at the expense
of the approximate nature of the results. Nevertheless for many practical purposes
the results obtained can be made sufficiently accurate, and indeed can often provide
invaluable insight into the qualitative behaviour of the problem under investigation.
During the first half of the twentieth century it was demonstrated that a number
of problems involving small or large parameters developed a pathological behaviour,
which we now refer to as singular perturbations. This behaviour stemmed from the
fact that in certain regions of the solution domain we have a so called asymptotic
breakdown, where the power series expansion solution sought no longer becomes an
asymptotic series, under certain circumstances. An early attempt to tackle this prob-
lem was due to Prandtl (1904) in his paper on boundary-layer theory. Prandtl’s idea
was to subdivide the solution domain into separate regions where different asymp-
totic forms apply. Over the next half century these ideas were developed by many
(Friedrichs (1954), Kaplun (1967), Kaplun and Lagersrom (1957), Cole (1968) and
van Dyke (1964) to name but a few) and so the method of matched asymptotic ex-
pansions emerged. For a recent overview of how these techniques have been exploited
in finance to date see Howison (2005).
1.9 Layout of the thesis
The remainder of this thesis is organised as follows. Chapter 2 provides an heuristic
derivation of one of the more intuitive models attempting to incorporate liquidity into
option pricing theory and in addition shows how the majority of models introduced
in the current literature can be formulated in this framework. Chapter 3 investigates
the so-called first-order feedback model (an exceptional case of a linear PDE) and
CHAPTER 1. INTRODUCTION 47
furthermore highlights interesting differences of both the option value and American
option early-exercise boundary from the classical Black-Scholes-Merton case. Chap-
ter 4 investigates the fully nonlinear full feedback model using both analytical and
numerical techniques. Chapter 5 takes a closer look at this model in a regime in which
it appears no classical solutions exist; here so-called phase plane analysis is found to
be useful in determining such behaviour. In chapter 6 the perpetual options of the full
feedback model are considered. Chapter 7 takes a look at the existing models in the
literature from a viewpoint of the results found in chapters 2-6. Chapter 8 considers
briefly the so-called stock pinning effect which appears to be well explained by the
models outlined in this thesis. Chapter 9 concerns itself with the related topic of the
British option, which can provide an investor with protection against the liquidity
issues discussed in the rest of the thesis; here we concern ourselves mainly with the
behaviour of the free boundary which exhibits some interesting qualitative differences
with the standard American option free boundary. Finally chapter 10 provides some
concluding remarks and ideas for future research.
Chapter 2
The Modelling Framework
In the end, a theory is accepted not because it is confirmed by conven-
tional empirical tests, but because researchers persuade one another that
the theory is correct and relevant.
- Fischer Black (1938-1995) in 1986
In this chapter we present an heuristic derivation of one particular class of model for
incorporating liquidity into option pricing theory. We also attempt to highlight the
links between the existing models and furthermore we transpose these models into
a single intuitive analytical framework. This has not previously been done in the
literature.
In order to provide a derivation of the primary governing PDEs considered in this
thesis, we present the following arguments, which are similar to those employed in
Lipton (2001) and Liu and Yong (2005). We shall assume the underlying process
to be a geometric Brownian motion (but this can be generalised to any stochastic
process)
dS = µSdt +σSdW
t
, (2.1)
where S is the price of the underlying, µ and σ are the (constant) drift and volatility
respectively and W
t
is a standardised Brownian motion. It is possible to add a forcing
48
CHAPTER 2. THE MODELLING FRAMEWORK 49
term, f(S, t), to the process, which is dependent on the stock price and time, i.e.
dS = µSdt +σSdW
t
+λ(S, t)df, (2.2)
where λ(S, t) is an arbitrary function. Note that at this stage no assumptions need
be made regarding the form of the functions λ(S, t) and f(S, t), and particular finan-
cial interpretations can conveniently be postponed until certain manipulations are
complete.
Since f(S, t) is a function of S and t only, it is possible to incorporate the additional
contribution to the price dynamics into the drift and volatility coefficients µ and σ.
We commence by using Itˆ o’s formula on the function f(S, t), to obtain
df =
∂f
∂t
dt +
∂f
∂S
dS +
1
2

2
f
∂S
2
(dS)
2
+. . . ,
which substituting into (2.2), gives to leading order
1
_
1 −λ
∂f
∂S
_
dS =
_
µS +λ
∂f
∂t
_
dt +
λ
2

2
f
∂S
2
(dS)
2
+σSdW
t
. (2.3)
In order to proceed further we require an expression for (dS)
2
, which can be obtained
by simply squaring equation (2.3) to yield, as dt →0
(dS)
2
=
σ
2
S
2
dt
_
1 −λ
∂f
∂S
_
2
+o(dt), (2.4)
where we have used the condition that (dW
t
)
2
→ dt as dt → 0. Substituting (2.4)
into (2.3), and with a little rearranging, we arrive at the following stochastic process,
analogous to (2.1):
dS = ˆ µ(S, t)dt + ˆ σ(S, t)dW
t
, (2.5)
where
ˆ µ(S, t) =
1
1 −λ
∂f
∂S
_
µS +λ
_
∂f
∂t
+
1
2
ˆ σ
2

2
f
∂S
2
__
, (2.6a)
ˆ σ(S, t) =
σS
1 −λ
∂f
∂S
. (2.6b)
1
Note the term on the left-hand-side and how, even at this early stage in the derivation, we begin
to observe possible singular behaviour, . We shall return to this issue numerous times throughout
the remainder of the thesis.
CHAPTER 2. THE MODELLING FRAMEWORK 50
We can interpret the function f(S, t) as a forcing mechanism on an underlying stochas-
tic process which results in the process (2.1) being modified to the process (2.5). The
financial interpretation of this forcing term will be considered in full detail shortly.
It is tempting to expect that the stochastic process (2.5) will exhibit some boundary
behaviour at the location of the singularity in the drift, i.e. when
∂f
∂S
= 1/λ, since
at this location the drift will become infinite and consequently the process might
be contained within a fixed domain. However the volatility of the process also be-
comes singular at the same location and so it may be possible to move beyond the
‘boundary’. The interested reader is referred to Sch¨ onbucher and Wilmott (2000)
who provide an analysis of the behaviour of the modified stochastic process at such
singular locations.
We now turn our attention to option pricing under the modified stochastic process.
To do this we will use the well-known Generalised Black-Scholes equation (for a more
detailed derivation see for example Duffie, 1996), which leads to the following pricing
PDE for the modified stochastic process incorporating the aforementioned forcing
term
∂V
∂t
+
1
2
σ
2
S
2
_
1 −λ
∂f
∂S
_
2

2
V
∂S
2
+rS
∂V
∂S
−rV = 0. (2.7)
Note that, consistent with standard Black-Scholes arguments, the drift of the modified
process ˆ µ(S, t) does not appear in the option pricing PDE.
Thus far we have been deliberately vague about the financial interpretation of the
forcing term in (2.1). In the context of markets with finite elasticity, we can define
f(S, t) to be the number of extra shares that should be held due to some deterministic
hedging/trading strategy and hence df(S, t) will specify the number of shares needed
to be bought or sold at time t and price S due to such a strategy. Also λ(S, t) can
be interpreted as some function dependent on how we choose to model the form of
price impact and liquidity; we shall return to this issue in section 2.3.
Markets are not complete to traders who do not have the opportunity to trade contin-
uously. Only large institutions can trade close to continuously and so, in a complete
CHAPTER 2. THE MODELLING FRAMEWORK 51
market, options provide no extra trading opportunities to them. For small traders
however, options open up new trading possibilities, resulting in many large institu-
tions selling the options to the small traders and then hedging the risk by replicating
the option. This results in a net long position (of the large institution) for stocks in
the market. In such a market there is a high demand for these replicating strategies
and it is not, therefore, unreasonable to assume that a trading strategy that could
impact the price significantly is that of delta hedging. In this case the trading strat-
egy f, in equation (2.7) should be set to an option delta, based on some form of
option V

, i.e.
2
f = ∆

=
∂V

∂S
. (2.8)
This leads to an interesting question about which strategy the hedgers are assumed
to follow. A naive strategy would be if V

were the Black-Scholes value V
BS
and thus
distinct from the solution V of equation (2.7). This leads to the linear PDE
∂V
∂t
+
1
2
σ
2
S
2
_
1 −λ

2
V
BS
∂S
2
_
2

2
V
∂S
2
+rS
∂V
∂S
−rV = 0. (2.9)
This case we call first-order feedback, which is analysed in detail in chapter 3. Another
(more interesting and challenging) case is when the hedger is assumed to be aware of
the feedback effect and so would change the hedging strategy accordingly. We shall
call this case full feedback, which corresponds to the case when V

≡ V , i.e. the
trading strategy adopted has to be found as part of the problem. This leads to the
fully nonlinear PDE,
∂V
∂t
+
1
2
σ
2
S
2
_
1 −λ

2
V
∂S
2
_
2

2
V
∂S
2
+rS
∂V
∂S
−rV = 0, (2.10)
which is dealt with in chapter 4. Note that although λ can be scaled out of (2.10)
using the simple substitution V (S, t) =
1
λ
w(S, t), this would then introduce λ into the
standard payoff conditions, and we therefore chose not to do this. Note too that for
simplicity, similar to Liu and Yong (2005), we have assumed that European contingent
2
Note that this is for a net long position in the market, if there was a net short position then
we would set f = −∆

. This case is considered in the model of stock pinning by Avellaneda and
Lipkin (2003) and will be discussed further in chapter 8.
CHAPTER 2. THE MODELLING FRAMEWORK 52
claims are settled by physical delivery of the underlying asset at maturity. In this
case we do not need to introduce liquidation costs at maturity into the replicating
portfolio. This is primarily due to the fact that the exact liquidation value is difficult
to determine, since it depends on the liquidation strategy chosen by the investor;
optimal liquidation strategies are discussed, for example, in Almgren and Chriss
(2001). How we choose to close out the contracts is not just an academic exercise
since, as noted by Frey (1998), in relatively illiquid markets, such market traders who
know that some other market participant has to dissolve a large hedged portfolio
in the near future, can try to profit from this information by front running the
anticipated trades.
Equation (2.10) has appeared in the literature several times with differing forms of
the function λ(S, t) according to the modelling assumptions. The simplest case occurs
in Sch¨ onbucher and Wilmott (2000), who have λ(S, t) constant and a dimensionless
measure of the liquidity of the market. Frey (1998) has the similar form λ(S, t) =
ˆ
λS
where
ˆ
λ ∈ R is again some measure of the liquidity of the market. Another form
for λ(S, t) can be found in Liu and Yong (2005) in which λ(S, t) =
ˆ
λ(1 − e
−β(T−t)
)
where
ˆ
λ is a constant price impact coefficient, T −t is time to expiry and β a decay
coefficient. As far as we can ascertain there is little financial justification for this, and
it appears to be introduced for numerical expediency to avoid difficulties associated
with the growing option gamma as expiration approaches. Indeed, the precise manner
in which this is achieved is discussed in section 7.5, and this highlights that this factor
fundamentally changes the option-price dynamics. In what follows it is assumed for
the most part that λ(S, t) is a constant, analogous with the work of Sch¨ onbucher and
Wilmott (2000), although a good deal of the analysis close to expiry presented here
is quite widely applicable to other models.
Finally, the question as to whether or not the model described above leads to a
complete market is of interest. In this context the answer to this question reduces to
showing whether or not an option can be perfectly hedged in such a market, hence
that there exists a unique solution to equations (2.9) and (2.10) with the appropriate
CHAPTER 2. THE MODELLING FRAMEWORK 53
payoff profile. In the first-order feedback case the linear nature of the equation makes
it easy to show this. For the full feedback problem it is not immediately clear. Recall,
however, that Frey (1998) showed such existence and uniqueness results, although
under some fairly restrictive assumptions; for more information see section 1.7.
2.1 Technical asides
In this section we describe some of the more technical details regarding the application
of standard analytic methods to the problem as outline above.
2.1.1 Markovian processes
In the full feedback case we effectively break the link between the solution of the
PDE and the solution of the SDE. It is well understood that the solution of a linear
parabolic second order PDE can be expressed as an expectation of a Markov pro-
cess. Introducing the nonlinearity in the above manner results in a breakdown of the
Feynman-Kac representation, and so the solution to the PDE no longer corresponds
to
V (S, t) = E
Q
S,t
_
e
−r(T−t)
(K −S
T
)
+
¸
,
where the expectation is taken under the risk-neutral measure, Q, of the modified
stochastic process (2.5). This is not to say that one cannot use the Feynman-Kac
representation theorem (see section 1.3.3) to formulate the solution to a nonlinear
PDE as an expectation. It is possible to do so if the nonlinear PDE can be linearised
by an appropriate transformation. For example, the nonlinear equation
3
u
t
+au
xx
+bu
2
x
= 0,
u(x, T) = h(x),
(2.11)
3
Note that this equation can be obtained from an appropriate transformation of Burgers’ equa-
tion, see for example Rosenerans (1972).
CHAPTER 2. THE MODELLING FRAMEWORK 54
can be linearised using a Cole-Hopf transformation w(x, t) = exp
_
b
a
u(x, t)
_
. The
resulting linear system
w
t
+aw
xx
= 0,
w(x, T) = exp
_
b
a
h(x)
_
,
can thus be written as an expectation using the standard Feynman-Kac representation
theorem for Markovian processes, i.e.
w(x, t) = E
P
x,t
_
exp
_
b
a
h(x
T
)
__
,
where x
t
follows the dynamics dx
t
=

2adW
P
t
. The linearising transformation can
then be applied to the above expectation to recover the original (nonlinear) value
function u(x, t), and so a link is re-established between the nonlinear PDE and a
Markovian stochastic process. This is a specific example of the fact that nonlinear
equations can be expressed as a functional of a Markov process. In the above example
the functional is given by the Cole-Hopf transform. A functional is any function on
the sample path of a process, for example the integral process or the maximum
process, compared to a function which is just dependent on the value of the process
at the current time (i.e. Markovian).
Note, however, that equation (2.11) is a quasi-linear PDE as opposed to equation
(2.10) which is fully nonlinear. This full nonlinearity makes it extremely unlikely
that such a linearising transform can be found and indeed the author could find
no such transform. For more on the Cole-Hopf transform solution to the nonlinear
Burgers’ equation see Rosenerans (1972).
2.1.2 Applicability of Itˆ o’s formula
In the application of Itˆ o’s formula it is assumed that the function f(S, t) is C
2,1
differentiable, if it is not then we have to include local time contributions. For a
detailed definition of local time see section IV.5 of Protter (1990) or Peskir (2003).
Consider for example a function that is C
2,1
in space-time in two separate regions
CHAPTER 2. THE MODELLING FRAMEWORK 55
separated by a kink along a curve in space-time. If we are to apply Itˆ o’s formula
across the curve, then we have to take into account the local time spent on that
curve (see Peskir, 2005a).
To illustrate this we briefly describe (a slight modification of) the so-called Itˆ o-Tanaka
formula, where we wish to apply Itˆ o’s formula to the function f(S, t) = [S−K[ where
K can be thought of as the strike price.
4
The first point to note is that this function
does not have a well-defined second derivative at S = K and so df is ill-defined at this
point. We can, however, overcome this by approximating the non-smooth function
by a smooth function such as
f(S, t) =
_
¸
¸
¸
_
¸
¸
¸
_
K −S, S ∈ (0, K −);
(S−K)
2
2||
+
||
2
, S ∈ (K −, K +);
S −K, S ∈ (K +, ∞),
(2.12)
where > 0 is a small parameter. Note that here we have a well-defined second
derivative in the entire domain. Evaluating df of (2.12) gives
df(S, t) =
_
¸
¸
¸
_
¸
¸
¸
_
−dS, S ∈ (0, K −);
(S−K)
||
dS +
1
2||
(dS)
2
, S ∈ (K −, K +);
dS, S ∈ (K +, ∞).
Taking the limit ↓ 0 leads to
5
df = sgn(S −K)dS + lim
↓0
_
1
2
¦(dS)
2
[S ∈ (K −, K +)¦
_
. (2.13)
Next we can calculate
(dS)
2
=
σ
2
S
2
dt
_
1 −λ sgn(S −K)
_
2
,
and thus we obtain
df = sgn(S −K)dS +σ
2
K
2
lim
↓0
_
1
2
¦dt[S
t
∈ (K −, K +)¦
_
. (2.14)
4
This would correspond to a trading strategy in which we would always hold stock and the size
of our holding would be equal to the distance the current stock price was from the strike price K.
5
The sgn function is defined as
sgn(x) =



−1, x < 0;
0, x = 0;
1, x > 0.
CHAPTER 2. THE MODELLING FRAMEWORK 56
We can define the local time spent on the curve S
t
= K as L
t
given by
L
t
= lim
↓0
_
1
2
¦u ∈ [0, t][S
u
∈ (K −, K +)¦
_
,
and hence equation (2.13) will become
df = sgn(S −K)dS +σ
2
K
2
dL
t
.
Note that for the Black-Scholes model the value function of a standard put option can
be shown to be C
2,1
differentiable everywhere in the interior of the solution domain
with non-smoothness only on the domain’s boundary (due to the payoff profile).
Since Itˆ o’s formula is not being applied across the kink in the payoff profile then Itˆ o’s
formula, without local time, is all that is required. Hence our application of Itˆ o’s
formula is valid for the first-order feedback case. However smoothness of the solution
to the full feedback PDE has not been determined a priori and if it transpires that
it is not C
2,1
differentiable in the interior of the domain then we will have to apply
a local time correction to our application of Itˆ o’s formula in a similar manner to the
above.
2.2 Alternative models
Bordag and Frey (2007) identify three distinct frameworks that attempt to model
illiquid markets: transaction-cost models; reaction-function or equilibrium models;
and reduced-form SDE models. The derivation of the governing PDEs provided in
this chapter aims to illustrate the links between these frameworks, in particular the
latter two. A brief overview of each framework is provided below.
2.2.1 Transaction-cost models
The main model is this class is due to Cetin et al. (2004). In this framework the
transaction price S
t
is given by the formula
S
t
(α) = e
ρα
ˆ
S
t
CHAPTER 2. THE MODELLING FRAMEWORK 57
where
ˆ
S
t
is some fundamental stock price (usually given by geometric Brownian
motion d
ˆ
S
t
= µ
ˆ
S
t
dt +σ
ˆ
S
t
dW
t
), ρ > 0 is a liquidity parameter and α is the number of
shares being traded. Obviously the trader will pay more than the fundamental price
for the stock when buying (i.e. when α > 0) and receive less when selling (α < 0).
Cetin et al. (2004) show that this transaction cost is proportional to the quadratic
variation of the stock trading strategy.
2.2.2 Reaction-function (equilibrium) models
The models in this class include Jarrow (1994), Frey and Stremme (1997), Platen and
Schweizer (1998), Frey and Co-authors (1996-2001), Sircar and Papanicolaou (1998),
Sch¨ onbucher and Wilmott (2000), Lyukov (2004) and Bank and Baum (2004). In such
models there are two types of traders in the market, namely ordinary investors and a
large investor. The overall supply of the stock is normalised to one. The normalised
stock demand of the ordinary investors at time t is modelled as a function D(S
t
, U
t
, t),
where S
t
is the price of the stock. The normalised stock demand of the large investor
is written in the form λΨ
t
, where λ ≥ 0 is a parameter that measures the size of the
trader’s position relative to the total supply of the stock. The equilibrium price S
t
is
then determined by the market clearing condition, (where supply meets demand)
D(S
t
, U
t
, t) +λΨ
t
= 1.
Furthermore assuming that this strategy Ψ
t
is Markovian, i.e. that Ψ
t
= f(S
t
, t) for
a smooth function f, then the market clearing condition becomes
D(S
t
, U
t
, t) +λf(S
t
, t) = 1.
It can be shown that under suitable assumptions on the function D, the above admits
a unique solution and hence it can be inverted to solve for S
t
. Different models propose
different functional forms for D which lead to slightly different prices. We shall
return to this framework after we have considered the somewhat more intuitive final
framework. For a very general analysis of the dynamics of self-financing strategies in
reaction-function models, see Bank and Baum (2004).
CHAPTER 2. THE MODELLING FRAMEWORK 58
2.2.3 Reduced-form SDE models
The models in this class are due to Frey (2000), Frey and Patie (2002), Jandaˇcka and
ˇ
Sevˇecoviˇc (2005) and Liu and Yong (2005). Here investors are assumed to be large
traders in the sense that their actions affect the equilibrium price and the liquidity
adjusted price process in the presence of a large trader is given directly by
dS
t
= µ(S
t
, t)dt +σ(S
t
, t)dW
t
+λ(S
t
, t)dΨ
t
, (2.15)
where as before Ψ
t
is a semi-martingale representing the trading strategy. Again we
can make the assumption that the strategy is Markovian, i.e. that Ψ
t
= f(S
t
, t) for
a smooth function f. This framework provides a very intuitive means of obtaining
the stock price process in the presence of a large trader, since the final term in the
SDE can be considered as incorporating price impact. Note that the model outlined
in the first half of this chapter falls under the reduced-form SDE class. In the next
section we aim to illustrate how all three frameworks may be ‘transposed’ into a
reduced-form SDE (2.15).
2.3 A unified framework
In this section we attempt to unify the equilibrium and reduced-form SDE models.
We show that any of the equilibrium models existing in the literature can be recast in
terms of a reduced-form SDE and so (at least for the purposes of analysis) the reduced-
form SDE models can be seen as the more general framework, whose properties we
aim to analyse in this thesis. We shall consider, in turn, each of the equilibrium
models and show that they can be rewritten as an SDE of the form (2.15) and hence
all the modelling can be encapsulated into the function λ(S, t). In addition, the
transaction cost model described in section 2.2.1 can also be rewritten as a reduced
form SDE and we shall discuss this next.
CHAPTER 2. THE MODELLING FRAMEWORK 59
2.3.1 Cetin et al. (2004)
Rewriting the model of Cetin et al. (2004) as
S
t
= e
λf(S,t)
ˆ
S
t
we can take differentials to get
dS
t
= d
_
e
λf
¸
ˆ
S
t
+e
λf
d
ˆ
S
t
= λdfe
λf
ˆ
S
t
+e
λf
_
µ
ˆ
S
t
dt +σ
ˆ
S
t
dW
t
_
+O(dt)
= e
λf
ˆ
S
t
(λdf +µdt +σdW
t
) +O(dt)
= S
t
(λdf +µdt +σdW
t
) +O(dt)
⇒dS
t
= µS
t
dt +σS
t
dW
t
+λS
t
df(S
t
, t) +O(dt)
where we have not included any quadratic variation terms in the calculation as this
would affect only the drift of the process and for the purposes of option pricing we are
only really interested in the volatility and price impact terms. The function f(S, t)
in the above model is identified as the number of shares traded rather than held and
so it is not obvious that we should thus identify f(S, t) to be the trading strategy
as before. However, in the interest of brevity we will not investigate this model any
further.
2.3.2 Platen and Schweizer (1998)
The model of Platen and Schweizer (1998) defines the market clearing condition
D(S
t
, U
t
, t) = constant
where the demand is modelled as
D(S
t
, U
t
, t) = U
t
+γ (log S
t
−log S
0
) +f(S
t
, t),
where S
0
and γ constant. Hence
6
dD(S
t
, U
t
, t) = dU
t

dS
t
S
t
+df(S
t
, t) +O(dt) = 0,
6
Again, note that we are neglecting the quadratic variation terms since these would only influence
the drift and clutter the algebra.
CHAPTER 2. THE MODELLING FRAMEWORK 60
where S
t
denotes the equilibrium price. Also the authors assume that dU
t
= mdt +
νdW
t
for m, ν ∈ R and so we have that
dS
t
S
t
= −γ
−1
_
mdt +νdW
t
+df(S
t
, t)
_
+O(dt),
hence we can identify
σ(S
t
, t) = −νγ
−1
,
λ(S
t
, t) = −γ
−1
.
There is discussion about the sign of the parameter γ in the paper of Platen and
Schweizer (1998), but in this formulation it is clear that it must be negative in order
to produce a price process that has a positive drift and volatility.
2.3.3 Mancino and Ogawa (2003)
The model of Mancino and Ogawa (2003) extends the work of Platen and Schweizer
(1998) and so they also define the market clearing condition as
D(S
t
, U
t
, t) = constant,
where the demand is modelled as
D(S
t
, U
t
, t) = U
t
+γ (log S
t
−log S
0
) +H
_
f(S
t
, t)
_
,
for any function H. Again dU
t
= mdt +νdW
t
so we have that
dS
t
S
t
= −γ
−1
_
mdt +νdW
t
+
dH
df
df(S
t
, t)
_
+O(dt),
hence we can identify
σ(S
t
, t) = −νγ
−1
,
λ(S
t
, t) = −γ
−1
dH
df
.
CHAPTER 2. THE MODELLING FRAMEWORK 61
2.3.4 Lyukov (2004)
The model of Lyukov (2004) defines the market clearing condition to be
dU
t
+df(S
t
, t) = dM
t
,
where the right hand side is the supply from the market maker. He also defines
liquidity L to be
L =
dM
t
/N
dS
t
/S
t
and
dU
t
= Nmdt +NνdW
t
,
where N is the total number of shares and m, ν ∈ R. Putting these together we have
dS
t
S
t
=
m
L
dt +
ν
L
dW
t
+
1
LN
df(S
t
, t),
hence we can identify
µ(S
t
, t) = mL
−1
,
σ(S
t
, t) = νL
−1
,
λ(S
t
, t) = (LN)
−1
.
2.3.5 Sircar and Papanicolaou (1998)
The model of Sircar and Papanicolaou (1998) define the (normalised) market clearing
condition to be (cf. section 2.2.2)
D(S
t
, U
t
, t) +ρf(S
t
, t) = 1, (2.16)
where f(S
t
, t) is the normalised aggregate demand per security traded and ρ is the
ratio of options being hedging to total supply. The authors also note that if we
restrict the demand function to the form
D(S
t
, U
t
, t) = D(S
t
, U
t
),
CHAPTER 2. THE MODELLING FRAMEWORK 62
i.e. there is no explicit time dependence, then in order for the model to reduce to the
Black-Scholes model in the limit of ρ →0 the demand must take the form
D(S
t
, U
t
) = φ(U
γ
t
/S
t
),
where
dU
t
U
t
= µ
1
dt +σ
1
dW
t
, (2.17)
and γ is the ratio
γ =
σ
0
σ
1
,
where σ
0
is the volatility of the Black-Scholes process given by
dS
BS
t
S
BS
t
= µ
0
dt +σ
0
dW
t
,
hence γ is the ratio of the volatility of the reference process U
t
to the volatility of the
Black-Scholes process S
BS
t
. Further the authors assume that
φ(z) = βz,
i.e. linear, hence
D(S
t
, U
t
, t) =
βU
γ
t
S
t
. (2.18)
Therefore the market clearing condition becomes
7
dD(S
t
, U
t
, t) +ρdf = 0,
⇒d
_
βU
γ
t
S
t
_
+ρdf = 0,

βU
γ
t
S
t
_
γ
dU
t
U
t

dS
t
S
t
_
+ρdf +O(dt) = 0,

dS
t
S
t
= γ
dU
t
U
t
+
ρS
t
βU
γ
t
df +O(dt).
Now it is clear from (2.16) and (2.18) that
βU
γ
t
S
t
= D(S
t
, U
t
, t) = 1 −ρf,
and so we have
dS
t
S
t
= γ
dU
t
U
t
+
ρdf
1 −ρf
+O(dt).
7
Ignored the quadratic variation terms.
CHAPTER 2. THE MODELLING FRAMEWORK 63
Finally substitution for U
t
from (2.17) gives
dS
t
S
t
=
σ
0
µ
1
σ
1
dt +σ
0
dW
t
+
ρ
1 −ρf
df +O(dt),
hence we can identify
σ(S
t
, t) = σ
0
,
λ(S
t
, t) =
ρ
1 −ρf
.
With this survey complete we now proceed in the next chapter to investigate the case
of first-order feedback (with λ constant for simplicity) and show how the illiquidity,
even in this case, has a significant effect on the option replication price, especially as
we approach expiry.
Chapter 3
First-order Feedback Model
As a starting point to investigating how liquidity can affect the option value, we
assume that a hedger holds the number of stocks dictated by the analytical Black-
Scholes delta, rather than the delta from the modified option price. This leads to the
linear PDE (assuming λ constant)
∂V
∂t
+
1
2
σ
2
S
2
_
1 −λ

2
V
BS
∂S
2
_
2

2
V
∂S
2
+rS
∂V
∂S
−rV = 0. (2.9)
which is somewhat easier to solve than the full-feedback problem PDE (2.10), but
still has important and interesting differences from the classical Black-Scholes PDE.
This chapter investigates the analytical properties of equation (2.9), in particularly
in the region close to expiry, highlighting the differences with the classical Black-
Scholes model. We also consider American options in this framework which has not
previously been attempted.
This idea of first-order feedback leading to a modified, but still linear PDE also
appears in Sch¨ onbucher and Wilmott (2000), but under a different guise. They call
the solution to the PDE (2.9) the price taker’s price. In an illiquid market influenced
by a large trader (or by an equivalent large group of small traders) following the
Black-Scholes hedging strategy, a small trader can trade any number of shares, on a
small scale, without affecting the price. Hence equation (2.9) models the replicating
64
CHAPTER 3. FIRST-ORDER FEEDBACK MODEL 65
cost of an option for such small traders, who are aware of the large traders influence
on the market; for these traders only, the market appears liquid.
Figure 3.1 shows numerical results from the solution of equation (2.9) (obtained using
a Crank-Nicolson procedure
1
) for European call options (all with time to maturity,
T = 1 year, risk-free rate, r = 0.04, volatility, σ = 0.2, and exercise price, K = 1)
for λ = 0, 1, 2, 5, 10. Here, the standard call expiry payoff at t = T has been
implemented, i.e. condition (1.1) on page 21. The result with λ = 0 is, of course,
the classic Black-Scholes result. As λ is increased, the option value is apparently
eroded monotonically towards the amount by which the contract is currently in the
money or, if out of the money, zero (some of the analysis below will confirm this).
Corresponding results for put options (using the same parameters as for figure 3.1),
with the standard put payoff condition (1.2) are presented in figure 3.2, and these
too strongly point to a monotonic asymptote on to the payoff function (for fixed T)
as the liquidity parameter λ increases. Although the illiquid results appear to be
rather qualitatively similar to the liquid (λ = 0) results, a more detailed analysis
(applicable for times close to expiry) follows, and this highlights some subtle, but
important differences.
It should be noted at this stage that the size of errors and related implementation
details will be omitted from the presentation of numerical results. The techniques
used are more often than not standard and have well understood error estimates. In
all calculations the error levels were more than acceptable, often with errors within
the line width of the graphs presented.
1
Note that finite difference methods will be the preferred method of solution throughout this
thesis. Finite difference methods have the advantage over the alternative finite element methods
because we almost exclusively work in rectangular domains (asset price and time); in such situations
finite difference methods are much easier to implement. For more on finite difference methods see
Smith (1978).
CHAPTER 3. FIRST-ORDER FEEDBACK MODEL 66
0
0.1
0.2
0.3
0.4
0.5
0.6
0 0.2 0.4 0.6 0.8 1 1.2 1.4
PSfrag replacements
S
C
a
l
l
v
a
l
u
e
λ = 0
λ = 10
Figure 3.1: Value of European call options with first-order feedback (T = 1, r = 0.04,
σ = 0.2, K = 1) for λ = 0, 1, 2, 5, 10; the variation with λ appears to be monotonic.
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
0 0.2 0.4 0.6 0.8 1 1.2 1.4
PSfrag replacements
S
P
u
t
v
a
l
u
e
λ = 0
λ = 10
Figure 3.2: Value of European put options with first-order feedback (T = 1, r = 0.04,
σ = 0.2, K = 1) for λ = 0, 1, 2, 5, 10; the variation with λ appears to be monotonic.
CHAPTER 3. FIRST-ORDER FEEDBACK MODEL 67
3.1 Analysis close to expiry: European options
In this section we consider the behaviour of the option value close to expiry. This is
generally the most critical and intricate period for option pricing models and offers
us some insight into the valuation dynamics, shedding more light on the value of
options as the parameter λ is increased. The standard substitution, setting τ = T −t
(representing time to expiry), transforms (2.9) into
V
τ

σ
2
S
2
V
SS
2 (1 −λV
BS
SS
)
2
−rSV
S
+rV = 0, (3.1)
where subscripts now denote derivatives and V
BS
is the solution to the corresponding
Black-Scholes equation
V
BS
τ

1
2
σ
2
S
2
V
BS
SS
−rSV
BS
S
+rV
BS
= 0. (3.2)
We next investigate the small τ behaviour of (3.1) (i.e. for times close to expiry), for
which we also need to know the behaviour of the Black-Scholes equation (3.2) in this
limit. To obtain this, we wish to zoom in on the solution domain close to strike and
expiry. This zoomed domain we refer to as the inner region and the solution in this
domain, the inner solution. Naturally the domain and solution outside of this region
are given the prefix outer. Mathematically this zooming is done via the following well
known transformation, hence as τ →0 the solution takes the form
V
BS
= τ
1
2
f(η) +O(τ), (3.3)
where
η =
S −K
τ
1
2
, (3.4)
which is often called the inner variable and whose form can be verified a posteriori;
such a solution is sometimes called a self-similar solution.
2
It can be shown (see for
example Wilmott et al., 1995) that the solution f when η = O(1), is given by the
solution to the ordinary differential equation (ODE)
σ
2
K
2
f
ηη
+ηf
η
−f = 0. (3.5)
2
For a survey of these methods applied to the equations arising in continuum mechanics see
Barenblatt (1996).
CHAPTER 3. FIRST-ORDER FEEDBACK MODEL 68
For a put the appropriate boundary conditions become
f →0 as η →∞, f →−η as η →−∞
and for a call
f →η as η →∞, f →0 as η →−∞.
Using these boundary conditions it is straightforward and well known to show (cf.
Wilmott et al., 1995) that equation (3.5) leads to the solution for a put
f
P
(η) = η
_
Φ
_
η
Λ
_
−1
_
+
Λ


e

1
2
(
η
Λ
)
2
(3.6)
and likewise for a call
f
C
(η) = ηΦ
_
η
Λ
_
+
Λ


e

1
2
(
η
Λ
)
2
,
where Λ = σK and Φ() is the standard normal cumulative distribution function
defined as
Φ(x) =
1


_
x
−∞
e

1
2
y
2
dy. (3.7)
Considering the second derivative gives
f
P
ηη
= f
C
ηη
=
1
Λ


e

1
2
(
η
Λ
)
2
,
and, consequently, rewriting in terms of the original variables, the local Black-Scholes
gamma is given by
V
BS
SS
=
1
σK

2πτ
e

(S−K)
2
2τσ
2
K
2
. (3.8)
We can now proceed to incorporate this into the first-order feedback illiquid problem
(3.1). To investigate the small τ behaviour of this equation, we can perform a local
similarity analysis similar to that just performed for the liquid Black-Scholes equation.
To illustrate this powerful technique the analysis will be explained in detail. First we
seek a solution of the form
V = τ
α
g(ξ), (3.9)
where
ξ =
S −K
τ
β
, (3.10)
CHAPTER 3. FIRST-ORDER FEEDBACK MODEL 69
and is assumed to be O(1). α and β are constants to be determined. The first
point to note is that if the Black-Scholes local solution described above is used, i.e.
α = β =
1
2
, then the second derivative term in (3.1) becomes much smaller than the
other terms in the equation in the limit τ →0. Therefore it would appear that close
to expiry the dynamics of the first-order feedback model are significantly different
from the standard Black-Scholes model. Substituting (3.9) and (3.10) into (3.1) and
re-writing the approximation of V
BS
SS
close to expiry (3.8) in terms of the new inner
variable ξ gives
τ
α−1
(αg −βξg
ξ
) −
σ
2
K
2
τ
α−2β
g
ξξ
2
_
1 −
λ
σK

2πτ
e

ξ
2
τ
2β−1

2
K
2
_
2
+rKτ
α−β
g
ξ
+rτ
α
g = 0. (3.11)
It is clear that the denominator of the second term is O(τ
−1
) in the limit τ → 0
(provided that 2β −1 > 0, which can verified a posteriori ). Consequently the second
derivative term is O(τ
α−2β+1
) as τ →0. To obtain an appropriate scaling we balance
this with the time derivative term which is O(τ
α−1
), leading to the conclusion that
α −1 = α −2β + 1 ⇒β = 1.
To fix α we exploit the fact that the inner solution τ
α
g(ξ) must match with the outer
solution, the solution that is valid outside of our inner region close to strike and
expiry. In this (outer) region the second derivative of the solution is effectively zero
since the payoff profile has no curvature here. Hence the outer solution is given by
the solution to equation (2.9) without the diffusion term, i.e.
V
τ
−rSV
S
+rV = 0. (3.12)
This can be solved using the method of characteristics, in conjunction with the ap-
propriate initial condition, to obtain
V
P
(S, τ) =
_
Ke
−rτ
−S
_
+
, (3.13a)
V
C
(S, τ) =
_
S −Ke
−rτ
_
+
, (3.13b)
for puts and calls respectively. Thus we require τ
α
g(ξ) = S −Ke
−rτ
for a call option
in the limit ξ →∞. We shall discuss this matching procedure in more detail shortly,
CHAPTER 3. FIRST-ORDER FEEDBACK MODEL 70
however the preceding arguments suggest that for the matching to work we require
S − K = O(τ
α
). In addition, by construction ξ = O(1) in the inner region, hence
(3.10) suggests we must also have S −K = O(τ
β
). We conclude that
3
α = β = 1.
PSfrag replacements
S
τ
K
ξ →∞
ξ →−∞
V
P
(S, τ) = 0
V
C
(S, τ) = S −Ke
−rτ
V
P
(S, τ) = Ke
−rτ
−S
V
C
(S, τ) = 0
V
P
(S, τ) = τg
P
(ξ)
V
C
(S, τ) = τg
C
(ξ)
O(τ)
Figure 3.3: Asymptotic Matching.
Note that the scaling here implies a region O(τ) in asset space S, close to the strike
price, that is somewhat smaller than the classical Black-Scholes model, (3.3), which is
O(τ
1
2
) as τ →0 (see (3.4)); this is clearly an important difference from the standard
Black-Scholes model behaviour close to expiry. Substituting for α and β into (3.11)
gives
g −ξg
ξ

σ
2
K
2
τ
−1
g
ξξ
2
_
1 −
λ
σK

2πτ
e

ξ
2
τ

2
K
2
_
2
−rKg
ξ
+rτg = 0,
and taking the O(1) terms leads to
πσ
4
K
4
λ
2
g
ξξ
+ (ξ +rK) g
ξ
−g = 0. (3.14)
Note that on the relatively short ξ = O(1) scale, we are effectively replacing (3.8)
with
V
BS
SS
=
1
σK

2πτ
. (3.15)
3
Note that this satisfies our a priori assumption that 2β −1 > 0.
CHAPTER 3. FIRST-ORDER FEEDBACK MODEL 71
The appropriate boundary conditions to equation (3.14) for standard puts and calls
are obtained from an asymptotic matching procedure (cf. van Dyke, 1964). For
asymptotic matching we require the inner solution, τg(ξ) in the limit [ξ[ → ∞ to
match with the outer solution (3.13). A schematic of this is given in figure 3.3, and
formally the matching condition is defined as
lim
S→K,τ→0
V
OUTER
(S, τ) = lim
|ξ|→∞
τg(ξ). (3.16)
Practically we re-write the outer solution in terms of the inner variable ξ and then
equate the result to the inner solution τg(ξ) to give the appropriate boundary con-
ditions. This procedure leads to the boundary conditions for a put:
g →0 as ξ →∞, g →−(ξ +rK) as ξ →−∞,
and for a call:
g →ξ +rK as ξ →∞, g →0 as ξ →−∞.
Equation (3.14) can be solved analytically; for a put, the solution is
g
P
(ξ) = (ξ +rK)
_
Φ
_
ξ +rK
κ
_
−1
_
+
κ


e

1
2
(
ξ+rK
κ
)
2
, (3.17)
where κ =

πσ
2
K
2
λ
, and for a call
g
C
(ξ) = (ξ +rK)Φ
_
ξ +rK
κ
_
+
κ


e

1
2
(
ξ+rK
κ
)
2
, (3.18)
where Φ() is the cumulative normal distribution function defined by (3.7). Note
that increasing illiquidity (λ → ∞) implies κ → 0 and this in turn indicates that
(3.17) and (3.18) become increasingly focused about ξ = −rK, i.e. S = K(1 − rτ),
taking on the payoff form away from this point, consistent with our observations
above regarding figures 3.1 and 3.2. Furthermore differentiating (3.17) and (3.18)
with respect to λ directly gives
∂g
P
∂λ
=
∂g
C
∂λ
= −
σ
2
K
2


2
e

1
2
(
ξ+rK
κ
)
2
< 0,
confirming that, on the inner scale at least, the option value is monotonic decreasing
in the liquidity parameter λ.
CHAPTER 3. FIRST-ORDER FEEDBACK MODEL 72
Figure 3.4 shows the difference between the inner solution and the payoff function for
both put and call options for various values of the liquidity parameter λ. In addition
to confirming the monotonic behaviour in λ, it can be seen that call values always lie
above the payoff curve (i.e. g
C
−[ξ]
+
> 0 for all ξ). As with the classical Black-Scholes
result for European calls, in the present case it is never optimal to early exercise calls.
In the case of the puts, it is possible for g
P
− [−ξ]
+
< 0 (i.e. V − payoff < 0) for
certain ranges of ξ, which opens up the potential for the optimal early exercise (on
the ξ scale), and so a consideration of this possibility is considered next.
-0.05
0
0.05
0.1
0.15
0.2
0.25
0.3
-2 -1.5 -1 -0.5 0 0.5 1 1.5 2
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
g
P
(
ξ
)

[

ξ
]
+
g
C
(
ξ
)

[
ξ
]
+
ξ
λ ↓ 0
(a) Put
-0.05
0
0.05
0.1
0.15
0.2
0.25
0.3
-2 -1.5 -1 -0.5 0 0.5 1 1.5 2
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
g
P
(
ξ
)

[

ξ
]
+
g
C
(
ξ
)

[
ξ
]
+
ξ
λ ↓ 0
(b) Call
Figure 3.4: Inner solution minus the payoff for put and call options, r = 0.04, σ = 0.2,
K = 1 and for λ = 0.1, 0.15, 0.2, . . ., 0.4.
3.2 Analysis close to expiry: American put op-
tions
The remarks above naturally beg the question as to the value of a put option on a
finitely liquid underlying if early exercise is permitted. In the context of first-order
feedback, the most consistent model has the delta in (2.8) on page 51 computed
using the liquid (λ = 0) American put value V
BS
AM
, which does permit early exercise;
note that the free boundary (optimal exercise price) of the illiquid put option, V ,
need not necessarily be the same as the free boundary of the liquid option V
BS
AM
.
Figure 3.5 shows results for the American put with the same financial parameters
as for the earlier European options, obtained via a standard Projected Successive
CHAPTER 3. FIRST-ORDER FEEDBACK MODEL 73
Over Relaxation (PSOR) iterative procedure. The convergence criteria chosen for
the algorithm was that maximum error between subsequent iterations was less than
1 10
−6
.
At each node the Black-Scholes American value was computed using a PSOR algo-
rithm and then this value was used in the PSOR algorithm for the first-order feedback
PDE (2.9) subject to (1.2). Again we see the ‘collapse’ of the option value on to the
payoff as the liquidity parameter λ is increased (which implies the location of the
free boundary always moves towards the exercise price as λ increases). However,
although the results appear to be qualitatively similar to the λ = 0 case, there are
subtle differences, as we shall now show.
0
0.05
0.1
0.15
0.2
0.25
0.8 0.9 1 1.1 1.2 1.3 1.4 1.5
PSfrag replacements
S
P
u
t
v
a
l
u
e
λ = 0
λ = 10
Figure 3.5: Value of American put options, T = 1, r = 0.04, σ = 0.2, K = 1 and for
λ = 0, 1, 2, 5, 10; the variation with λ appears to be monotonic.
Analysis of the liquid (λ = 0) American put option close to expiry leads to a somewhat
complicated structure, as detailed by Kuske and Keller (1998). Here, the η scale
defined in (3.4) can be shown to fail to capture the free (exercise) boundary. Instead,
the free boundary is located at a somewhat larger distance (O(

−τ log τ)) from
the exercise price (with a significant price variation in a region O(
_
−τ/ log τ) of this
exercise boundary). It was shown by Widdicks (2002) that as τ →0, on the η = O(1)
scale, the solution of the liquid (λ = 0) American option takes the same form as that
CHAPTER 3. FIRST-ORDER FEEDBACK MODEL 74
of its European counterpart, i.e. (3.6). Therefore, it is entirely self consistent to
use this form and, indeed, the European gamma (3.8), for the American case when
η = O(1) or smaller, which is relatively distant from the free boundary.
However, recall that for the case when λ ,= 0, with ξ = O(1) we have clear indications
of the possibility of early exercise (on the ξ scale) for the illiquid put. In other words
the ξ scaling for the first-order feedback equation encompasses the free boundary
(unlike the η scaling for the liquid (λ = 0) case). Therefore, the American problem
in this case reduces to the solution of (3.14), subject to the conditions
4
g →0 as ξ →∞, (3.19a)
g = −ξ and g
ξ
= −1 on ξ = ξ
f
, (3.19b)
where we have used the usual smooth pasting conditions (continuity of the option
value and its derivative) and ξ
f
denotes the location of the free boundary (on the
ξ scale). It is straightforward to solve the system (3.14), (3.19) fully numerically,
however it is also possible to reduce the above problem to a transcendental equation
for ξ
f
, a procedure which has not previously been done in the literature and shall be
outlined below.
It is convenient to make the shift z = ξ + rK which transforms the system (3.14),
(3.19) to
κ
2
g
zz
+zg
z
−g = 0, (3.20a)
g →0 as z →∞, (3.20b)
g = −z +rK, g
z
= −1 on z = z
f
, (3.20c)
where κ is as before and z
f
the free boundary on the z-scale. To proceed we seek a
solution of the form,
g(z) = zˆ g(z)
4
Note that here the outer solution is given by V
P
(S, τ) = (K − S)
+
rather than V
P
(S, τ) =
(Ke
−rτ
− S)
+
since we are dealing with the American option and so the outer solution will be
trivially the payoff profile.
CHAPTER 3. FIRST-ORDER FEEDBACK MODEL 75
which upon substitution leads to
ˆ g
zz
ˆ g
z
= −
2
z

z
κ
2
.
Integrating once gives
ˆ g
z
=
A
z
2
e

1
2
(
z
κ
)
2
,
where A is a constant of integration. Integrating once more gives
[ˆ g]

z
=
_

z
A
y
2
e

1
2
(
y
κ
)
2
dy,
⇒ ˆ g(∞) − ˆ g(z) =
_

A
y
e

1
2
(
y
κ
)
2
_

z

A
κ
2
_

z
e

1
2
(
y
κ
)
2
dy,
⇒ ˆ g(z) = −
A
z
e

1
2
(
z
κ
)
2
+
A
κ
2
_

z
e

1
2
(
y
κ
)
2
dy,
where we have applied the boundary condition (3.20b). Returning to the original
function g(z) gives
g(z) = zˆ g(z) = −Ae

1
2
(
z
κ
)
2
+
Az
κ
2
_

z
e

1
2
(
y
κ
)
2
dy. (3.21)
It is now required to determine the value of A using the remaining boundary condi-
tions on the free boundary. To do this we differentiate equation (3.21) to obtain
g
z
(z) =
A
κ
2
_

z
e

1
2
(
y
κ
)
2
dy.
We can now apply the two boundary conditions at z
f
, i.e.
g(z
f
) = −z
f
+rK = −Ae

1
2
(
z
f
κ
)
2
+
Az
f
κ
2
_

z
f
e

1
2
(
y
κ
)
2
dy, (3.22)
g
z
(z
f
) = −1 =
A
κ
2
_

z
f
e

1
2
(
y
κ
)
2
dy. (3.23)
From (3.23) we have
A =
−κ
2
_

z
f
e

1
2
(
y
κ
)
2
dy
,
hence substituting into (3.22) gives
−z
f
+rK =
κ
2
e

1
2
(
z
f
κ
)
2
_

z
f
e

1
2
(
y
κ
)
2
dy
−z
f
,
⇒rK
_

z
f
e

1
2
(
y
κ
)
2
dy = κ
2
e

1
2
(
z
f
κ
)
2
,
CHAPTER 3. FIRST-ORDER FEEDBACK MODEL 76
which can be written in the form of the standard cumulative normal distribution
function as
Φ
_
z
f
κ
_
= 1 −
κ
rK


e

1
2
(
z
f
κ
)
2
.
Transforming back to the original ξ variable yields
Φ
_
ξ
f
+rK
κ
_
= 1 −
κ
rK


e

1
2

ξ
f
+rK
κ

2
,
or further
Φ
_
λ(ξ
f
+rK)

πσ
2
K
2
_
= 1 −
σ
2
K

2rλ
e

λ
2

ξ
f
+rK
σ
2
K
2

2
. (3.24)
-6
-4
-2
0
2
4
6
8
0 1 2 3 4 5
PSfrag replacements
l
o
g
(

ξ
f
)
λ
Figure 3.6: First-order feedback put (with early exercise), location of free boundary
(as τ →0) with λ, K = 1, r = 0.04, σ = 0.2.
Figure 3.6 shows the variation of the local free boundary ξ
f
(more particularly
log(−ξ
f
)) with λ for the financial parameters considered earlier, i.e. r = 0.04, σ = 0.2,
K = 1. The key point to note is that solutions of the system do exist, i.e. the short
S −K = O(τ), ξ = O(1) scale captures the location of the free boundary with first-
order feedback, whilst as noted above, the liquid (λ = 0) case evolves on a relatively
longer scale of S − K = O(

−τ log τ); consistent with this as λ → 0, ξ
f
→ −∞.
Further asymptotic analysis can describe this behaviour, but is omitted in the in-
terests of brevity. Note that transforming back to the original (S, τ) variables using
equation (3.10) we can see that
S
f
(τ) = K +ξ
f
τ +. . .
CHAPTER 3. FIRST-ORDER FEEDBACK MODEL 77
where ξ
f
is determined by equation (3.24). Hence the free boundary approaches the
strike price at expiry linearly for small times to expiry.
3.3 The vanishing of the denominator
One further interesting property of the first-order feedback model is that we have
the possibility of the denominator of the volatility term vanishing, hence a possible
breakdown in the diffusion term of the first-order feedback PDE.
5
Considering equa-
tion (2.9) one might naively think that a singularity occurs when 1 − λV
BS
SS
= 0.
Using the analytic solution for the Black-Scholes equation we find that
V
BS
SS
=
e

1
2
d
1
(S,τ)
2
σS

2πτ
for both puts and calls where
d
1
(S, τ) =
log
_
S
K
_
+
_
r +
1
2
σ
2
_
τ
σ

τ
.
Hence the location where the denominator of equation (2.9) vanishes is given by the
solution to the equation
1 −
λe

1
2
d
1
(S

,τ)
2
σS


2πτ
= 0. (3.25)
This equation can be solved explicitly by setting x = ln(S/K) and doing so we arrive
at
S

(τ) = K exp
_

_
r +
3
2
σ
2
_
τ ±


2
τ
_
(r +σ
2
)τ −log
_
λ
σK

2πτ
__1
2
_
.
Figure 3.7 shows the results for the same set of financial parameters as used through-
out this chapter.
It can be seen that equation (3.25) has two distinct solutions for τ ∈ (0, τ
0
) for some
finite time-to-expiry τ
0
, determined by the solution of the transcendental equation
(r +σ
2

0
= log
_
λ
σK

2πτ
0
_
.
5
This shall be even more important in our consideration of the full feedback problem discussed
in chapter 4.
CHAPTER 3. FIRST-ORDER FEEDBACK MODEL 78
0.97
0.98
0.99
1
1.01
1.02
0 0.005 0.01 0.015 0.02 0.025 0.03 0.035 0.04 0.045
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
S

τ
τ
0
Figure 3.7: Location of the vanishing of the denominator of (2.9) with λ = 0.1,
K = 1, r = 0.04 and σ = 0.2.
For τ > τ
0
the equation has no solutions, i.e. the denominator does not vanish in this
region. Note that when considering the Frey (2000) model an explicit expression for
τ
0
can be obtained (see section 7.1). Also note that the location of the singularity at
τ = 0 is K as one might expect.
Having determined the location in which the denominator of equation (2.9) vanishes
it is now interest to investigate the behaviour of the solution at these points. It
is a well known property of ODEs
6
that singularities of the solution occur only at
singularities of the equation when it is written in the standard form
V
(n)
= F
_
V
(n−1)
, V
(n−2)
, . . . , V, S
_
,
i.e. for a second order ODE in the form
V
SS
= F (V
S
, V, S) .
Hence possible singularities of the solution occur at singularities of the function F().
Even though equation (2.9) is a PDE, and thus the above result cannot be applied
directly, it is informative to re-write (2.9) in standard form to give
V
SS
=
2
σ
2
S
2
(V
τ
−rSV
S
+rV )
_
1 −λV
BS
SS
_
2
,
6
See, for example, Kruskal et al. (1997)
CHAPTER 3. FIRST-ORDER FEEDBACK MODEL 79
from which we can see that the right hand side has no singularities except at [V
BS
SS
[ →
∞, which only occurs at (S, τ) = (K, 0). Hence it is expected that no singularities
will appear in the solution for τ > 0, instead it is clear that at the locations of the
vanishing of the denominator the second derivative will be forced to zero.
-1
-0.8
-0.6
-0.4
-0.2
0
0.85 0.9 0.95 1 1.05 1.1 1.15
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
S

=

V

S
τ = 0.01
τ = 0.05
Figure 3.8: The first derivative (∆) of the Black-Scholes equation (3.2) (dotted line)
and the first order feedback PDE (2.9) (solid line) for τ = 0.01, 0.015, . . ., 0.05.
Compare the location of the vanishing denominator 3.7.
0
5
10
15
20
25
30
35
40
45
0.85 0.9 0.95 1 1.05 1.1 1.15
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
S
Γ
=

2
V

S
2
τ = 0.01
τ = 0.05
S

Figure 3.9: The second derivative (Γ) of the Black-Scholes equation (3.2) (dotted
line) and the first order feedback PDE (2.9) (solid line) for τ = 0.01, 0.015, . . ., 0.05.
Compare the location of the vanishing denominator 3.7.
Figures 3.8 and 3.9 show the first and (more importantly) the second derivative
CHAPTER 3. FIRST-ORDER FEEDBACK MODEL 80
of the solution of (2.9) in the vicinity of S

respectively. It can be seen that the
solution at S

appears to be at least C
2,1
differentiable and further that V
SS
remains
positive, just ‘skimming’ zero as S

is approached, thus indicating that the solution
remains convex as τ increases; despite the vanishing of the denominator. Indeed
convexity preservation is a well-known property of option prices under the assumption
of geometric Brownian motion, see for example Bergman et al. (1996) or El Karoui
et al. (1998). Convexity preservation means that given convexity at t the option price
remains convex for all times prior to t. This is true only in certain models and is
not necessarily true for certain models when in higher dimensions. Ekstr¨ om et al.
(2005) show that geometric Brownian motion is the only convexity preserving model
in higher dimensions. More importantly they show that (in one dimension) a local
volatility model, i.e. a model for the underlying with an arbitrary volatility function
σ(S, τ) as we have here, will be convexity preserving. The numerical investigations
of the first-order feedback equation described above indicate that the solution profile
does indeed remain convex, i.e V
SS
≥ 0 for all (S, τ), in agreement with the stated
results.
One final subtlety of the behaviour of the first-order feedback equation comes when we
take a closer look at the hypothesised monotonic decreasing behaviour of the option
value with the liquidity parameter λ. We have shown that for small times to expiry
the solution is indeed monotonically decreasing in the parameter λ, however this in
not the whole story for τ = O(1). Figure 3.10 shows the solution to equation (3.1)
for two slightly different values of λ (the dotted line representing the higher value)
and also at three different times to maturity. It can be seen that for the closest time
to maturity a monotonic decreasing relationship is shown, however as we increase the
time to expiry, this relationship appears to be increasing for sufficiently large times
away from maturity.
We can begin to see what may be happening if we take a closer look at the modified
volatility term of the first-order feedback case, i.e.
ˆ σ
2
(S, τ) =
σ
2
S
2
(1 −λV
BS
SS
)
2
. (3.26)
CHAPTER 3. FIRST-ORDER FEEDBACK MODEL 81
0
0.02
0.04
0.06
0.08
0.1
0.12
0.14
0.16
0.85 0.9 0.95 1 1.05 1.1 1.15
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
S
V
τ = 0.0125
τ = 0.0375
τ = 0.075
Figure 3.10: First-order feedback put option value for two different values of λ at
various times to expiry; τ = 0.0125, 0.0375, 0.075. For r = 0.04, σ = 0.2, K = 1 and
λ = 0.09 (solid line) and λ = 0.1 (dotted line). Compare with figure 3.7.
Recall that the results of Ekstr¨ om et al. (2005) suggest that the solution to the PDE
(3.1) (for convex payoff profiles) remains convex for all (S, τ). As such we have the
relationship that an increase in volatility will result in an increase in option price,
7
hence to determine the option price dependence on λ we need only determine the
dependence of the modified volatility on λ. Differentiating (3.26) with respect to λ
yields
∂ˆ σ
2
∂λ
=
σ
2
S
2
V
BS
SS
2 (1 −λV
BS
SS
)
3
(3.27)
and it is clear that the sign of the above may change, dependent on the size of V
BS
SS
.
In fact, (3.27) indicates that the solution dependency on the liquidity parameter λ is
monotonic increasing in regions in which V
BS
SS
< 1/λ and monotonic decreasing for
V
BS
SS
> 1/λ. However in the limit as λ → ∞ the region V
BS
SS
> 1/λ expands to fill
the whole domain and so this will become the dominant behaviour for a fixed time
to expiry. The above agrees well with the results shown in figure 3.10, since for the
parameters used, figure 3.7 indicates that the denominator of equation (3.1) does not
vanish for τ 0.04 and so we are in the region in which V
BS
SS
< 1/λ and we should
thus expect monotonic increasing behaviour in λ, which it appears we have.
7
See for example Bergman et al. (1996), El Karoui et al. (1998) or Janson and Tysk (2003)
CHAPTER 3. FIRST-ORDER FEEDBACK MODEL 82
With this necessary background complete, in the next chapter we may proceed to
investigate the more challenging full-feedback model.
Chapter 4
Full-feedback Model
We now turn our attention to the full feedback case, namely the equation
V
τ

σ
2
S
2
V
SS
2 (1 −λ(S, τ)V
SS
)
2
−rSV
S
+rV = 0, (4.1)
where the trading strategy assumed to affect the price is not simply the Black-Scholes
delta hedging strategy as discussed in the previous chapter, but rather is based on
the actual delta of the modified price, and as a consequence the price impact is fully
considered in the trading strategy. This corresponds to a situation where all market
participants performing such hedging strategies are aware of the effect that their
strategies have on the price. In this case the trading strategy has to be determined
as part of the problem, resulting in nonlinearity.
The full feedback equation has been studied extensively in the literature with various
functional forms of the liquidity parameter λ(S, t). Existence and uniqueness was
given by Frey (1998) which shows that options in such a market can be perfectly
replicated, hence the market is complete. These results, however, are not applica-
ble to standard put or call options (nor any non-smooth payoff profile) and so here
we investigate the solutions to the PDE in such regimes. The aim being to illus-
trate exactly how things go wrong, with the view to informing modellers on how to
incorporate non-smooth payoffs into the intuitive framework outlined in chapter 2.
83
CHAPTER 4. FULL-FEEDBACK MODEL 84
The full-feedback model described here is what Sch¨ onbucher and Wilmott (2000) call
the paper value replication for the large trader, so-called because the value satisfying
the PDE is just the paper value of the option. Liquidating the portfolio would change
the price, and due to the negative slope of the demand curve the realised value would
be less than the paper value. However, numerous difficulties arise when liquidation
strategies are incorporated into such dynamic hedging strategies. It is for this reason
that the majority of models in the literature (and the present study) consider only
the paper value or make the assumption that the option is closed out using physical
delivery to bypass any difficulties with the liquidation value.
Nonlinear diffusion equations are a frequent occurrence in the physical sciences and
the work done in these disciplines can provide much insight into the nonlinear be-
haviour of the models arising in mathematical finance. As such the aim of this chapter
is investigate thoroughly the properties of the nonlinear PDE (4.1), with the standard
put and call payoff profiles (1.2) and (1.1), using various analytical and numerical
techniques. We also give a brief overview of some of the techniques used to solve
general nonlinear PDEs and appraise their appropriateness for equation (4.1).
Note that equation (4.1) has the form
V
τ

1
2
F(S, τ, V
SS
)S
2
V
SS
−rSV
S
+rV = 0,
and as such is fully nonlinear. Equations of this form were first studied by Barenblatt
and co-workers in the context of hydrodynamics and more recently have arisen in
models occurring in quantitative finance, for example in many transaction cost models
such as Barles and Soner (1998).
The nonlinearity of equation (4.1) has many important consequences. If we have a
nonlinear PDE then one of the most striking differences with linear equations is that
the sum of two or more solutions is no longer necessarily a solution itself. As such
there is a significant difference in the value of the option to someone holding a long
position as opposed to a short position, hence we must take care to specify the option
CHAPTER 4. FULL-FEEDBACK MODEL 85
position. It is quite remarkable therefore that the inherent nonlinearity of the pricing
equations leads, quite naturally, to the concept of the bid-ask spread.
The effect of transaction costs and liquidity costs are always a sink of money for
hedgers. As an example of this, let us consider any nonlinear transaction cost model.
A portfolio consisting of the same option held both long and short would be priced
at zero since this portfolio has a zero payoff and is thus worthless. However when
pricing each option separately, transaction costs will be incurred on both options and
such costs will aggregate causing a disparity between the value of the portfolio and
the sum of its constituent parts; the difference being that of the total transaction
costs incurred.
When faced with a partial differential equation, there are many questions that one
must ask. The most fundamental being does there exist a solution, and if so is this
solution unique? The latter question becomes even more important when dealing
with nonlinear equations, well known to exhibit possible multiple solutions. For
linear (diffusion) equations, existence and uniqueness results are well known, and in
fact the Black-Scholes equation can be shown to be a sufficiently well-posed problem.
Stating some results from general PDE theory, a problem is well-posed if:
1
1. The problem has a solution,
2. This solution is unique,
3. The solution depends continuously on the data given in the problem.
In addition if we require the solution of a PDE of order k to be at least k times
continuously differentiable, then we call a solution with this much smoothness a
classical solution of the PDE. Many PDEs do not have classical solutions but are
nonetheless well-posed if we allow for properly defined generalised or weak solutions.
As it turns out this idea of a weak solution is exactly what is needed when tackling
the solution to equation (4.1) with non-smooth payoff profiles, see section 4.6.
1
See for example Evans (1998)
CHAPTER 4. FULL-FEEDBACK MODEL 86
As previously mentioned, Frey (1998) showed that equation (4.1) was well-posed for
λ(S, τ) =
ˆ
λS and for sufficiently smooth payoff profiles. This was done by differen-
tiating the fully nonlinear PDE in V to obtain a quasi-linear PDE in the hedging
strategy ∆(S, τ) for which existence and uniqueness was shown using arguments sim-
ilar to Ladyzenskaja et al. (1968).
2
In the sequel we will be considering the more
general scenario of non-smooth payoff profiles, where existence an uniqueness results
have not been established.
4.1 Put-call parity
Firstly we note that put-call parity can be shown to still hold, even in this highly
nonlinear situation. This can be shown by simply substituting the put call parity
relationship
V
P
= V
C
−S +Ke
−rτ
into the nonlinear equation for the put value V
P
(S, τ), i.e.
V
P
τ

σ
2
S
2
V
P
SS
2 (1 −λV
P
SS
)
2
−rSV
P
S
+rV
P
= 0,
and the payoff profile
V
P
(S, 0) = (K −S)
+
.
Doing so we obtain
V
C
τ

σ
2
S
2
V
C
SS
2 (1 −λV
C
SS
)
2
−rSV
C
S
+rV
C
= 0,
with
V
C
(S, 0) = (S −K)
+
,
hence we can recover the call option value from the put option value. Note that the
nonlinear equation (4.1) differs from the Black-Scholes equation by a function of the
second derivative of the option value only, i.e. σ = σ(S, τ, V
SS
), hence it is clear that
the parity relationship will still hold, since the second derivative of the put and call
option coincide.
2
An alternative and novel approach to providing existence and uniqueness results, exploiting the
maximum principle for parabolic equations, can be found in section A.2.2.
CHAPTER 4. FULL-FEEDBACK MODEL 87
4.2 A solution by inspection
It should be noted that it is possible to find exact analytic solutions to the PDE (4.1).
Such solutions can be obtained by exploiting symmetries of the governing equation
(and boundary conditions). These similarity solutions, based on the theory of Lie
groups, can be useful in investigating nonlinear problems, however the application of
such methods tends to be limited by the fact that many nonlinear PDEs do not have
such symmetries. In addition, the solutions obtained in this way are generally only
valid for very restrictive boundary conditions. As an example of this, if we assume
that λ(S, τ) in equation (4.1) is a function of τ only, i.e. λ = λ(τ), then we can seek
a solution of the following form
V (S, τ) = S
2
h(τ).
Substitution into (4.1) gives
h
τ

σ
2
h
(1 −2λh)
2
−rh = 0,
which is now an ODE and so open to standard solution techniques. Making the
further assumption that λ is constant we can arrive at the implicit solution for h:
ln(h) +
σ
2
2r
ln
_
(1 −2λh)
2
+
σ
2
r
_
+
σ

r
arctan
_√
r
σ
(1 −2λh)
_
= (r +σ
2
)τ +A,
where A is a constant determined by the payoff profile. It should be emphasised here
that we have been restricted to a constant λ(S, t) in order to obtain this solution
(without any real financial justification), and furthermore is only valid for payoff
profiles depending quadratically on S. Note too that regularity issues arise if h =
1

,
which are not unrelated to the analysis of chapter 5.
4.3 Similarity solutions
In order to gain more analytical insight into the behaviour of the highly nonlinear
PDE (4.1) we can employ the powerful technique of similarity solutions. It should be
CHAPTER 4. FULL-FEEDBACK MODEL 88
noted, however, that the similarity solution technique is rarely successful in solving a
complete boundary value or Cauchy problems, because it requires special symmetries
in the equation and the initial/boundary conditions. On the other hand, it can be
extremely useful when considering a local analysis in space or in time, for example the
initial behaviour of the American option free-boundary problem and the value of an
at-the-money option shortly before exercise, which are difficult to resolve numerically.
The idea behind similarity solutions is to exploit the fact that the equations and
the initial (final) and boundary conditions are invariant under a certain scaling, for
example S → νS, τ → ν
2
τ for any real number ν. Such a scaling is called a
one-parameter group of transformations. Under this transformations an equation is
invariant and so
S

τ
is the only combination of S and τ that is independent of ν and
hence the solution must be a function of
S

τ
only.
The global similarities (of Lie type) to equation (4.1) can be found in Bordag (2007).
In that paper, under the assumption that λ = λ(S), it is proved that λ ∼ S
k+1
where k ∈ R is the only case with a non-trivial symmetry group and a complete set
of invariant solutions is also found. Hence for equation (4.1) where λ(S, τ) =
ˆ
λS
k+1
,
there exists a global similarity transform of the form
V (S, τ) = S
1−k
u(z) where z = log S +aτ, a ,= 0. (4.2)
Note that k = −1 corresponds to the model of Sch¨ onbucher and Wilmott (2000), i.e.
with constant liquidity parameter λ. In addition the case k = 0 corresponds to the
model developed by Frey and his co-workers (see section 7.1). Substitution of (4.2)
into equation (4.1) gives the following (highly nonlinear) ODE
(a −r)u
z
+ rku −
σ
2
_
u
zz
+ (1 −2k)u
z
−k(1 −k)u
_
2
_
1 −
ˆ
λ
_
u
zz
+ (1 −2k)u
z
−k(1 −k)u
_
_
2
= 0. (4.3)
If k = 1 then equation (4.3) becomes the much simpler
(a −r)u
z
+ru −
σ
2
_
u
zz
−u
z
_
2
_
1 −
ˆ
λ(u
zz
−u
z
)
_
2
= 0, (4.4)
CHAPTER 4. FULL-FEEDBACK MODEL 89
and when k = 0 (corresponding to the Frey model) we have the (even simpler)
equation
(a −r)u
z

σ
2
_
u
zz
+u
z
_
2
_
1 −
ˆ
λ(u
zz
+u
z
)
_
2
= 0. (4.5)
Under the assumption of non-zero interest rates we can quite easily obtain a solution
to (4.5) by setting a = r. This leads to the ODE
u
zz
+u
z
= 0
which has the most general solution
u(z) = A−Be
−z
where A and B are constants to be determined by the boundary and payoff conditions.
After transforming back to the financial variables this gives
V (S, τ) = AS −Be
−rτ
which is indeed a valid solution of equation (4.1), however it does not satisfy any
practical boundary and payoff conditions. In addition Bordag and her co-workers
showed families of explicit solutions to equations (4.4) and (4.5) under the assumption
of zero interest rates (r = 0); for the k = 1 case see Bordag (2007) and for k = 0
see Bordag and Chmakova (2007) and Bordag and Frey (2007). However, all the
solutions found in this way correspond to differentiable payoff profiles, which differ
from the majority of the payoff profiles considered in the present thesis (which are
more financially relevant). However, these global solutions may be useful to test the
accuracy of numerical techniques applied to such highly nonlinear systems.
For the present model being studied, i.e. k = −1, equation (4.3) reduces to
(a −r)u
z
−ru −
σ
2
_
u
zz
+ 3u
z
+ 2u
_
2
_
1 −
ˆ
λ
_
u
zz
+ 3u
z
+ 2u
_
_
2
= 0,
which appears to have no analytic solution and so we are forced to turn to numerical
techniques. We can start to see already that singular behaviour is inherent in this
CHAPTER 4. FULL-FEEDBACK MODEL 90
highly nonlinear system by rearranging the above equation into a quadratic equation
in u
zz
, i.e.
_
ˆ
λ
2
ψ
_
u
2
zz
+
_
σ
2
2
−2
ˆ
λψ + 2
ˆ
λ
2
φψ
_
u
zz
+
_
σ
2
φ
2
+ψ −2
ˆ
λφψ +
ˆ
λ
2
φ
2
_
= 0
where φ = 3u
z
+ 2u and ψ = (r − a)u
z
− ru. If we solve this using the quadratic
formula we obtain
u
zz
=
1
ˆ
λ
−φ −
σ
2
4
ˆ
λ
2
ψ
_
_
1 ±
_
1 −
8
ˆ
λψ
σ
2
_1
2
_
_
,
from which it is clear that difficulties will occur if the square root were to become
negative. We shall return to this in section 4.6.
4.4 Perturbation expansions
Since it appears that no analytical solution can be found with the required boundary
conditions, we are forced to turn to numerical solutions. However it is possible to
find an approximate solution for small values of the parameter λ. This can be done
by exploiting the techniques of asymptotic expansions. First we re-write equation
(4.1) in the more convenient form
(1 −λV
SS
)
2
(V
τ
−rSV
S
+rV ) −
1
2
σ
2
S
2
V
SS
= 0. (4.6)
Now we expand V (S, τ) as follows
V (S, τ) = V
0
(S, τ) +λV
1
(S, τ) +λ
2
V
2
(S, τ) +. . .
where V
n
(S, τ) are functions to be found. Substituting this expansion into (4.6) and
collecting together terms of the same order in λ gives
3
O(λ
0
) : V


1
2
σ
2
S
2
V
0SS
−rSV
0S
+rV
0
= 0,
O(λ
1
) : V


1
2
σ
2
S
2
V
1SS
−rSV
1S
+rV
1
= 2V
0SS
(V

−rSV
0S
+rV
0
) ,
O(λ
2
) : V


1
2
σ
2
S
2
V
2SS
−rSV
2S
+rV
2
= 2V
0SS
(V

−rSV
1S
+rV
1
)
+
_
2V
1SS
−V
2
0SS
_
(V

−rSV
0S
+rV
0
) .
3
Note that a similar perturbation analysis is outlined in the appendix of Sch¨ onbucher and
Wilmott (2000).
CHAPTER 4. FULL-FEEDBACK MODEL 91
This reveals some structure in the successive approximations, the left-hand-side is
merely the Black-Scholes operator L
BS
acting on the n
th
approximation and the right
hand side is a function of the previous approximations (which have been found), i.e.
L
BS
V
0
= 0,
L
BS
V
1
= f
1
(V
0
),
L
BS
V
2
= f
2
(V
0
, V
1
),
.
.
.
L
BS
V
n
= f
n
(V
0
, V
1
, . . . , V
n−1
).
This recursive process is continued until the desired level of accuracy is required (al-
though in practise solving past the second correction term V
2
becomes too analytically
cumbersome or numerically expensive). However, it should be noted that in order to
permit a regular asymptotic expansion of the kind outlined above we must assume
sufficient regularity in the function V (S, τ), specifically we need the derivatives of
V (S, τ) to be bounded.
4
This cannot be guaranteed a priori and the unbounded
second derivative of the payoff profile suggests that we may not be able to apply such
a regular expansion in the region around any singular points. For more on singular
perturbations see Johnson (2004).
Figure 4.1 shows the first-order correction term V
1
(S, τ) to the price of a European
put option. These results indicate that (similar to first-order feedback in the regime
[V
SS
[ < 1/λ) the inclusion of market illiquidity increases the put option price. More-
over, it can be shown (see appendix A) that if we restrict ourselves to the regime
in which [V
SS
[ < 1/λ in the entire solution domain (corresponding to sufficiently
smooth payoff profiles) then the solution to equation (4.1) is monotonic increasing in
the liquidity parameter λ; this is in agreement with the result shown in figure 4.1.
4
See for example Johnson (2004).
CHAPTER 4. FULL-FEEDBACK MODEL 92
0
0.05
0.1
0.15
0.2
0.25
0.3
0.6 0.8 1 1.2 1.4
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
V
1
(
S
,
τ
)
S
τ increasing
Figure 4.1: The leading order correction term V
1
(S, τ) to the Black-Scholes (i.e.
λ = 0) European put option for various time to expiry. K = 1, r = 0.04, σ = 0.2,
T = 1 and τ = 0.1, 0.2, . . . , 1.
4.5 Numerical solutions
Consider next a numerical treatment of (4.1) with λ constant for simplicity, subject
to the put payoff condition (1.2). Figure 4.2 shows results obtained using a simi-
lar Crank-Nicolson scheme to that successfully employed on the first-order feedback
model, but of course, incorporating iteration in order to treat properly the inherent
nonlinearity in the problem. The results (for the delta) are clearly erroneous, even
though they were obtained with a relatively fine grid (time-step δτ of 10
−3
, grid-size
δS of 5 10
−4
); in addition, the output was found to be highly dependent on the
choice of grid. Note that this erroneous behaviour is not simply due to the well
documented ‘ringing’ behaviour associated with the Crank-Nicolson finite-difference
scheme (see Duffy, 2004).
This sort of difficulty is understandably sidestepped in published works (for specific
details see chapter 7) but a study of its causes will surely be helpful for the next
phase of modelling in the field. In fact there are two problematic issues with regard
to these difficulties, which are not unconnected. The first is linked to the inevitable
infinite behaviour of the gamma with standard payoff conditions, which even a cur-
sory inspection of (4.1) suggests will be problematic; this is considered below. The
CHAPTER 4. FULL-FEEDBACK MODEL 93
second difficulty (again revealed by a cursory inspection of (4.1)) is the likelihood of
difficulties if there is a zero in the denominator of the volatility term. A discussion of
this issue, which is associated with smoothed payoff functions, will be deferred until
chapter 5.
-1.5
-1
-0.5
0
0.5
1
1.5
0.96 0.98 1 1.02 1.04
PSfrag replacements

=

V

S
S
τ = 1
τ = .1
Figure 4.2: Deltas for full-feedback (European) put, K = 1, r = 0.04, σ = 0.2,
λ = 0.1 and T = 1.
4.6 Analysis close to expiry
As noted earlier, a thorough asymptotic analysis of the option valuation close to
maturity (τ →0) can yield significant insight into the dynamics of the problem, and
consequently this limit is studied next. For this we seek a local solution for the put
value of the form (which can be justified a posteriori )
V (S, τ) = −τ
1
2
ηH(−η) +τφ(η) +. . . (4.7)
where η is defined in (3.4). H() denotes the Heaviside function, which is necessary to
‘mimic’ the behaviour of the payoff, close to expiry. Consequently, we have a different
form for the valuation equation in two regions, one in S > K (above the strike) and
the other in S < K (below the strike). Thus, although the option value is assumed to
be continuous, clearly we are allowing for a discontinuous delta close to expiry at the
CHAPTER 4. FULL-FEEDBACK MODEL 94
exercise price. Indeed, we sought solutions with continuous deltas, without success,
and it is our assertion that such solutions do not exist for this problem. It should
be noted that the above indicates that the crucial regime is within a distance O(τ
1
2
)
of the exercise price as τ → 0 (a result determined through asymptotic analysis),
similar to the λ = 0 liquid options (as discussed in the previous section), which is
rather broader than the scale appropriate for the first-order feedback options (where
S −K = O(τ)).
In the region S > K (i.e. η > 0) the following equation describes φ:
φ −
η
2
φ
η

σ
2
K
2
φ
ηη
2 (1 −λφ
ηη
)
2
= 0, (4.8)
with φ →0 as η →∞. In the region S < K (i.e. η < 0) the appropriate equation is
φ −
η
2
φ
η

σ
2
K
2
φ
ηη
2 (1 −λφ
ηη
)
2
+rK = 0, (4.9)
with φ → −rK as η → −∞. At η = 0, smooth pasting (φ, φ
η
continuous) is
appropriate. Sample results for a put option are shown in figure 4.3 (obtained via a
straightforward Runge-Kutta fourth-order shooting method). These results indicate
that the option values all lie below the payoff
5
(the repercussions of this will be
discussed below). Note also the slower decay to the [η[ → ∞ asymptotes as the
volatility increases due to the O(σ
2
K
2
) scaling that emerges from (4.8) and (4.9) in
these limits.
It is helpful to shift φ as follows:
φ = φ


rK
2
,
which leads to the equation
φ


η
2
φ

η

σ
2
K
2
φ

ηη
2
_
1 −λφ

ηη
_
2
+
rK
2
[2H(−η) −1] = 0, (4.10)
which has the useful property of antisymmetry of φ

with respect to η = 0 (and so
φ


sgn(η)
2
rK as [η[ →∞). In addition, it enables us (with a little work) to deduce
5
Since from (4.7) and (3.4) it is evident that V (S, τ) −(K −S)
+
≡ τφ(η).
CHAPTER 4. FULL-FEEDBACK MODEL 95
the results for calls from the results for puts, namely
φ
C
(η) = φ
P
(−η) + rK, (4.11)
i.e., we can recover the local solution for calls from that of puts. Note that this
symmetry of the local solutions is simply a manifestation of the put-call parity rela-
tionship which still holds for all time, even in this highly nonlinear case (see section
4.1); provided that early exercise is not permitted. The standard Black-Scholes put-
call parity is given by
V
P
= V
C
−S +Ke
−r(T−t)
.
For the nonlinear problem, the chosen scaling for the inner region is given by
S = K +ητ
1
2
,
V
P
= −ητ
1
2
H(−η) +τφ
P
(η) +o(τ),
V
C
= ητ
1
2
H(η) +τφ
C
(−η) +o(τ),
e
−rτ
= 1 −rτ +o(τ).
Note that the scaling for a call was obtained by replacing η by −η in the put scaling.
Substitution thus gives, after a little rearranging
ητ
1
2
[1 −H(−η) −H(η)] +τ
_
φ
P
(η) −φ
C
(−η)
¸
= −rτK,
which reduces to
φ
C
(−η) = φ
P
(η) + rK,
which corresponds to the symmetry obtained for the inner equations, namely (4.11),
confirming put-call parity for the nonlinear case.
The key observation in the above is the discontinuity in the delta (∆ =
∂V
∂S
) at η = 0
as indicated in (4.7), and it is the neglect of this that is undoubtedly responsible for
the apparent spurious results observed in figure 4.2. Another point to be noted is
that figure 4.3 indicates the possibility of negative put options values, a somewhat
undesirable property (although (4.11) indicates this is not the case with calls).
CHAPTER 4. FULL-FEEDBACK MODEL 96
Before a consideration of the problem for calculations for non-small values of τ (i.e.
at times away from expiry), it turns out that yet another anomaly occurs, this time
in the limit as σ decreases (with other parameters held fixed). For values of σ just
below 0.15 (taking the other parameters used in figure 4.2), the numerical treatment
applied to (4.8) and (4.9) failed, with the onset of negative roots in the computation.
-0.04
-0.035
-0.03
-0.025
-0.02
-0.015
-0.01
-0.005
0
-0.6 -0.4 -0.2 0 0.2 0.4 0.6
PSfrag replacements
σ decreasing
η
φ
Figure 4.3: Local (τ → 0) solution of a full-feedback put, K = 1, λ = 0.1, r = 0.04
and σ = 1, 0.95, . . ., 0.15.
To understand this, we rewrite (4.8) and (4.9) in the form of a quadratic in φ
ηη
;

2
ψφ
2
ηη

_
4λψ +σ
2
K
2
_
φ
ηη
+ 2ψ = 0,
where ψ = φ −
η
2
φ
η
+ rKH(−η). Using the quadratic formula we can write the
‘solution’ for φ
ηη
as
φ
ηη
=
1
λ
+
σ
2
K
2

2
ψ
_
1 −
_
1 +
8λψ
σ
2
K
2
_1
2
_
,
where we have taken the negative root in order to satisfy the condition that φ
ηη
→0
as [η[ → ∞. Indeed, this is the form that was taken as the basis of the numerical
treatment used to treat the results shown in figure 4.3, and inspection of the results
indicated that difficulties arose if
1 +
8λψ
σ
2
K
2
< 0.
CHAPTER 4. FULL-FEEDBACK MODEL 97
Hence, we may expect this regime to arise for large values of the ratio λ/σ
2
K
2
, i.e.
for sufficiently large λ, or sufficiently small σ (since ψ must be an odd function about
η = 0, as evidenced by 4.10). We shall return to a consideration of this regime later
in section 4.7.1, which concerns itself with the full problem.
4.7 Numerical results - full problem
We now revisit the choice of parameters employed in figure 4.2, which led to the
aforementioned difficulties. The analysis in the previous section points to
6
a discon-
tinuity in the delta (∆) at the strike price (S = K) of +1 in the case of a put option.
In order to incorporate this into our numerics, an alternative strategy was adopted,
based on the Keller (1978) scheme. This modified procedure involved writing (4.1) as
a system of two first-order equations namely in V (S, τ) and V
1
(S, τ) = ∂V/∂S. The
grid was then chosen in such a manner that the strike price K coincided with the S
grid. At S = K two values of the option price and its delta were computed, namely
V

and V

1
(for S

= K) and V
+
and V
+
1
(for S
+
= K), such that V

= V
+
and
V
+
1
= V

1
−1. This latter condition effectively builds the proposed jump in the delta
at the strike price into the numerical scheme. In the time-wise direction, a standard
Crank-Nicolson-type scheme was adopted. Calculations performed in this manner
provided accurate and highly reliable results, as evidenced in figure 4.4, showing dis-
tributions of V (S, τ) − max(K − S, 0), i.e. the difference between the option value
and payoff, and as such can be compared directly with the small-time-to-maturity
solutions displayed in figure 4.3. Furthermore, figure 4.5 shows the corresponding
distributions of the delta (
∂V
∂S
), clearly indicating the jump in its value at S = K.
The computations shown are highly robust (i.e. grid independent), which adds sig-
nificant credence to the integrity of the results, in particular to the correctness of the
jump condition. These results also help to justify of the original form of the solution,
(4.7).
6
Since no inner solution with a continuous delta could be found.
CHAPTER 4. FULL-FEEDBACK MODEL 98
There is, however, a further issue relating to the results observed in figure 4.4, namely
that this indicates the put option value (close to expiry) is always less then the option
payoff. This has implications for the pricing of American options in this framework,
because if the European option value is always below the payoff immediately prior to
expiry then, by a simple backward induction argument, the corresponding American
option will always be exercised immediately when the contract is initiated at t = 0 (or
τ = T), i.e. the solution to the American put will trivially correspond to the payoff
for all time; this could also be regarded as a somewhat undesirable and unrealistic
feature of the model.
A corollary to the above remarks is that it can also be seen (from figure 4.4) that
the model permits negative values for put options. Whilst in certain extreme option
valuations, such as those involving storage costs, this may be acceptable, generally
this may be regarded as an unwanted facet of the model. It makes little financial
sense to allow negative option values in any model incorporating market frictions,
at least under the dynamic hedging (replication) pricing paradigm. For example, in
transaction cost models the writer would not re-hedge the portfolio (and hence incur
extra transaction costs) at times when he does not need to, provided the option is still
perfectly hedged. The same is true for liquidity, the price being modelled is the cost
of replicating the option by trading in the underlying. In doing this, we have freedom
in our hedging strategy, provided it perfectly replicates the option payoff. Essentially
the hedging strategy should never force the hedger into an irrational position. This
could be avoided in practise by imposing the condition V ≥ 0 which effectively creates
another free boundary on the PDE at S
b
where the conditions V (S
b
(τ), τ) = 0 and
∂V
∂S
(S
b
(τ), τ) = 0 should be applied. Note that Bakstein and Howison (2003) make a
similar observation and call this condition the ‘American’ constraint.
Figure 4.6 shows results (option value - payoff) for the corresponding call. This
clearly reveals that call values not only remain positive, but are also always above
the payoff and, hence, indicates that there is no value in early exercise.
CHAPTER 4. FULL-FEEDBACK MODEL 99
-0.04
-0.035
-0.03
-0.025
-0.02
-0.015
-0.01
-0.005
0
0 0.5 1 1.5 2
PSfrag replacements
V
-
p
a
y
o

S
τ = 1
τ = .1
Figure 4.4: Full feedback put, K = 1, r = 0.04, σ = 0.2 and λ = 0.1; modified
numerical scheme.
-1
-0.8
-0.6
-0.4
-0.2
0
0.2
0.96 0.98 1 1.02 1.04
PSfrag replacements

S
τ = 1
τ = .1
Figure 4.5: Full feedback put, K = 1, r = 0.04, σ = 0.2 and λ = 0.1; modified
numerical scheme.
4.7.1 A second solution regime
Returning now to the other regime outlined in section 4.6, i.e. when 1 +
8λψ
σ
2
K
2
< 0,
which turns out to be even more problematic, since here even the τ ¸ 1 regime is
unclear. It was therefore decided to mount an homotopy type of approach in this
regime, specifically by considering a payoff function of the form
V (S, 0) =
1
2
_
K −S +
_
(K −S)
2

2
_
(4.12)
CHAPTER 4. FULL-FEEDBACK MODEL 100
0
0.005
0.01
0.015
0.02
0.025
0.03
0.035
0.04
0 0.5 1 1.5 2
PSfrag replacements
V
-
p
a
y
o

S
τ = 1
τ = .1
Figure 4.6: Full feedback call, K = 1, r = 0.04, σ = 0.2 and λ = 0.1; modified
numerical scheme.
in conjunction with the full problem (4.1). In this way, it is possible to mimic a
standard put payoff as the smoothing parameter ρ →0.
In Frey and Stremme (1997) and Frey (1998) this smoothed payoff profile was used
to represent an ‘idealised’ option payoff, which represented a well-diversified portfo-
lio containing a multitude of different payoffs with different strikes which combine
to produce a sufficiently smooth payoff to satisfy the smoothness assumptions im-
posed for existence and uniqueness. Here its use is slightly different, it is merely a
mathematical tool to investigate the limit of smoothness. Results corresponding to
the parameter choice of figure 4.4, but instead with σ = 0.1 and at a time shortly
before expiry (τ = 0.1) and for three choices of ρ are shown in figure 4.7. These
results were based on the method employed for figure 4.2, but were tested extensively
for numerical grid convergence and found to be numerically consistent on the scale
shown.
These calculations strongly indicate that in the limit as ρ → 0, the solution for the
put takes the trivial form:
V (S, τ) =
_
_
_
0 for S > K,
Ke
−rτ
−S for S < K,
(4.13)
CHAPTER 4. FULL-FEEDBACK MODEL 101
-0.0004
-0.0003
-0.0002
-0.0001
0
1e-04
0.0002
0.0003
0.0004
0.96 0.98 1 1.02 1.04
PSfrag replacements
ρ = .0005
ρ = .001
ρ = .00025
S
V
-
p
a
y
o

Figure 4.7: Full feedback put, smoothed payoff, K = 1, r = 0.04, σ = 0.1, λ = 0.1
and τ = 0.01.
for all time, solutions which do (trivially) satisfy (4.1).
Note that this form of solution indicates discontinuous option values (compare the
small volatility analysis of Widdicks et al., 2005; Duck et al., 2008). Here the diffusion
term effectively eliminates itself completely and the discontinuity at S = K and τ = 0
cannot propagate away from this point for τ > 0 since there is no diffusion. Note also
that (4.13) indicates that American options in this regime will always be exercised
immediately (at t = 0), for the same reasons expounded earlier for the other regime.
One interpretation of the above results is that the effect of the nonlinearity, for
standard (non-smooth) payoff profiles, is to suppress the diffusion term of the equation
in regions of non-smoothness, thereby failing to smooth out any discontinuities in the
derivative of the payoff profile, as would normally be the case with the Black-Scholes
equation.
The following chapter investigates another breakdown of the nonlinear PDE, (4.1),
which occurs for smoothed payoff profiles. Such a breakdown can be seen to be a
direct result of the singular nature of the diffusion coefficient in the the governing
equation.
Chapter 5
Smoothed Payoffs - Another
Breakdown
The difficulties encountered in the previous chapter have been, so far, attributed
to the discontinuous delta (i.e. infinite gamma) of the payoff profile. If we instead
assume smoothness in the payoff (i.e. finite gamma), it can be seen that there is the
potential for further difficulties to arise due to the vanishing of the denominator in
(4.1), i.e. when
1
V
SS
=
1
λ
. (5.1)
Firstly, note that for standard put and call payoff profiles, condition (5.1) must always
be satisfied somewhere in the domain T ⊆ R
+
[0, T]; since the solution must pass
from V
SS
= ∞ at (K, 0) to V
SS
→ 0 as τ → ∞. Secondly, note that for sufficiently
smooth payoff profiles, condition (5.1) may never be satisfied in the solution domain.
To illustrate the circumstances under which we should expect such singular behaviour,
we will once again consider the smoothed payoff profile
V (S, 0) =
1
2
_
K −S +
_
(K −S)
2

2
_
(5.2)
where ρ ≥ 0. This function is smooth, but in the limit as ρ → 0 recovers the
discontinuous payoff profile of a put option. One can consider this as parameterising
1
Note that for simplicity here λ is a constant but can be generalised in what follows.
102
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 103
the smoothness of the payoff profile by ρ, with the limit ρ → 0 representing highly
non-smooth functions (in the sense of very large second derivatives in the region of the
strike) and conversely the limit ρ → ∞ representing increasingly smooth functions
(small second derivatives).
If we wish to prevent the denominator from vanishing then this can be seen as placing
a restriction on the size of the liquidity function λ(S, τ), i.e. we must have
λ(S, τ) ≤ sup
(S,τ)∈D
_
1
V
SS
_
,
or alternatively as placing a restriction on the payoff profile, i.e.
sup
(S,τ)∈D
¦V
SS
¦ ≤
1
λ(S, τ)
.
For the analysis in the remainder of this chapter λ(S, τ) will be considered constant
for simplicity.
Furthermore it can be shown, via a judicious application of the maximum principle,
outlined in appendix A, that the maximum of the second S-derivative of the solution
in the entire domain will coincide with the maximum at τ = 0, in other words,
sup
(S,τ)∈D
¦V
SS
¦ = sup
(S,τ)∈D
0
¦V
SS
¦ ,
where T
0
= R
+
¦0¦. In fact it is intuitively clear from the diffusive nature of
equation (4.1) for increasing τ that this should be so. With this in mind the crucial
property in determining the existence of singular behaviour will be the maximum of
the second derivative of the solution at τ = 0, i.e. the payoff profile. Returning to
the smoothed payoff profile (5.2) direct computation gives
V
S
(S, 0) = −
1
2
_
1 +
(K −S)
_
(K −S)
2

2
_
, (5.3a)
V
SS
(S, 0) =
ρ
2
2
_
(K −S)
2

2
_3
2
, (5.3b)
V
SSS
(S, 0) =

2
(K −S)
2
_
(K −S)
2

2
_5
2
, (5.3c)
V
SSSS
(S, 0) =

2
2
_
_
4(K −S)
2
−ρ
2
_
(K −S)
2

2
_7
2
_
_
. (5.3d)
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 104
The maximum of V
SS
(S, 0) is determined by setting V
SSS
(S, 0) = 0, which yields
(obviously) that the maximum occurs at S = K. To check that this is indeed a
maximum of V
SS
(S, 0) we can see that
V
SSSS
(K, 0) =
−3

3
≤ 0
since ρ ≥ 0 by definition. Therefore the maximum of the second derivative of the
payoff profile is given by
sup
D
0
¦V
SS
¦ = V
SS
(K, 0) =
1

,
and we can exclude the denominator from vanishing if we place the restriction that
λ ≤ 2ρ, (5.4)
from which it can be seen that the smoother the payoff profile the more liquidity the
model can handle. Also a corollary to this result is that if we have a payoff profile
with a discontinuous first derivative (delta), which includes the majority of the payoff
profiles used in practise, then to restrict the denominator from vanishing it is required
to set λ = 0 and so this model cannot treat non-smooth payoff profiles.
Condition (5.4) may seem rather restrictive and indeed it is when considering standard
put and call payoff profiles. In what follows we shall assume smooth payoff profiles
and investigate the nature of the singularities that arise if this restriction is not
imposed, i.e. when we are in the regime that λ > 2ρ.
It should be noted at this stage that the results for existence and uniqueness of a
replicating portfolio provided by Frey (1998) only apply when the denominator is not
allowed to vanish (here we impose no such restriction). It should also be mentioned
that problems associated with the vanishing of the denominator have been highlighted
previously in the literature, but that this regime has deliberately been avoided. For
example Sircar and Papanicolaou (1998) set the option value to be the Black-Scholes
price a small time prior to expiry, where is determined to be sufficiently large
such that the denominator in the diffusion term is always positive - see section 7.3.
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 105
In addition Lipton (2001) states that to avoid any undesirable behaviour of the the
option prices we have to limit the magnitude of the local volatility from above and
from below, although he gives no suggestions about how to do this. Along the same
lines Frey and Patie (2002) modify the diffusion term of the equation in an ad hoc
manner, more specifically they set
ˆ σ(S, τ) = max
_
δ
0
,
σS
1 −min ¦δ
1
, λV
SS
¦
_
for sufficiently large δ
0
and sufficiently small δ
1
. This is done in order to bypass
any problems associated with the limits σ → 0 or σ → ∞, hence ensuring the
denominator is nonzero and that the denominator does not become too large to
‘annihilate’ the diffusion term. Finally Liu and Yong (2005) suggest a form of the
liquidity function λ(S, τ) that is hoped to suppress such singular behaviour, this has
the effect of fundamentally changing the option price dynamics close to expiry, see
section 7.5. Here we make no such modifications and attempt to fully investigate the
nature of these singularities.
We can expect singular behaviour of (4.1) when the singularity condition (5.1) is
satisfied. For the smooth payoff profile (5.2) we can calculate the explicit locations
of any singularities (denoted S
0
) at τ = 0 by equating the second derivative (5.3b)
to 1/λ. Doing so yields
S
0
= K ±
¸
_
λρ
2
2
_2
3
−ρ
2
.
Hence for the payoff (5.2) there are two singularities, each equally spaced either side of
the strike K. Note that the solutions at τ = 0 are not themselves singular, but what
remains is to determine if and how singularities propagate through the solution for
τ > 0. To solve the full equation (4.1) near these singular points will be particularly
difficult, both analytically and numerically, due to the inherent singular behaviour.
Instead a local similarity solution is to be attempted which reduces the PDE (4.1)
to a simpler ODE valid locally in the region close to the singularity. This analysis is
outlined in the next section.
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 106
5.1 Local analysis about the singularities
We consider a general form of payoff profile, which we have determined to have an
isolated singularity in the payoff profile at S = S
0
; isolated in the sense that there are
no other singularities in the vicinity of S
0
.
2
A local expansion for small τ is sought
about the point where the equation becomes singular, i.e. where V
SS
= 1/λ. Since
we are assuming a smooth payoff profile, the solution in the vicinity of the singular
point S
0
must be analytic (at least for τ = 0) and so can be expressed in the form of
a Taylor series about S = S
0
, i.e.
V (S, 0) = V (S
0
, 0)+(S−S
0
)V
S
(S
0
, 0)+
(S −S
0
)
2
2
V
SS
(S
0
, 0)+
(S −S
0
)
3
6
V
SSS
(S
0
, 0)+. . . .
(5.5)
In addition, to remain close to the singular point at τ = 0 we also require that
V
SS
(S
0
, 0) =
1
λ
.
Next we seek a similarity solution for small τ of the form
V (S, τ) = V (S, 0) +τ
β
ˆ
V (η), (5.6)
with
η =
S −S
0
τ
α
,
where α and β are to be determined from the appropriate balancing of terms and
asymptotic matching (cf. section 3.1). Combining the Taylor series about S
0
(5.5)
and the small τ expansion (5.6) we therefore seek a similarity solution in the vicinity
of the singularity of the form
V (S, τ) = V
0

α
ηV
1


η
2


β
ˆ
V (η) +. . . , (5.7)
where V
0
= V (S
0
, 0) and V
1
= V
S
(S
0
, 0); both of which are assumed to be known,
given the form of the payoff profile. Direct substitution of (5.7) into (4.1) gives
τ
β−1
_
β
ˆ
V −αη
ˆ
V
η
_

σ
2
S
2
0
_
λ
−1

β−2α
ˆ
V
ηη
_

2
τ
2β−4α ˆ
V
2
ηη
−rS
0
_
V
1
+
τ
α
η
λ

β−α
ˆ
V
ηη
_
+r
_
V
0

α
ηV
1
+
τ

η
2


β
ˆ
V
_
= 0.
(5.8)
2
Note that for the case of the put or call payoff profile (i.e. ρ = 0) then the two singularities will
coincide, at the strike price, and so can not be thought of as isolated anymore and the following
analysis will not be appropriate.
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 107
To balance the diffusion term and the time derivative term in (5.8) it is clear that we
require
β −1 = 4α −2β ⇒ 3β −4α = 1. (5.9)
To fix the values of α and β, the matching of the inner and outer solution is used.
To be consistent, the form of the solution in the vicinity of the singularity (5.7) in
the limit as [η[ →∞ (i.e. as τ →0) must match with the Taylor series expansion of
the solution at τ = 0, i.e. (5.5). Hence
lim
|η|→∞
_
V
0

α
ηV
1


η
2


β
ˆ
V (η) +. . .
_
= V
0
+(S−S
0
)V
1
+
(S −S
0
)
2

+
(S −S
0
)
3
6
V
3
+. . . ,
where we have defined V
i
=

i
V
∂S
i
(S
0
, 0). Since the first three terms on both sides are
identical (by construction) this reduces to
lim
|η|→∞
_
τ
β
ˆ
V (η) +. . .
_
=
(S −S
0
)
3
6
V
3
+. . .
⇒ lim
|η|→∞
_
τ
β
ˆ
V (η)
_
=
τ

η
3
6
V
3
+. . . .
For a non-trivial inner solution
ˆ
V (η) we require that
ˆ
V = O(1) as τ →0, this forces
us to set
β = 3α. (5.10)
Note that the above matching procedure has also provided us with the appropriate
boundary conditions (for large η) of the inner solution, i.e. that
ˆ
V (η) →
η
3
V
3
6
as [η[ →∞. (5.11)
Substituting (5.10) into (5.9) we find that
α =
1
5
, β =
3
5
,
hence the appropriate form of the solution to try around the singularity is given by
V (S, τ) = V
0

1
5
ηV
1

2
5
η
2


3
5
ˆ
V (η) +. . . ,
which after substitution into (4.1) and evaluating in the limit τ →0 yields
3
ˆ
V −η
ˆ
V
η


2
S
2
0

3 ˆ
V
2
ηη
= 0. (5.12)
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 108
Before attempting to solve (5.12) given the appropriate boundary conditions (5.11),
we first look a little closer at the matching procedure performed above and the rele-
vant boundary conditions that arise.
5.1.1 Asymptotic matching
Let us look again more closely at the boundary conditions (5.11) that were derived
from an asymptotic matching procedure. We can see that (5.11) is not a solution of
the inner equation (5.12), rather it is only the leading order term in the asymptotic
matching procedure, which must contain higher order matching terms. We can de-
termine the next order correction by seeking a solution to the inner equation (5.12)
of the algebraic form
ˆ
V (η) =
η
3
V
3
6
+Aη
γ
, (5.13)
where A and γ are constants to be found. Note that the second term is a higher order
correction as [η[ →∞ iff γ < 3. Substitution into (5.12) gives
(3 −γ)Aη
γ


2
S
2
0

3
_
ηV
3
+γ(γ −1)Aη
γ−2
_
2
= 0.
Since we are interested in the solution as [η[ →∞ we can approximate the denomi-
nator as follows
(3 −γ)Aη
γ


2
S
2
0

3
η
2
V
2
3
_
1 +
γ(γ−1)A
V
3
η
γ−3
_
2
= 0,
⇒(3 −γ)Aη
γ


2
S
2
0

3
η
2
V
2
3
_
1 −
2γ(γ −1)A
V
3
η
γ−3
+. . .
_
= 0.
Hence in the limit [η[ →∞ we must have γ = −2, which leads to the equation
_
5A−

2
S
2
0

3
V
2
3
_
1
η
2
= 0(η
−5
),
therefore we have that the constant A must be given by
A =
σ
2
S
2
0

3
V
2
3
.
It is clear that we have an infinite asymptotic series solution as [η[ → ∞ with each
subsequent term corresponding to a higher-order term in the Taylor series expansion
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 109
of the outer solution. It appears that the inner solution is a power series in η starting
from η
3
and decreasing by powers of five; these further terms can be determined
by performing the same procedure adopted above. To summarise, the matching
condition (5.11) is modified to
ˆ
V (η) =
η
3
V
3
6
+
σ
2
S
2
0

3
V
2
3
η
2
+O(η
−7
) as [η[ →∞. (5.14)
The significance of the extra term can be seen if we transform the large η behaviour
(5.14) back to the outer variables. Doing so we have that
ˆ
V (η) =
V
3
(S −S
0
)
3

3
5
+
σ
2
S
2
0
τ
2
5

3
V
2
3
(S −S
0
)
2
+O
_
τ
7
5
(S −S
0
)
−7
_
,
and the form of the similarity solution (5.7) in terms of the outer variable is given by
V (S, τ) =V
0
+ (S −S
0
)V
1
+
1

(S −S
0
)
2
+
V
3
6
(S −S
0
)
3
+
τσ
2
S
2
0

3
V
2
3
(S −S
0
)
2
+O
_
τ
2
(S −S
0
)
−7
_
.
(5.15)
This shows that the matching procedure results in integer powers of τ, suggesting
strongly that the scaling used is the correct scaling for this problem.
One final point to note is that the sign of V
3
may affect the qualitative behaviour of
the solution. V
3
is identified as the third derivative of the payoff profile evaluated at
the location of the singularity. Returning to the smoothed payoff for a moment we
can see with a little work that
V
3
= ∓

2
2
_
2
λρ
2
_5
3
¸
_
λρ
2
2
_2
3
−ρ
2
,
which shows that V
3
can be either positive or negative depending on which of the two
singularities we are seeking a local expansion near.
Now that we have the corrected boundary conditions (5.14) to the inner equation
(5.12) we can attempt to solve this nonlinear system, which is the focus of the next
section.
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 110
5.1.2 Properties of the inner solution
For simplicity we shall rewrite the inner equation (5.12) as
ˆ
V
2
ηη
_
3
ˆ
V −η
ˆ
V
η
_
= κ (5.16)
where κ =

2
S
2
0

3
. The first point to note is that κ can be scaled out of the problem
by setting
ˆ
V = κ
1
3
ˆ
V , however this scaling would then place the constant κ into the
boundary conditions (5.14). If we are a little more sophisticated we could perform
the transformation
ˆ
V = κ
3
5
ˆ
V ,
η = κ
1
5
η,
which would remove the constant from the equation and also from the leading term
of the boundary condition, however it would not be removed completely from the
boundary condition and consequently we shall not make any such scalings.
It is also noted that an exact solution of the ODE (5.16) exists. Trying a solution of
the form
ˆ
V (η) = Bη
χ
where B and χ are constants, leads to χ = 4/3 and to the exact solution
ˆ
V (η) =
_
243κ
80
_1
3
η
4
3
=
_
3
2
_5
3
(σS
0
)
2
3
λ
η
4
3
. (5.17)
However this clearly does not satisfy the matching condition (5.14), i.e. η
3
leading-
order behaviour as [η[ →∞. Therefore in order to obtain a solution with the required
boundary conditions we must turn to numerical techniques, such as shooting or finite
difference methods.
Unfortunately, numerical solutions of (5.16) with the boundary conditions above
proved fruitless; shooting methods floundered and finite-difference schemes failed to
converge. The previous statement suggests that a solution to equation (5.16) subject
to the boundary conditions (5.14) may not exist. The remainder of this chapter
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 111
attempts to prove that this is, in fact, the case. An investigation of the phase portrait
of equation (5.16) using phase-plane analysis can provide us with such a proof and
also give us invaluable insight into the qualitative behaviour of the solutions to (5.16).
This analysis will be outlined in the following subsection.
5.1.3 Introduction to phase-plane analysis
A useful tool for the study of differential equations, especially if they are in two
dimensions, is the so-called phase portrait. Below we shall attempt to provide a
brief overview of the main properties of such phase portraits. For a more detailed
introduction see for example Jordan and Smith (1999) or Hirsch and Smale (1974)
and the references therein. Any general second order (autonomous) ODE of the form
u
xx
= g(u, u
x
)
can be expressed as two coupled first order ODEs by defining the new variable
v := u
x
,
hence
_
_
_
u
x
= v,
v
x
= g(u, v).
More generally we can have
u
x
= f(u, v), (5.18a)
v
x
= g(u, v). (5.18b)
The emphasis of phase portraits is on the general qualitative properties of differential
equations and their solutions rather than finding a closed form solution. This indeed
becomes extremely useful when such systems have no such closed form solutions.
Eliminating the x variable in (5.18) gives the following
dv
du
=
g(u, v)
f(u, v)
,
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 112
where the variables u and v provide the axes for the phase portrait. This derivative
represents the field direction in the phase portrait. The only problem that can arise
is if we ever have f(u, v) = g(u, v) = 0, since at these points the equation becomes
singular and nothing can be said about the direction of the field at these points.
One might assume that a zero in the denominator, i.e. f(u, v) = 0 alone would cause
problems, however in this case we could simply shift the axis and consider
du
dv
=
f(u, v)
g(u, v)
,
which would give zero gradient in the (v, u) plane, which corresponds to a vertical
slope in the (u, v) plane.
The points where f(u, v) = g(u, v) = 0 are identified as fixed points (also called
equilibrium or stationary points) of the system, so called because if a solution starts
at (or reaches) a fixed point, then it remains at that point for all x since here u
x
=
u
xx
= 0. In addition, phase paths cannot normally intersect, if they do then this
would contradict uniqueness. In fact the only place where phase paths can intersect
is when either f(u, v) or g(u, v) are singular, which includes the fixed points.
If we assume a linear system of the form
u
x
= au +bv,
v
x
= cu +dv,
which can be better represented in matrix form as
_
_
u
v
_
_
x
=
_
_
a b
c d
_
_
_
_
u
v
_
_
,
or more concisely
u
x
= A.u, (5.19)
then the only possible fixed point of such systems are at u = v = 0. It can be shown
that the nature (and stability) of the fixed point is determined by the solution of the
linear system (5.19) and, as it transpires, the determinant of the coefficient matrix
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 113
A. As an example, if we have a linear homogeneous system of the form (5.19) with
the eigenvalues of A given by ω
1,2
= α
1,2
+iβ
1,2
, then the general solution is given by
_
_
_
u(x) = u
0
e
α
1
x
(cos β
1
x +i sin β
1
x),
v(x) = v
0
e
α
2
x
(cos β
2
x +i sin β
2
x).
Three qualitatively different classes of fixed points can be identified, namely nodes,
spirals and saddle points, which are entirely determined by the values of α
1,2
and β
1,2
.
Nodes If β
1,2
= 0, i.e. the eigenvalues are real and if both α
1,2
have the same sign
then we have a nodal fixed point. Furthermore if α
1,2
< 0 we have an stable
node (sink) since in the limit x → ∞ the solution will tend to the fixed point
and if α
1,2
> 0 then we have a unstable node (source) since the solution will
move away from the fixed point as x →∞.
Saddle Points If again β
1,2
= 0, i.e. real eigenvalues and α
1
and α
2
have opposite
sign then such a situation corresponds to a saddle point. A saddle point is stable
along one direction (corresponding to the eigenvector of the negative eigenvalue)
and unstable along another (corresponding to the positive eigenvalue)
Spirals If β
1,2
,= 0 we have a complex conjugate pair of eigenvalues, i.e. α
1
= α
2
= α
and β
1
= −β
2
= β. In this case we have a spiral fixed point, so-called because,
due to the periodic functions (sin and cos) in the solution, the solutions will
spiral into or out of these fixed points. Furthermore if α < 0 then we have a
stable spiral (sink) and if α > 0 at unstable spiral (source).
In addition if β
1,2
,= 0 but α
1,2
= 0 then the solutions become periodic but the
trajectories are closed, in this case the fixed point is called a centre.
For a nonlinear system, however, the structure of the phase portrait is not obvious,
since there can be multiple fixed points which may interact. However it can be
shown
3
that provided the system is structurally stable, then matters are nearly as
simple as in the linear case outlined above. When considering a nonlinear system,
3
See for example Peixoto (1997).
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 114
multiple singularities can exist (but only a finite number), the combination of which
entirely determines the qualitative behaviour of the ODE and its solutions. Moreover
each singularity (fixed point) is of the same elementary type as for linear systems
(e.g. nodes, spirals and saddles) and in this case linear stability implies non-linear
stability (provided none of the eigenvalues have zero real parts, i.e. a centre).
For nonlinear systems, however, there is the additional possibility of so-called limit
cycles in the phase portrait. These are fixed orbits that attract (or repel) nearby
paths and correspond to fixed oscillatory solutions of the ODE. Furthermore, where
the nonlinear system is dependent on some parameter, the solution could undergo bi-
furcations at critical values of the parameter, where the number of solutions increases
or decrease. Fortunately, however, the nonlinear system (5.16) does not exhibit such
nonlinear behaviour and so this will not be discussed further.
Consider the nonlinear system (5.16), the observant reader may have noticed that
this equation is not of the autonomous type (since the independent variable η appear
explicitly in the equation) and so will not have a two dimensional phase portrait.
However it turns out that we can produce an autonomous system by making an
appropriate transformation, which will be outlined in the following subsection.
5.1.4 Deriving an autonomous system
Equation (5.16) can be made autonomous. Firstly we make the variable transforma-
tion
η = ±e
x
. (5.20)
Immediately we can see that the choice of the positive sign corresponds to a mapping
from x ∈ (−∞, ∞) to η ∈ (0, ∞) and the negative sign corresponds to the negative
semi-infinite plane in η. Hence we are effectively making two separate transformations
on two different Riemann surfaces. Substituting (5.20) into (5.16) yields (for both
transformations)
(V
xx
−V
x
)
2
(3V −V
x
) = κe
4x
,
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 115
and further making the transformation
V = e
µx
u(x),
gives (after substitution)
_
µ(µ −1)u + (2µ −1)u
x
+u
xx
_
2
_
(3 −µ)u −u
x
_
e
3µx
= κe
4x
,
from which it is clear that the equation will become autonomous if we set µ =
4
3
,
resulting in
_
4
9
u +
5
3
u
x
+u
xx
_
2
_
5
3
u −u
x
_
= κ,
where x = ln η and u = e

4x
3
V . This can be rearranged to make u
xx
the argument,
i.e.
u
xx
= −
4
9
u −
5
3
u
x
±
_
κ
5
3
u −u
x
.
As outlined in the previous section, this second order ODE can be expressed as a
system of coupled first order equations. Setting v = u
x
we arrive at the coupled
system
_
_
u
v
_
_
x
=
_
_
_
v

4
9
u −
5
3
v ±
_
κ
5
3
u−v
_
_
_
, (5.21)
from which we can eliminate the independent variable x to produce the equation for
the field lines of the phase portrait, i.e.
dv
du
= −
4u
9v

5
3
±
1
v
_
κ
5
3
u −v
. (5.22)
Consistent with standard phase-plane theory, the behaviour of this nonlinear system
is entirely determined by the location and behaviour of its fixed points, i.e. the
points where u
x
= u
xx
= 0; for further details see for example Peixoto (1997). These
points correspond to the singular points of (5.22), where the field direction cannot
be determined. The nature and stability of the fixed point can be determined by
investigating the linearised system in the vicinity of the fixed point. The next section
outlines the linearisation procedure and the classification of the fixed points in more
detail. However before proceeding we note that a further simplification can be made
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 116
to the system (5.21), the parameter κ can be scaled out of the equation entirely by
another appropriate transformation. If we seek a solution of the form
u = κ
α
1
ˆ u, (5.23a)
v = κ
α
2
ˆ v, (5.23b)
then it can be shown that the equation in (ˆ u, ˆ v)-space will be independent of the
parameter κ, if we choose
α
1
= α
2
=
1
3
.
Hence for all intents and purposes we can set κ = 1 in the original system (5.21) and
we recover the correctly scaled solution via the transformation (5.23).
Now that we have our autonomous system in the simplest possible form we can begin
to investigate the structure of the phase plane. Recall that the phase plane’s structure
is entirely determined by the location and nature of its fixed points, hence the aim of
the next section is to find and classify the fixed points of the nonlinear system (5.21).
5.1.5 Behaviour of the fixed points
We wish to find and classify the fixed points of the system
u
x
= f(u, v) = v,
v
x
= g(u, v) = −
4
9
u −
5
3
v +
1
_
5
3
u −v
,
(5.24)
where we have dropped the hats for simplicity of notation. The fixed points are
defined by f(u
0
, v
0
) = g(u
0
, v
0
) = 0 and so it can be seen from (5.24) that the fixed
points correspond to v
0
= 0 with u
0
the solution of the following equation
4
u
3
0
=
243
80
.
4
Note that if we were to take the negative squareroot of the equation then the fixed point equation
becomes

4u
9

3
5u
= 0,
which only has two solutions, both of which are complex, i.e.
u =

243
80
1
3
e
±
2iπ
3
.
Hence the positive root seems the correct choice.
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 117
Obviously this has three roots, one real and a complex conjugate pair. They are
u
01
=
_
243
80
_1
3
, (5.25a)
u
02
=
_
243
80
_1
3
e
2iπ
3
, (5.25b)
u
03
=
_
243
80
_1
3
e

2iπ
3
. (5.25c)
Interestingly, the real part of the fixed points above in (u, v)-space corresponds to the
exact solution of (5.12) in (V, η)-space, namely (5.17); however recall that this solu-
tion does not satisfy the required boundary conditions (5.14). In order to determine
the nature of these fixed points, we need to undertake analysis in the local neigh-
bourhood of the fixed point, and this can be performed by linearising the nonlinear
equation around these points, by setting
u = u
0
+¯ u, (5.26a)
v = v
0
+¯ v, (5.26b)
where is a small parameter (corresponding to a small perturbation) and performing
a Taylor series expansion on the functions f(u, v) and g(u, v) about the fixed points
(u
0
, v
0
) which gives
f(u, v) = f(u
0
+¯ u, v
0
+¯ v) = f(u
0
, v
0
) +¯ u
∂f
∂u
(u
0
, v
0
) +¯ v
∂f
∂v
(u
0
, v
0
) +o(),
g(u, v) = g(u
0
+¯ u, v
0
+¯ v) = g(u
0
, v
0
) +¯ u
∂g
∂u
(u
0
, v
0
) +¯ v
∂g
∂v
(u
0
, v
0
) +o().
Hence the system becomes
_
_
u
0
+¯ u
v
0
+¯ v
_
_
x
=
_
_
f(u
0
, v
0
) +¯ u
∂f
∂u
(u
0
, v
0
) +¯ v
∂f
∂v
(u
0
, v
0
) +o()
g(u
0
, v
0
) +¯ u
∂g
∂u
(u
0
, v
0
) +¯ v
∂g
∂v
(u
0
, v
0
) +o()
_
_
,
_
_
u
0
v
0
_
_
x
+
_
_
¯ u
¯ v
_
_
x
=
_
_
f(u
0
, v
0
)
g(u
0
, v
0
)
_
_
+
_
_
∂f
∂u
(u
0
, v
0
)
∂f
∂v
(u
0
, v
0
)
∂g
∂u
(u
0
, v
0
)
∂g
∂v
(u
0
, v
0
)
_
_
_
_
¯ u
¯ v
_
_
+o().
The first term in the above equation disappears as it is a derivative of a constant
(fixed point). In addition the other O(1) term also disappears as it is the functions
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 118
f and g evaluated at the fixed points which by definition is equal to zero. This leads
to the following linear system for (¯ u, ¯ v),
_
_
¯ u
¯ v
_
_
x
=
_
_
∂f
∂u
(u
0
, v
0
)
∂f
∂v
(u
0
, v
0
)
∂g
∂u
(u
0
, v
0
)
∂g
∂v
(u
0
, v
0
)
_
_
_
_
¯ u
¯ v
_
_
.
The linearisation performed here does not always work however; the long term be-
haviour of the linearised system near a fixed point can differ qualitatively from the
long term behaviour near a fixed point of the fully nonlinear system. Fortunately
however there are only two situations where this can occur. One is when the fixed
point of the linearised system is a centre and the other when the linearised system
has zero as an eigenvalue. In all other cases the local picture of the nonlinear system
near a fixed point looks like its linearisation. For the nonlinear system (5.24) we have
∂f
∂u
= 0,
∂f
∂v
= 1,
∂g
∂u
= −
4
9

5
6
_
5
3
u −v
_

3
2
,
∂g
∂v
= −
5
3
+
1
2
_
5
3
u −v
_

3
2
.
We now evaluate these derivatives at each fixed point in turn. Considering first u
01
,
at this point, the system becomes
_
_
¯ u
¯ v
_
_
x
=
_
_
0 1

2
3

23
15
_
_
_
_
¯ u
¯ v
_
_
.
The behaviour of this linear system is determined by its eigenvalues, which are de-
termined by the solution to the following characteristic equation
det
_
_
0 −ω 1

2
3

23
15
−ω
_
_
= 0,
which has two (complex) solutions
ω
1,2
=
1
30
_
−23 ±i

71
_
. (5.28)
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 119
Systems with complex eigenvalues correspond to spiral node fixed points and since
the real part of the eigenvalue is negative (see section 5.1.3) we have a stable fixed
point, usually called a spiral sink.
Next consider the fixed point u
02
, at this point the local linear system corresponds to
_
_
¯ u
¯ v
_
_
x
=
_
_
0 1

2
9

9
5
_
_
_
_
¯ u
¯ v
_
_
which has two real, negative eigenvalues
ω
1
= −
2
15
, (5.29a)
ω
2
= −
5
3
. (5.29b)
It also turns out that the final fixed point u
03
has the same linearised system as above
and so the same eigenvalues. Recall that two negative real eigenvalues correspond
to a stable node. However since these fixed points are in the complex domain we are
strictly required to perform a full (four-dimensional) complex stability analysis about
these fixed points (i.e. in the complex domain) to fully determine their behaviour.
However since we are only really interested in real solutions to the nonlinear system
(5.24) the two complex fixed points can be omitted from our analysis. To conclude
we have determined that the (real) fixed point is a (stable) spiral sink.
Figure 5.1 shows the phase portrait of the the autonomous system (5.24) (with κ
scaled out of the problem completely). The results were obtained using MATLAB and
the pplane ODE software package
5
which employed the Dormand-Prince modification
to the standard Runge-Kutta shooting technique, (cf. Dormand and Prince, 1980).
The important point to note is that in the absence of any other fixed points, every
path (each corresponding to a different boundary condition) passes through this fixed
point. What this implies for the solution of (5.12) subject to the boundary condition
(5.14) is that it too must pass through this fixed point, and so will be unable to
satisfy the boundary conditions as η → ∞ and η → −∞. Further, assume that we
5
Copyright John C. Polking. For more information see http://math.rice.edu/∼dfield/.
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 120
-8
-6
-4
-2
0
2
4
6
8
0 2 4 6 8 10
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
u
v
Complex Region
Figure 5.1: Phase portrait of the autonomous system (5.24). Note the fixed point at
u =
_
243
80
_1
3
, v = 0 and the field direction lines. The dotted line represents an analytic
envelope for the phase portrait close to the singular line v =
5u
3
, cf. equation (5.31).
have obtained the solution for η ∈ (−∞, 0) and ‘jumped’ to the current phase plane.
Solving from η = 0 corresponds to shooting in the current phase plane (Riemann
surface) from x = −∞. This path (like all paths) must pass through the fixed point
and by definition it must remain there for all x as x →∞, corresponding to η →∞.
However, since the solution at the fixed point is fixed as η → ∞, and in fact takes
the form V ∼ η
4
3
(i.e. (5.17)), we have no hope of satisfying the boundary condition
(5.14) as η →∞.
Before we can conclude that no smooth solution to the ODE (5.12) exists (and hence
no smooth inner solution about the point S
0
) satisfying the boundary condition (5.14),
we must first check that all fixed points of the system have been found and indeed
that every path must pass through the fixed point we have previously found. The
following subsection investigates the structure of the phase plane in yet more detail.
5.1.6 Structure of the phase portrait
Firstly it is clear that the equation (5.24) only has real solutions for
5u
3
−v > 0,
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 121
hence the line v =
5u
3
is a limiting point for imaginary solutions and is in fact a
singular line, which corresponds to solutions of the form V ∼ η
3
in the original
variables. Similarly solutions of the form V ∼ η
4
3
correspond to the line v = 0 on the
phase plane and solutions of the form V ∼ const. correspond to the line v = −
4u
3
on
the phase plane.
The singular line thus corresponds to where we must apply the boundary conditions
of the ODE (5.12) and so it should be clear that we have no chance of applying the
boundary condition on this singular line. However the extra term in the matching
condition (5.14) means that the boundary condition is to be applied slightly below
this singular line. To see this recall that the boundary behaviour (5.14) for large η
has the form
V = A
0
η
3
+
A
1
η
2
+. . .
where A
0
and A
1
are known constants. We wish to determine whereabouts on the
phase plane this condition corresponds to. We first transform variables to give
u = A
0
e
5x
3
+A
1
e

10x
3
,
and so
v = u
x
=
5A
0
3
e
5x
3
+
10A
1
3
e

10x
3
. (5.30)
Clearly this cannot be expressed explicitly in terms of just u and v, but we can make
an approximation for large x that
x =
3
5
ln
_
u
A
0
_
,
which after substituting into (5.30) gives
v =
5u
3

10A
1
A
2
0
3u
2
.
Recalling that A
0
=
V
3
6
and A
1
=
1
5V
2
3
yields
v =
5u
3

1
54u
2
. (5.31)
Hence this is just below the singular line, and so there is a chance that shooting
methods will work here.
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 122
It can also be seen from figure 5.1 that the field lines appear to be approaching v = 0
in a square root fashion, for example v ∼ (u −u
1
)
1
2
, where u
1
is the v = 0 intercept.
It can be shown that this is indeed the correct behaviour by seeking a solution of the
form
v = C
2
(u −u
1
)
α
2
to give
α
2
C
2
2
(u −u
1
)

2
−1
= −
4
9
u −
5
3
C
2
(u −u
1
)
α
2
+
1
_
5
3
u −C
2
(u −u
1
)
α
2
.
We are interested in the limit u → u
1
, here we have that u
1
¸ (u −u
1
)
α
2
provided
α
2
> 0. This gives
α
2
C
2
2
(u −u
1
)

2
−1
≈ −
4
9
u
1
+
_
3
5u
1
,
and so we must have

2
−1 = 0 ⇒α
2
=
1
2
,
which also gives the value of C
2
to be
C
2
= ±
_

8
9
u
1
+
_
12
5u
1
_
1
2
. (5.32)
The constant C
2
found in equation (5.32) only has real solutions provided
u
1
<
_
243
80
_1
3
= u
0
,
the location of the fixed point. If we are interested in calculating the behaviour to
the right of the fixed point then a solution of the form
v = C
2
(u
1
−u)
α
2
should be used.
5.1.7 Other fixed points
Recall that in phase plane analysis, once we have determined the location and be-
haviour of all the fixed points of the system we have entirely determined the qualita-
tive behaviour of the solution. However, there may still be fixed points which we have
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 123
still not considered, namely those at [u[ = [v[ = ∞. To investigate any fixed points at
infinity it is convenient to transform the problem into plane polar coordinates. This
is done via the transformation
u = r cos θ,
v = r sin θ,
and differentiation gives
r
x
=
uu
x
+vv
x
r
,
θ
x
=
uv
x
−vu
x
r
2
.
Substitution of equation (5.24) into the above yields
r
x
=
5
9
r cos θ sin θ −
5
3
r sin
2
θ +
sin θ
r
1
2
_
5
3
cos θ −sin θ
_1
2
, (5.33a)
θ
x
= −
4
9
cos
2
θ −
5
3
cos θ sin θ +
cos θ
r
3
2
_
5
3
cos θ −sin θ
_1
2
−sin
2
θ. (5.33b)
Next in order to investigate the behaviour at infinity we make the transformation
6
ρ =
1
r
,
φ = −θ,
and differentiating gives
ρ
x
= −ρ
2
r
x
,
φ
x
= −θ
x
.
This leads to the following system in (ρ, φ)-space
ρ
x
= f(ρ, φ) =
5
9
ρ cos φsin φ +
5
3
ρ sin
2
φ +
ρ
5
2
sin φ
_
5
3
cos φ + sin φ
_1
2
, (5.34a)
φ
x
= g(ρ, φ) =
4
9
cos
2
φ −
5
3
cos φsinφ −
ρ
3
2
cos φ
_
5
3
cos φ + sin φ
_1
2
+ sin
2
φ. (5.34b)
6
Note that this corresponds to the transformation ˆ z = z
−1
in complex space z = re

.
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 124
Clearly the only fixed point of this system is when ρ = 0 and when φ satisfies the
following equation
φ
x
=
4
9
cos
2
φ −
5
3
cos φsin φ + sin
2
φ = 0. (5.35)
Equation (5.35) can be factorised as follows
_
4
3
cos φ −sin φ
__
1
3
cos φ −sin φ
_
= 0.
Hence this has solutions when either tan φ =
4
3
or tan φ =
1
3
which have infinitely
many solutions, however we are only interested in the principle branch when 0 ≤ φ ≤
2π, and so we have only two solutions. Transforming these fixed points back to the
original (u, v) coordinates it can be shown that these two fixed points corresponds to
the point at infinity along the lines u = −
4
3
v and u = −
1
3
v.
All that remains is to determine the nature of these fixed points. For simplicity we
shall remain in the transformed space (ρ, φ). The nature of the fixed points in this
space will remain unchanged under the transformation back to the original coordinate
system. Again to investigate the nature of the fixed point it is required to perform a
linearisation about the fixed points. Doing so leads to the following linear system in
(¯ ρ,
¯
φ)
_
_
¯ ρ
¯
φ
_
_
x
=
_
_
∂f
∂ρ

0
, φ
0
)
∂f
∂φ

0
, φ
0
)
∂g
∂ρ

0
, φ
0
)
∂g
∂φ

0
, φ
0
)
_
_
_
_
¯ ρ
¯
φ
_
_
.
Evaluating the partial derivatives of our system yields
∂f
∂ρ
=
5
9
cos φsin φ +
5
3
sin
2
φ +

3
2
sin φ
2
_
5
3
cos φ + sin φ
_1
2
,
∂f
∂φ
=
10ρ
3
cos φsin φ +

9
_
cos
2
φ −sin
2
φ
_

ρ
5
2
_
1 + sin
2
φ +
5
3
cos φsin φ
_
2
_
5
3
cos φ + sin φ
_3
2
,
∂g
∂ρ
= −

1
2
cos φ
2
_
5
3
cos φ + sin φ
_1
2
,
∂g
∂φ
=
10
9
cos φsin φ −
5
3
_
cos
2
φ −sin
2
φ
_
+
ρ
3
2
_
1 + sin
2
φ +
5
3
cos φsin φ
_
2
_
5
3
cos φ + sin φ
_3
2
.
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 125
First we will consider the fixed point at (ρ, φ) = (0, arctan
4
3
) ≈ (0, 0.9273). Here the
linearised system becomes
_
_
¯ ρ
¯
φ
_
_
x
=
_
_
4
3
0
0 1
_
_
_
_
¯ ρ
¯
φ
_
_
which, since the matrix is diagonal clearly has eigenvalues
ω
1
=
4
3
, (5.36a)
ω
2
= 1, (5.36b)
with eigenvectors along the ρ-direction and the φ-direction. These eigenvalues are
both real and positive which corresponds to a nodal source fixed point, which is
unstable.
Finally considering the fixed point at (ρ, φ) = (0, arctan
1
3
) ≈ (0, 0.3218) leads to the
following linearised system
_
_
¯ ρ
¯
φ
_
_
x
=
_
_
1
3
0
0 −1
_
_
_
_
¯ ρ
¯
φ
_
_
which has eigenvalues
ω
1
=
1
3
, (5.37a)
ω
2
= −1. (5.37b)
Here we have real eigenvalues, but of opposite sign, corresponding to a saddle node,
which has a stable direction (here corresponding to the φ-direction) and an unstable
direction (the ρ-direction). In other words any perturbation in the ρ-direction will
result in the solutions being pushed away from this fixed point.
One final point of interest is that the analysis of the fixed points at infinity has
revealed a path which does not terminate at the fixed point near the origin. We can
move from the nodal source at infinity along the φ direction and arrive at the saddle
node (also at infinity) provided there is no movement in the radial direction. This path
however is not realistic in the context of numerical solutions of the original ODE, as
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 126
any solution method would introduce small numerical perturbations and the solution
would always terminate at the spiral sink near the origin. Hence we have shown, via
phase plane analysis, that every numerically simulated path in the phase space of the
nonlinear system under consideration, corresponding to solutions of the second order
ODE with any given boundary condition (at a point) will always terminate at the
fixed node near the origin. Hence any solution of a numerical shooting method given
any condition at any boundary will asymptote to the fixed point solution u =
_
243
80
_1
3
,
which corresponds to the solution
V =
_
243κ
80
_1
3
η
4
3
in the original variables. Hence the fixed point in u corresponds to the exact solution
of the original equation.
In this section we have used phase-plane analysis to show that it does not appear
possible to resolve the singular behaviour of equation (5.12), even using small-scale
analysis, suggesting that, despite applying a smoothed payoff profile, non-smoothness
has been ‘induced’ into the solution for τ > 0. The corollary to this is, therefore, that
there is insufficient financial modelling in (4.1), for standard option payoff profiles,
to prevent such behaviour, indicating (another) failure in the underlying modelling.
Finally, it should be pointed out that strictly the parameter values taken in figure
4.7 are in the range ρ <
λ
2
, as discussed in the present chapter. However, there is
a further subtlety as ρ → 0 (which we do not explore), insofar as in this limit yet
further asymptotic analysis is applicable, involving another small parameter, namely
ρ itself. Note too that as ρ → 0, the two values of S
0
will coincide and in this limit
the problems associated with the vanishing of the denominator are in some ways
mediated by the problems of the infinite gamma. Figure 4.7 is still useful, however,
in guiding the asymptotics described earlier.
Chapter 6
Perpetual Options
Explicit solutions to parabolic free-boundary problems are rare. The situation is quite
different, however, if we consider perpetual American options. For these options the
dependence on time, or rather on time left to maturity, is removed, so the partial
differential equation is reduced to an ordinary differential equation. This chapter
investigates such perpetual options in the context of the nonlinear models described
in chapter 2.
Although section 4.7 has demonstrated that the full-feedback model with early exer-
cise leads to what amounts to a trivial problem for puts, the question that naturally
arises (given the results of the previous chapter) is what of other payoff conditions,
in particular those which do not have discontinuous deltas (and assuming the dif-
ficulties raised in chapter 5 can be bypassed). The next set of results (obtained
using a straightforward PSOR scheme), shown in figure 6.1, correspond to a calcu-
lation obtained taking the smoothed payoff condition (5.2). This set of results (for
an American-style put option) corresponds to the payoff condition with ρ = 0.15
(together with K = 1, r = 0.04, σ = 0.2, λ = 0.25), in this parameter regime the
denominator does not vanish since λ < 2ρ (cf. (5.4)). To be consistent with the final
payoff conditions, the early-exercise condition was imposed by taking
V = max
_
1
2
_
K −S +
_
(K −S)
2

2
_
, V
PDE
_
,
127
CHAPTER 6. PERPETUAL OPTIONS 128
at all S and τ at each iteration of the PSOR algorithm, where V
PDE
is the solution to
(4.1). The computation was permitted to continue until a near steady state had been
attained (i.e. the asymptote to a perpetual valuation). Figure 6.1 clearly indicates
that the computation could be extended, unabated, for long maturities. This does
emphasise, of course, that much of the difficulty reported above with standard payoff
conditions is associated with the vanishing of the denominator in (4.1), which will
certainly be the case for standard payoff functions on account of the discontinuous
deltas.
0
0.2
0.4
0.6
0.8
1
1.2
0 0.5 1 1.5 2 2.5 3
PSfrag replacements
τ = 0
τ = 10
S
V
Figure 6.1: Full feedback American put, K = 1, r = 0.04, σ = 0.2, λ = 0.25, ρ = 0.15
(smoothed payoff), τ = 0, 1, . . . , 10. Note that we are in the regime λ < 2ρ and so
we should expect no singular behaviour.
There is a subtlety with the application of the smoothed payoff profile (5.2) to per-
petual options that should be noted and that we shall attempt to outline below. If
we apply the smoothed payoff profile to the standard Black-Scholes equation, (3.2),
and evaluate V
τ
at final maturity (directly from the PDE) then this will provide
us with an indication of whether there will exist any early-exercise regions or not,
more specifically if V
τ
ever changes sign. For a smoothed put numerical investigation
shows that V
τ
at expiry can be both positive and negative, indicating that there is
an early-exercise region. However for ρ large enough then this is not the case and
V
τ
always remains negative and thus the option will always be exercised immediately
CHAPTER 6. PERPETUAL OPTIONS 129
(at t = 0). Hence for the Black-Scholes equation the early-exercise boundary exists
only for
0 ≤ ρ < ρ
max
.
Numerical investigations reveal that the same behaviour is also seen for the nonlinear
equation (4.1) where we can now identify four regimes
I. ρ = 0,
II. 0 < ρ ≤
λ
2
,
III.
λ
2
< ρ < ρ
max
,
IV. ρ > ρ
max
.
For regime I, i.e. kinked payoff profiles, we have demonstrated in chapter 4, using
a local expansion about τ = 0, that American options are always early exercised.
Regime IV is of little interest (since we would never optimally exercise the option) and
also figure 6.1 indicates that in regime III there exists a well-posed American option
problem. However, the behaviour of the solution to the American option problem
in regime II still remains unclear, since the (Crank-Nicolson) finite difference scheme
successfully employed to the system in regime III proved unsuccessful in regime II.
We shall not investigate this regime further but recall however, that in chapter 5 it
was shown that we should expect non-smooth behaviour for the European option in
this regime and hence it is likely that the American counterpart will exhibit similar
solution difficulties.
Given that long-term solutions to (4.1) (with early exercise) can exist under certain
parameter regimes, it is of some interest to investigate the behaviour of this system
with the time variation omitted, i.e.
1
2
σ
2
S
2
V
SS
(1 −λV
SS
)
2
+rSV
S
−rV = 0, (6.1)
subject to (the standard early-exercise put conditions) V → 0 as S → ∞, and
V = K −S,
dV
dS
= −1 on the free boundary S = S
f
. This system was solved using a
straightforward Runge-Kutta algorithm, which performed an iteration procedure to
CHAPTER 6. PERPETUAL OPTIONS 130
evaluate S
f
. Results, based on (6.1) are shown in figure 6.2 for a range of values of the
parameter λ, with K = 1, σ = 0.2, r = 0.04. The location of the free boundary is also
clearly marked, and thus reveals yet another interesting feature, namely the approach
of the free boundary towards S = 0. For λ 1.1, for the choice of parameters taken
above, it would appear that it is never optimal to early exercise the perpetual option
(the free boundary reaches S = 0 at λ ≈ 1.1).
As a final cautionary note on the numerical solution of the nonlinear ODE (6.1), it
was observed that multiple solution branches could be found using certain numerical
techniques, such as finite difference methods and the so-called body-fitted coordinate
system (described further in section 9.3). These solutions exhibited non-smooth be-
haviour and were thought to be a possible steady-state solution of the time dependent
PDE (4.1). However these solution branches appear to be merely a numerical artifact
of the equation (and the solution technique) as increasing the resolution of the grid
saw these solution branches collapse down onto the ‘stable’ branch, corresponding to
the smooth solutions shown in figure 6.2.
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
PSfrag replacements
λ = 0
λ = 1.1
S
V
Figure 6.2: Perpetual full-feedback American put, K = 1, r = 0.04, σ = 0.2, λ =
0, 0.1, 0.2, . . . , 1.1; free-boundary location as indicated.
CHAPTER 6. PERPETUAL OPTIONS 131
6.1 Analytic solutions and perturbation methods
It is well known that the Black-Scholes perpetual American put option admits an
exact analytical solution
V
P
(S) = (K −S
f
)
_
S
S
f
_
−α
(6.2)
where α =
2r
σ
2
> 0 and S
f
is the (fixed) location of the free boundary determined by
S
f
=
αK
α + 1
. (6.3)
Furthermore, as stated in section 1.3.5 the American call option value is coincident
with the European call option value and so there exists no (optimal) early-exercise
region for the American call. Hence the value of a perpetual American call option
will be trivially equal to the current value of the stock. If, however, we include the
payment of a constant dividend yield in the underlying then the optimal exercise
boundary becomes non-trivial and thus its perpetual counterpart will have a non-
zero value. In fact the value of the perpetual American call option on an underlying
paying a constant dividend yield D is given by
V
C
(S) = (S
f
−K)
_
S
S
f
_
β
, (6.4)
where β > 0 is given by
β =
1
σ
2
_
_

_
r −D −
1
2
σ
2
_
+
¸
_
r −D −
1
2
σ
2
_
2
+ 2rσ
2
_
_
,
and the free boundary S
f
given by
S
f
=
βK
β −1
.
Interestingly we can see that as D → 0, we have β → 1 and so the free boundary
for the American call tends to infinity and the solution reduces to the trivial solution
V
C
(S) ≡ S.
Unfortunately the nonlinear ODE (6.1) has no analytical solution. As an alternative
to resorting to fully numerical solutions we can utilise perturbation methods to obtain
CHAPTER 6. PERPETUAL OPTIONS 132
an approximation of the solution for small values of the parameter λ. It is useful to
rewrite (6.1) as
1
2
σ
2
S
2
V
SS
+ (rSV
S
−rV ) (1 −λV
SS
)
2
= 0 (6.5)
and we proceed by trying a regular expansion of V in powers of λ, i.e.
V = V
0
+λV
1

2
V
2
+. . . .
Substituting the above into equation (6.5) and collecting together the powers of λ
gives the following asymptotic set of equations (cf. sections 1.8 and 4.4)
O(λ
0
) :
1
2
σ
2
S
2
V
0SS
+rSV
0S
−rV
0
= 0, (6.6a)
O(λ
1
) :
1
2
σ
2
S
2
V
1SS
+rSV
1S
−rV
1
= 2V
0SS
(rSV
0S
−rV
0
) , (6.6b)
O(λ
2
) :
1
2
σ
2
S
2
V
2SS
+rSV
2S
−rV
2
= 2V
0SS
(rSV
1S
−rV
1
)

_
V
2
0SS
−2V
1SS
_
(rSV
0S
−rV
0
) . (6.6c)
The solution to the leading order equation (6.6a) is simply the solution to the Black-
Scholes perpetual option, (6.2), or more generally
V
0
(S) = AS +BS
−α
,
with α as previously defined and constants A and B are to be determined from the
appropriate boundary conditions. Note that we are required to use this solution in
order to solve the next order equation (6.6b), now a non-homogeneous Black-Scholes
equation, which can also be solved analytically. Hence equation (6.6b) becomes
1
2
σ
2
S
2
V
1SS
+rSV
1S
−rV
1
= −2rα(α + 1)
2
B
2
S
−2α−2
,
⇒S
2
V
1SS
+αSV
1S
−αV
1
= −2α
2
(α + 1)
2
B
2
S
−2α−2
. (6.7)
The general solution to this equation is thus
V
1
(S) = CS +DS
−α
,
where again the constants C and D are to be determined from the boundary condi-
tions. To deal with the non-homogeneity we seek a particular solution of the form
V
1
(S) = kS
−2α−2
, where k is to be determined. Substitution into (6.7) gives
(2α + 2) (2α + 3) k −α(2α + 2) k −αk = −2α
2
(α + 1)
2
B
2
,
CHAPTER 6. PERPETUAL OPTIONS 133
which can be solved for k to yield
k = −

2
(α + 1)
2
B
2
(2α + 3) (α + 2)
.
Hence the solution of the first order correction is
V
1
(S) = CS +DS
−α


2
(α + 1)
2
B
2
(2α + 3) (α + 2)
S
−2α−2
.
The constant B is found from the boundary conditions on the leading order equation
V
0
and C and D are found from the boundary conditions on the first order correction
V
1
; these shall now be determined for the case of a (non-dividend paying) perpetual
American put option. In this case the boundary conditions are given by
V (S) →0 as S →∞, (6.8a)
V (S
f
) = K −S
f
, (6.8b)
V
S
(S
f
) = −1. (6.8c)
First we must also apply an asymptotic expansion to the location of the free boundary
S
f
, namely
S
f
= S
f
0
+λS
f
1
+. . . .
Along with the perturbation in V (S) the boundary condition (6.8b) thus becomes
V
0
(S
f
0
+λS
f
1
+. . .) +λV
1
(S
f
0
+λS
f
1
+. . .) +. . . = K −S
f
0
−λS
f
1
−. . . .
Exploiting the smallness of λ and recalling Taylor’s theorem we have
V
0
(S
f
0
+λS
f
1
+. . .) = V
0
(S
f
0
) +λS
f
1
V
0S
(S
f
0
) +O(λ
2
),
V
1
(S
f
0
+λS
f
1
+. . .) = V
1
(S
f
0
) +λS
f
1
V
1S
(S
f
0
) +O(λ
2
),
hence equating powers of λ we can see that this boundary condition becomes
O(λ
0
) : V
0
(S
f
0
) = K −S
f
0
, (6.9a)
O(λ
1
) : V
1
(S
f
0
) = −S
f
1
_
1 +V
0S
(S
f
0
)
_
. (6.9b)
CHAPTER 6. PERPETUAL OPTIONS 134
A similar application of Taylor’s theorem to the smooth pasting condition (6.8c)
yields
O(λ
0
) : V
0S
(S
f
0
) = −1, (6.10a)
O(λ
1
) : V
1S
(S
f
0
) = −S
f
1
V
0SS
(S
f
0
). (6.10b)
Interestingly we can see that the smooth pasting condition (6.10a) when substituted
into (6.9b) results in the condition at the free boundary for the first-order correction
reducing to zero. This implies that the solution of V
1
(S) can be determined without
knowledge of the correction to the free boundary, S
f
1
. However we still have the
smooth pasting condition on this correction which can be exploited to give us an
estimate of the correction to the free boundary, therefore rearranging (6.10b) gives
S
f
1
= −
V
1S
(S
f
0
)
V
0SS
(S
f
0
)
.
Bringing things together we have that the leading order system is given by
_
¸
¸
¸
¸
¸
¸
¸
_
¸
¸
¸
¸
¸
¸
¸
_
V
0
(S) = AS +BS
−α
, General solution;
V
0
(S
f
0
) = K −S
f
0
, Boundary condition 1;
V
0
(S →∞) = 0, Boundary condition 2;
V
0S
(S
f
0
) = −1, Smooth pasting.
This coincides exactly with the Black-Scholes Perpetual Put whose solution was given
by (6.2), hence
A = 0,
B = (K −S
f
0
) S
α
f
0
,
S
f
0
=
αK
α + 1
.
The system for the first order correction V
1
is
_
¸
¸
¸
¸
¸
¸
¸
_
¸
¸
¸
¸
¸
¸
¸
_
V
1
(S) = CS +DS
−α


2
(α+1)
2
B
2
(2α+3)(α+2)
S
−2α−2
, General solution;
V
1
(S
f
0
) = 0, Boundary condition 1;
V
1
(S →∞) = 0, Boundary condition 2;
S
f
1
= −
V
1S
(S
f
0
)
V
0SS
(S
f
0
)
, Perturbed free boundary.
CHAPTER 6. PERPETUAL OPTIONS 135
Clearly from the boundary condition at infinity we have C = 0 and the condition at
the free boundary leads to
D =
2(α + 1)
2
S
α
f
0
(2α + 3)(α + 2)
.
To determine the position of the perturbed free boundary involves evaluating the
derivatives of V
0
and V
1
which, after some laborious algebra, results in
S
f
1
= −
2(α + 1)
2α + 3
.
Hence our approximate solution can be written as
V (S) =
S
f
0
α
_
S
S
f
0
_
−α
+
2λ(α + 1)
2
(2α + 3)(α + 2)
_
_
S
S
f
0
_
−α

_
S
S
f
0
_
−2α−2
_
+O
_
λ
2
_
,
(6.11)
with the free boundary now located at
S
f
= S
f
0

2λ(α + 1)
2α + 3
+O
_
λ
2
_
.
Figure 6.3 shows the first order correction term, i.e. λV
1
and compares it to the
difference of the (numerical) solution to the full problem (6.1) and the Black-Scholes
value, i.e. V − V
BS
; it can be seen that there is a good agreement in the solutions.
Note that V
1
has only been calculated in the region S ∈ (S
f
0
, ∞) since it is not
entirely clear whether the approximate solution (6.11) is valid in the region S < S
f
0
.
Figure 6.4 shows the same comparison as in figure 6.3 but for increasing values of the
parameter λ, expectedly the agreement with the ‘exact’ solution worsens for larger
values of λ.
CHAPTER 6. PERPETUAL OPTIONS 136
0
0.005
0.01
0.015
0.02
0.025
0 0.5 1 1.5 2 2.5 3 3.5
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
S
λ
V
1
S
f
0
S
f
Figure 6.3: The first order correction to the Black-Scholes perpetual American put
option (solid line) compared to the difference of the fully numerical option value with
the Black-Scholes (dotted line). K = 1, r = 0.04, σ = 0.2 and λ = 0.1.
0
0.05
0.1
0.15
0.2
0.25
0 0.5 1 1.5 2 2.5 3 3.5 4
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
S
λ
V
1
λ = 0.1
λ = 0.5
λ = 1.0
S
f
0
Figure 6.4: The first order correction to the Black-Scholes perpetual American put
option (solid line) compared to the difference of the fully numerical option value with
the Black-Scholes (dotted line) for various values of λ. K = 1, r = 0.04, σ = 0.2 and
λ = 0.1, 0.5, 1.
Chapter 7
Other Models
We have shown that significant difficulties arise when the form of the function λ(S, t)
in (4.1) is taken to be constant, the model as introduced by Sch¨ onbucher and Wilmott
(2000). There have been alternative models proposed, including those which involve
non-constant λ(S, t) as was briefly discussed in chapter 2. We now discuss some of
these, in particular by investigating their small τ behaviour, from which we will be
able to ascertain whether or not the difficulties outlined in the preceding chapters (for
constant λ) are also present. We will not present derivations of the models below;
the interested reader is referred to the appropriate references.
7.1 Frey (1998, 2000)
The model of Frey (1998, 2000) is the most similar to that discussed earlier, and leads
to the same PDE as (2.10) but with λ(S, τ) =
ˆ
λS where
ˆ
λ ∈ R. In fact it can be
seen that the Frey model is in some sense a more consistent model of price impact
as this form of λ(S, τ) effectively models the price impact on the percentage price
change rather than the absolute price change, which is more consistent when using
geometric Brownian motion as the reference process.
The same scaling as was employed for the full-feedback model as τ →0, namely (4.7)
can be used here. The solution turns out to be very similar, and for a put is given
137
CHAPTER 7. OTHER MODELS 138
by the equation
φ −
η
2
φ
η

σ
2
K
2
φ
ηη
2
_
1 −
ˆ
λKφ
ηη
_
2
+rKH(−η) = 0,
and for a call
φ −
η
2
φ
η

σ
2
K
2
φ
ηη
2
_
1 −
ˆ
λKφ
ηη
_
2
−rKH(η) = 0.
It is clear that this model will exhibit the same behaviour as the model discussed
previously, since the addition of S is not sufficient to alter the qualitative behaviour
of the solution - it merely leads to a rescaling of λ. The same argument holds in the
case of call options.
Equally, the arguments expounded earlier (in section 3.3 and chapter 5) regarding
the zero in the denominator of (2.10) remain applicable. However, one interesting
difference in the model of Frey (1998, 2000) is when we consider first-order feedback.
When considering the location of the vanishing of the denominator similar to the
analysis in section 3.3 the denominator of the first-order Frey (1998, 2000) model
vanishes when
1 −
λe

1
2
d
1
(S

,τ)
2
σ

2πτ
= 0 (7.1)
where
d
1
(S, τ) =
log
_
S
K
_
+
_
r +
1
2
σ
2
_
τ
σ

τ
,
and S

(τ) is the location of the singular denominator. Similar to the Sch¨ onbucher
and Wilmott (2000) model equation (7.1) can be solved explicitly to obtain
S

(τ) = Ke
−(r+
1
2
σ
2

exp
_
±σ
¸
τ log
_
λ
2
2πσ
2
τ
_
_
, (7.2)
Figure 7.1 shows these locations for the same parameters as figure 3.7. Again it can
be seen that there exists no solution past a critical value of τ. This can be seen
directly from equation (7.2) since there exists no real solution when
λ
2
2πσ
2
τ
< 1,
hence when τ > τ
crit
where
τ
crit
=
λ
2
2πσ
2
.
CHAPTER 7. OTHER MODELS 139
For the parameters used in figure 3.7, i.e. λ = 0.1 and σ = 0.2, then we have
τ
crit
≈ 0.039789.
0.97
0.98
0.99
1
1.01
1.02
0 0.005 0.01 0.015 0.02 0.025 0.03 0.035 0.04 0.045
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
S
τ
Figure 7.1: Location of the vanishing of the denominator of the Frey (1998, 2000)
(solid line) and Sch¨ onbucher and Wilmott (2000) (dotted line) model with λ = 0.1,
K = 1, r = 0.04 and σ = 0.2.
7.2 Frey and Patie (2002)
Here an asset dependent liquidity is introduced in order to reproduce the volatility
smile with
λ(S, t) =
ˆ
λ
_
1 + (S −S
0
)
2
_
a
1
I
{S≤S
0
}
+a
2
I
{S≥S
0
}
__
, (7.3)
where I denotes the indicator function and
ˆ
λ, a
1
and a
2
are found by minimising the
squared distance of the observed price from the model. This form of the liquidity
structure incorporates so called liquidity drops, i.e. that λ(S, t) increases if the stock
price drops. However this additional structure is not seen on the small scale close to
expiry where the scaling (4.7) reduces (7.3) to
λ(S, τ) =
ˆ
λ
_
1 + τ(η −η
0
)
2
_
a
1
I
{η≤η
0
}
+a
2
I
{η≥η
0
}
__
,
which as τ → 0 reduces to
ˆ
λ, i.e. the model of Sch¨ onbucher and Wilmott (2000),
where the previous analysis is thus applicable.
CHAPTER 7. OTHER MODELS 140
7.3 Sircar and Papanicolaou (1998)
Another interesting model is that of Sircar and Papanicolaou (1998), who arrived at
the following PDE
V
τ

1
2
σ
2
S
2
_
1 −
ˆ
λV
S
1 −
ˆ
λV
S

ˆ
λSV
SS
_
2
V
SS
−rSV
S
+rV = 0, (7.4)
where again
ˆ
λ ∈ R. With a little rearranging we can see that this equates to (2.10)
with
λ(S, τ; V
S
) =
ˆ
λS
1 −
ˆ
λV
S
.
The authors state that there will be difficulties with the PDE when the denominator
passes through zero (as has been outlined in chapter 5 of the present study). To
circumvent this difficulty, Sircar and Papanicolaou set the value of the option close
to expiry to be equal to the Black-Scholes analytical value. More specifically this is
done in the region 0 < τ < , where is chosen such that for τ > the denominator
of (7.4) remains positive. This is effectively introducing a smoothing in the payoff
function and, indeed, is switching off the effect of the price impact close to expiry.
They do, however, offer the financial argument that transaction costs act as a natural
smoothing close to strike and close to expiry and so the cost of replication (hence the
price) would naturally be smoothed.
It turns out that the small τ analysis considered earlier is quite similar to (7.4), in
particular using the scaling (4.7) leads to the following small-τ equation for a put:
φ −
η
2
φ
η

σ
2
K
2
φ
ηη
2
_
1 −
_
ˆ
λK
1+
ˆ
λH(−η)
_
φ
ηη
_
2
+rKH(−η) = 0, (7.5)
and, similarly, for a call
φ −
η
2
φ
η

σ
2
K
2
φ
ηη
2
_
1 −
_
ˆ
λK
1−
ˆ
λH(η)
_
φ
ηη
_
2
−rKH(η) = 0. (7.6)
The two equations above are subject to the same boundary conditions as employed
in section 4.6. Indeed, note that these are the same form considered in section
4.6 but with a discontinuous jump in the value of the elasticity/liquidity parameter
CHAPTER 7. OTHER MODELS 141
(equivalent to λ) at S = K (η = 0). Another interesting point to note is that
the symmetry seen in the full-feedback model of section 4.6 has now been broken,
φ
call
(η) ,= φ
put
(−η) + rK; this is as a consequence of the inclusion of V
S
into the
function λ(S, τ).
Equations (7.5) and (7.6) were then solved in a manner similar to that employed on
(4.8) and (4.9), and results for a call and a put are presented for a range of values
of
ˆ
λ in figures 7.2 and 7.3 respectively, with K = 1, σ = 0.2, r = 0.04. Although in
both cases there appears to be very little variation with
ˆ
λ, it was found for values in
excess of those shown (up to 0.3 in the cases of puts, 0.2 in the case of calls) that
the calculation failed, in a manner described in section 4.6, with the occurrence of
negative square roots in the calculation, suggesting yet again another solution regime.
This matter was not pursued further but it would appear that a treatment along the
lines of section 4.6 is again relevant, as is our discussion regarding the vanishing of
the denominator in (2.10).
0
0.005
0.01
0.015
0.02
0.025
0.03
0.035
0.04
-0.4 -0.2 0 0.2 0.4
PSfrag replacements
η
φ
ˆ
λ = 0
ˆ
λ = 0.2
Figure 7.2: Local (τ →0) call solution of the Sircar and Papanicolaou (1998) model
K = 1, r = 0.04, σ = 0.2, and
ˆ
λ = 0, 0.05, . . . , 0.2.
7.4 Bakstein and Howison (2003)
Bakstein and Howison (2003) developed a model for liquidity effects which results in
CHAPTER 7. OTHER MODELS 142
-0.04
-0.035
-0.03
-0.025
-0.02
-0.015
-0.01
-0.005
0
-0.4 -0.2 0 0.2 0.4
PSfrag replacements
η
φ
ˆ
λ = 0
ˆ
λ = 0.3
Figure 7.3: Local (τ →0) put solution of the Sircar and Papanicolaou (1998) model
K = 1, r = 0.04, σ = 0.2, and
ˆ
λ = 0 0.05, . . ., 0.3.
the following PDE,
V
τ

1
2
σ
2
S
2
V
SS

ˆ
λσ
2
S
3
V
2
SS

1
2
ˆ
λ
2
(1 −α)
2
σ
2
S
4
V
3
SS
−rSV
S
+rV = 0, (7.7)
where
ˆ
λ ∈ R is a measure of the market’s liquidity and α is a measure of the price
slippage impact of a trade felt by all market participants, α = 1 corresponding to no
slippage. The first point to note is that this equation looks uncannily like a small
ˆ
λ
expansion of the previously discussed models, but we shall return to this later. First
we shed a little light onto the term price slippage.
When a large order has been placed, the large trader will inevitably obtain a worse
price for the order than the quoted prices. However, a question that may be asked is
whether this large order should have a permanent affect on the price process or not.
Assuming that a market maker provides the quotes, and that he has also provided
the other side of the large trade, then it is not unreasonable to expect that in the
next period the market maker will quote different prices in order to neutralise his
position, hence a permanent impact will be felt by the market; this is what Bakstein
and Howison (2003) term price slippage.
It can be shown that the non-smooth scaling (4.7) can be applied to the Bakstein and
Howison (2003) model to obtain a valid local solution, and indeed this shall be done
CHAPTER 7. OTHER MODELS 143
in the following subsection. However it transpires that, unlike in the Sch¨ onbucher
and Wilmott (2000), Frey (1998, 2000) and Sircar and Papanicolaou (1998) cases, a
suitable scaling (applicable to standard put and call payoff profiles) can be found in
the class of smooth functions. The following outlines the procedure adopted to find
such a scaling.
For the standard payoff profile (puts and calls) we have that, due to the increasing
gamma in the region close to strike and expiry, the cubic V
SS
term in equation (7.7)
will dominate over the other lower order terms in V
SS
. Hence to find an appropriate
scaling we require a balancing between this cubic term and the time derivative, i.e.
V
τ

1
2
ˆ
λ
2
(1 −α)
2
σ
2
S
4
V
3
SS
. (7.8)
We seek a solution of the form
V (S, τ) = τ
γ
1
f(η) where η =
S −K
τ
γ
2
where we require γ
1
= γ
2
= γ in order to obtain an O(1) inner solution and correctly
match with the standard payoff profiles (cf. section 3.1). Substituting this into
equation (7.8) we have
γτ
γ−1
(f −ηf
η
) ∼
1
2
ˆ
λ
2
(1 −α)
2
σ
2
K
4
f
3
ηη
τ
−3γ
we can see that in order to obtain an appropriate balance of terms (for all τ) we are
forced to set
γ −1 = −3γ ⇒ γ =
1
4
.
Hence applying this scaling to the full equation (7.7) it can be shown that in the limit
τ →0 the equation for the inner solution becomes the cubically nonlinear ODE
1
f
3
ηη

1
(ηf
η
−f) = 0 (7.9)
where ν
1
=
_
2
ˆ
λ
2
(1 −α)
2
σ
2
K
4
_
−1
. The boundary conditions arise from an asymp-
totic match which is the same as for the corresponding Black-Scholes (
ˆ
λ = 0) case,
1
Note that ν
1
can be scaled out by setting f(η) =

ν
1
ˆ
f(η) but we will not do so as this would
place the constant ν
1
into the boundary conditions.
CHAPTER 7. OTHER MODELS 144
i.e.
f →0 as η →∞, f →−η as η →−∞ for calls, (7.10a)
f →η as η →∞, f →0 as η →−∞ for puts. (7.10b)
The system (7.9) and (7.10) can be solved using standard finite-difference techniques.
Figure 7.4 shows sample results for the inner put solution with σ = 0.2, r = 0.04,
K = 1, α = 1.5 and with λ = 0.01, 0.5, 1, 5. Note that as λ is decreased (i.e. the
parameter ν
1
increased) the solution appears to collapse down onto the standard put
option payoff profile, with the solution becoming increasingly focused around η = 0.
-0.1
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
-1 -0.5 0 0.5 1
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
f
(
η
)
η
λ ↓, ν
1

Figure 7.4: Solution to equation (7.9) for a put option with λ = 0.01, 0.5, 1, . . ., 5,
σ = 0.2, r = 0.04, K = 1, and α = 1.5.
However there is another subtlety that arises with the above scaling in the limit
α → 1, i.e. in the absence of price slippage impact. Here the inner equation (7.9)
becomes degenerate and looking again at the full PDE (7.7) it is clear that the scaling
used above is no longer appropriate when α →1. In this limit, the smallness of 1−α
must be considered, in this case the quadratic V
2
SS
term in the equation can no longer
be neglected and will be of comparable size to the cubic term for certain ranges of
τ, suggesting that an asymptotic breakdown occurs when τ = O
_
(1 −α)
8
_
, this can
be seen by balancing the quadratic and cubic V
SS
terms in equation (7.7). Therefore
the limit α →1 is not a trivial one. When α = 1 however, the cubic term in equation
CHAPTER 7. OTHER MODELS 145
(7.7) disappears and the equation is reduced to
2
V
τ

1
2
σ
2
S
2
V
SS

ˆ
λσ
2
S
3
V
2
SS
−rSV
S
+rV = 0. (7.11)
In this case the appropriate balancing of terms is now between the quadratic term in
V
SS
and the time derivative. Performing the same power balancing analysis as above
leads to the conclusion that the appropriate scaling for the problem when α = 1 is
given by
V (S, τ) = τ
1
3
g(ξ) where ξ =
S −K
τ
1
3
,
leading to the equation (in the limit τ →0)
3
g
2
ξξ

2
(ξg
ξ
−g) = 0 (7.12)
where ν
2
=
_
3
ˆ
λσ
2
K
3
_
−1
and it is once again coupled with the boundary conditions
(7.10). Note that if we differentiate equation (7.12) then we obtain
g
ξξ
(2g
ξξξ

2
ξ) = 0
which suggests two solutions to equation (7.12)
g(ξ) = −
ν
2
ξ
4
48
+
C
1
ξ
2
2
+C
2
ξ +
C
2
1
ν
2
,
g(ξ) = D
1
ξ,
however neither of these satisfy the required boundary conditions (7.10). In addition,
attempts to solve the system numerically using the same techniques employed on
equation (7.9) proved ineffective. The results were not consistent with grid refinement
and kinked solutions started to appear. This suggests that either the chosen form of
the solution is inappropriate or that a smooth solution to the equation may not exist.
Furthermore the numerics indicate that the solution most likely takes on the form
of the (non-smooth) payoff profile. This shall not be investigated further, rather we
leave this as a subject of future research.
2
It is (very) interesting to note that this PDE also arises in the quadratic transaction cost model
of Cetin et al. (2004).
3
Note again that ν
2
can be scaled out by setting g(ξ) = ν
2
ˆ g(ξ) but we will not do this.
CHAPTER 7. OTHER MODELS 146
Finally, let us recall the equation arising from the Frey (2000) model, i.e.
V
τ

σ
2
S
2
V
SS
2
_
1 −
ˆ
λSV
SS
_
2
−rSV
S
+rV = 0. (7.13)
Making the assumption that
ˆ
λ is small and further that
ˆ
λSV
SS
¸ 1 then we can
make the approximation
(1 −
ˆ
λSV
SS
)
−2
≈ 1 + 2
ˆ
λSV
SS
+. . .
and hence equation (7.13) can be approximated by
V
τ

1
2
σ
2
S
2
V
SS

ˆ
λσ
2
S
3
V
2
SS
−rSV
S
+rV = 0,
which coincides with the Bakstein and Howison (2003) model for α = 1, i.e. equation
(7.11). Clearly the assumption that
ˆ
λSV
SS
¸ 1 prohibits the denominator of the
equation (7.13) vanishing, but also leads to a regime in which standard put and call
payoff profiles are not permitted due to their infinite second derivatives.
7.4.1 Non-smooth solutions to the Bakstein and Howison
(2003) model
As mentioned in the previous section, if we apply the scaling (4.7) to equation (7.7),
we can obtain a valid local solution and furthermore doing so for a put we obtain
φ −
η
2
φ
η

1
2
σ
2
K
2
φ
ηη

ˆ
λσ
2
K
3

ηη
)
2

ˆ
λ
2
2
(1 −α)
2
σ
2
K
4

ηη
)
3
+rKH(−η) = 0,
(7.14)
and
φ −
η
2
φ
η

1
2
σ
2
K
2
φ
ηη

ˆ
λσ
2
K
3

ηη
)
2

ˆ
λ
2
2
(1 −α)
2
σ
2
K
4

ηη
)
3
−rKH(η) = 0,
(7.15)
for a call, with the boundary conditions described in section 4.6.
The cubic nonlinearity in the second-order derivative φ
ηη
demands a somewhat dif-
ferent numerical approach from that adopted for the Sircar and Papanicolaou (1998)
CHAPTER 7. OTHER MODELS 147
model. Consequently, we followed a treatment which considered the problem as a
system in φ and φ
1
= φ
η
, thereby resulting in two first-order equations. Second-order
finite differencing, coupled with Newton iteration was then employed. Sample results
are shown in figures 7.5 and 7.6 for puts and calls respectively, with σ = 0.2, r = 0.04,
K = 1, α = 1.5, and with
ˆ
λ = −5, -4.75, . . . , 5. Bakstein and Howison (2003) do
discuss possible values for these latter two parameters (it appears that [
ˆ
λ[ is likely
very small). Other computations performed suggested that although the variation
of option values with α is generally quite small (with fixed
ˆ
λ), in some regimes the
numerical scheme failed to converge, suggesting the possibility of regimes for which
solutions of (7.14) and (7.15) do not exist (which in turn suggests the possibility of
a regime akin to that described in section (4.6)).
-0.04
-0.035
-0.03
-0.025
-0.02
-0.015
-0.01
-0.005
0
-0.6 -0.4 -0.2 0 0.2 0.4 0.6
PSfrag replacements
η
φ
ˆ
λ = 0
ˆ
λ = 5
ˆ
λ = −5
Figure 7.5: Local (τ → 0) put solution of the Bakstein and Howison (2003) model
K = 1, r = 0.04, σ = 0.2, α = 1.5, and
ˆ
λ = −5, -4.75, . . ., 5.
7.4.2 New non-smooth solutions to the Black-Scholes equa-
tion
It should be noted that when
ˆ
λ = 0, the Bakstein and Howison model degenerates
to the standard Black-Scholes equation and, somewhat intriguingly, figures 7.5 and
7.6 indicate that a non-trivial solution to the classical Black-Scholes problem does
CHAPTER 7. OTHER MODELS 148
0
0.005
0.01
0.015
0.02
0.025
0.03
0.035
0.04
-0.6 -0.4 -0.2 0 0.2 0.4 0.6
PSfrag replacements
η
φ
ˆ
λ = 0
ˆ
λ = 5
ˆ
λ = −5
Figure 7.6: Local (τ → 0) call solution of the Bakstein and Howison (2003) model
K = 1, r = 0.04, σ = 0.2, α = 1.5, and
ˆ
λ = −5, -4.75, . . ., 5.
exist with a discontinuous delta, quite distinct from the classical solution. Although
this new solution is found as the limiting case of the nonlinear Bakstein and Howison
model it can be illustrated by directly applying the scaling (4.7) to the Black-Scholes
equation, i.e. seeking a solution of the Black-Scholes equation (3.2) of the form
V
BS
= −τ
1
2
ηH(−η) +τφ
BS
(η).
Doing so we arrive at the equation for the inner solution of a put
φ
BS

η
2
φ
BS
η

1
2
σ
2
K
2
φ
BS
ηη
+rKH(−η) = 0,
i.e. equation (7.15) with
ˆ
λ = 0. To illustrate the non-smooth behaviour of these
solutions figure 7.7 gives sample numerical solutions of the Black-Scholes equation,
(3.2), using the Keller (1978) scheme (described in section 4.7) to build in the jump
in the first derivative.
Note that this does not contradict the standard and well known uniqueness results
of the (linear) Black-Scholes equation as these results are only valid in a restricted
class of smooth (classical) solutions to the PDE. In fact it should also be noted
that there also exists infinitely many smooth solutions to the Black-Scholes equation
but ones which do not satisfy the required growth conditions on the coefficients of
CHAPTER 7. OTHER MODELS 149
-0.2
0
0.2
0.4
0.6
0.8
1
0 0.5 1 1.5 2
PSfrag replacements
V
S
τ = .25
τ = 1
Figure 7.7: Non-smooth solution of the Black-Scholes equation. K = 1, r = 0.04,
σ = 0.2.
the PDE, namely the volatility term. Uniqueness of the Black-Scholes PDE relies
on its ability to be reduced to the heat equation where uniqueness results are well
known, furthermore uniqueness of the heat equation is only ensured if we prescribe
the behaviour of the solution for large [x[. Also Widder (1975) shows that there is at
most one solution that is nonnegative for t ≥ 0 and all x, a reasonable assumption
when u(x, t) models absolute temperature or option prices.
7.5 Liu and Yong (2005)
The model of Liu and Yong (2005), previously discussed in chapter 2, attempts to
overcome the undesirable asymptotic behaviour at expiry by effectively ‘switching off’
the effect of liquidity as we approach it. This is achieved by adding a time dependency
to the function λ(S, τ) of the form
λ(S, τ) =
ˆ
λ(1 −e
−βτ
) (7.16)
where
ˆ
λ, β ∈ R. The authors’ rationale behind this choice of the liquidity function is
stated that as time passes, the private information about the asset value is gradually
revealed so that the price impact gradually decreases to zero at maturity, which will
CHAPTER 7. OTHER MODELS 150
also prevents any stock price manipulation at maturity. The non-smooth scaling
(4.7) is no longer appropriate for this PDE and in fact it transpires that the standard
Black-Scholes scaling (3.3) is the relevant one to use as τ →0, leading to
σ
2
K
2
f
ηη
+ηf
η
−f = 0.
Note that this has the same structure as the standard Black-Scholes model as τ →0,
i.e. equation (3.5) and hence the asymptotic behaviour of the Liu and Yong (2005)
model close to expiry will be close to the Black-Scholes model. In addition, it appears
that this form of the liquidity function λ(S, τ) may not completely circumvent the
issues associated with the vanishing of the denominator, as we shall outline next.
7.5.1 Vanishing of the denominator
First we consider the first-order feedback case, i.e. equation (3.1) with λ(S, τ) defined
by (7.16). To determine if the denominator vanishes in this simple case reduces to
determining whether there exists a real solution S

(τ) to the equation
1 −
ˆ
λ(1 −e
−βτ
)
σS


2πτ
e

1
2
d
1
(S

,τ)
2
= 0,
where d
1
(S, τ) has been defined previously. The first point to note is that the Liu
and Yong (2005) model reduces to the Sch¨ onbucher and Wilmott (2000) model in
the limit β →∞; as such the location of the vanishing denominator in this limit was
shown in figure 3.7. Conversely when considering the limit β → 0, the denominator
will never vanish since here the denominator becomes uniformly unity. Figure 7.8
shows the location of the singular denominator for various values of β, hence we can
see that the denominator does still vanish for sufficiently large values of β. This will
not cause any problems in the first-order feedback model (as was outlined in chapter
3), but it may for the full feedback case which we now consider.
In the full feedback case of the Liu and Yong (2005) model at τ = 0 the denominator
never vanishes because the denominator reduces to 1 at τ = 0. However, it is of
interest to check to see if the denominator vanishes for τ > 0. The best we can do
CHAPTER 7. OTHER MODELS 151
0.97
0.98
0.99
1
1.01
1.02
0 0.005 0.01 0.015 0.02 0.025 0.03 0.035 0.04 0.045
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
τ
S
β increasing
Figure 7.8: Location of the vanishing of the denominator for the Liu and Yong (2005)
model for various value of β. K = 1, r = 0.04, σ = 0.2, λ = 0.1, and β = 1 10
5
,
2 10
5
, . . ., 1 10
6
.
is investigate the region close to strike and expiry, i.e. τ ¸ 1 and S ≈ K. In this
region the Liu and Yong (2005) model is identical to the Black-Scholes local solution
and hence we can approximate V
SS
in this region by the Black-Scholes local solution,
i.e.
V
SS
=
e

(S−K)
2
2τσ
2
K
2
σK

2πτ
,
valid for both puts and calls. Using this, and the knowledge that in this region
e
−βτ
≈ 1 −βτ the denominator will thus vanish if and when
1 −
βλ
σK
_
τ

e

(S−K)
2
2τσ
2
K
2
= 0.
The exponential is bounded above by one and so the denominator will not vanish
provided
β <
σK
λ
_

τ
,
in other words there is a potential for model failure (breakdown) in the region
τ = O(β
−2
),
if this is also in the region τ ¸1, hence if β is sufficiently large. Liu and Yong (2005)
use the value β = 100 in the numerics giving τ = O(10
−5
) which is within the region
where τ ¸1.
CHAPTER 7. OTHER MODELS 152
7.6 Jonsson and Keppo (2002)
Another model (in addition to Bakstein and Howison, 2003) that can be found to
be free of the problems with non-smooth solutions for standard put and call payoff
profiles, is the Jonsson and Keppo (2002) model. Here the price observed in the
market, S, is dependent on an exogenous Brownian motion (ds = µsdt +σsdW
t
) via
an exponential price impact function, i.e.
dS
S
= e
gf(S,t)
ds
s
, (7.17)
where f(S, t) again denotes the number of stocks held by the hedger and g a so called
effect parameter. This leads to a very different nonlinear pricing PDE, namely
V
τ

1
2
σ
2
S
2
e
2aV
S
V
SS
−rSV
S
+rV = 0, (7.18)
where a ∈ R. It transpires that the relevant scaling in this case is also that of
Black-Scholes (3.3), which leads to the equation
σ
2
K
2
e
2afη
f
ηη
+ηf
η
−f = 0, (7.19)
subject to
f
η
→1 as η →∞, f →0 as η →−∞,
for a call and
f
η
→−1 as η →−∞, f →0 as η →∞,
for a put. Note that in this case there is no discontinuity in the derivatives and we
appear to have a classical solution. However it is clear that this model will encounter
difficulties if we have discontinuous payoff profiles, such as binary options. The above
system was solved using a straightforward fourth-order shooting scheme; results for
calls and puts are shown in figures 7.9 and 7.10 respectively, with σ = 0.2, K = 1,
and for a = −1, -0.9, . . ., 1. Note that, in agreement with proposition 3.2 of Jonsson
and Keppo (2002), the call option value is monotonically increasing in the parameter
a, and conversely the put monotonically decreasing. We therefore conclude that
equation (7.18) admits well-behaved solutions at times close to expiry. However the
CHAPTER 7. OTHER MODELS 153
modelling assumptions used to arrive at this equation may be questioned; there does,
however, exist a link to the other models discussed in this chapter, a link which is
outlined below.
0
0.1
0.2
0.3
0.4
0.5
0.6
-0.4 -0.2 0 0.2 0.4
PSfrag replacements
η
f
a = 1
a = −1
Figure 7.9: Local (τ → 0) call solution of the Jonsson and Keppo (2002) model
K = 1, σ = 0.2, and a = −1, -0.9, . . ., 1.
0
0.1
0.2
0.3
0.4
0.5
0.6
-0.4 -0.2 0 0.2 0.4
PSfrag replacements
η
f
a = 1
a = −1
Figure 7.10: Local (τ → 0) put solution of the Jonsson and Keppo (2002) model
K = 1, σ = 0.2, and a = −1, -0.9, . . ., 1.
CHAPTER 7. OTHER MODELS 154
7.6.1 Connections with the other modelling frameworks
A connection of the Jonsson and Keppo (2002) model with the models of Frey (1998,
2000) etc. can be seen if we consider small values of the effect parameter g, or more
specifically if gf(S, t) ¸1. In this case equation (7.17) can be approximated to
dS
S

_
1 +gf(S, t)
_
ds
s
=
ds
s
+gf(S, t)
ds
s
= µdt +σdW
t
+gf(S, t)
ds
s
.
It is now possible to equate this model to the reduced form SDE model, (2.2), and
in order for the two processes to agree we require that
gf(S, t)
ds
s
= λ(S, t)
df(S, t)
S
,
in other words the liquidity function λ(S, t) can be chosen such that
λ(S, t)
S
= g
f
s
ds
df
.
If we identify f as the number of shares traded and s as their price, then it is possible
to define the quantity
s
f
df
ds
= L as the price elasticity of the market to trades (cf.
section 1.4). The models, therefore, become equivalent for small gf(S, t) if we allow
the parameter λ to be
λ(S, t) =
g
L
S. (7.20)
This is intuitive since, if the elasticity of the market increases, i.e. L → ∞ the
relationship (7.20) gives that λ → 0 and hence the liquidity of the market also
increases; in line with our understanding of price elasticity.
Chapter 8
Explaining the Stock Pinning
Phenomenon
This chapter aims to illustrate one of the most documented forms of price impact,
that of the stock pinning phenomenon. Stock pinning is defined as the tendency of
stock prices to move to the strike price of heavily traded option contracts as the
options approach expiry. It transpires that the models outlined in this thesis can
be used to partly explain and quantify such interesting market behaviour. First,
however, we start by discussing some of the empirical evidence for stock pinning.
The most comprehensive empirical investigation of stock price pinning was under-
taken by Ni et al. (2005), who provided striking evidence that the presence of options
perturbs the prices of underlying stocks, more specifically that on expiration dates,
clustering appeared when non-optionable stocks became optionable and disappeared
when optionable stocks became non-optionable. Prior to this there had been little
indication of any significant impact, despite understandable interest from market pro-
fessionals. Ni et al. (2005) suggested that this pinning effect is most likely due to
delta hedgers moving the price and possibly due to intentional market manipulation.
Krishnan and Nelken (2001) observed Microsoft stocks (during the period 1990-2001)
and concluded that the probability of the stock price pinning at strike (i.e. being
within a small of strike) on expiration days was 23.29%, and on non-expiration
155
CHAPTER 8. EXPLAINING THE STOCK PINNING PHENOMENON 156
days was only 13.52%. In addition, Avellaneda and Lipkin (2003) described anecdo-
tal evidence of the pinning of J.D. Edwards stocks in 2003.
8.1 Linear price impact
Avellaneda and Lipkin (2003) developed a model in which stock trading, undertaken
to maintain delta hedges on existing net-purchased-option positions is allowed to
impact the price and as a consequence pushes the stock price toward the strike price
as expiration approaches, i.e. pinning. The model assumes that the price impact is
proportional to the ‘rate of change’ of the Black-Scholes delta, i.e.
dS
S

∂∆
∂t
dt.
Furthermore they argue, counter to the assumptions made in chapter 2, that the net
position (in stock) of delta hedgers in the market is short rather than long. The
rational behind this is as follows: If large institutions such as hedge funds sell options
to market makers (defined in section 1.6), then the market makers will inevitably
hedge their position. Since the market makers will be long options, they must become
short the underlying in order to hedge their position. If the large institution is not
also hedging the sale of the options, then the net position (of the buyer and seller
of the option) in the market for the underlying will be short. With this in mind
Avellaneda and Lipkin (2003) therefore make the assumption that the underlying
stochastic process is modified to
dS
S
=
_
µ −nE
∂∆
∂t
_
dt +σdW
t
, (8.1)
where n is the open interest and E a constant price elasticity term; note the negative
sign. The focus of the work by Avellaneda and Lipkin (2003) is not on option pricing,
but rather on calculating the so-called pinning probability, defined as the probability,
denoted P(S, t), that the stock price will end up at S = K at t = T. This can be
calculated via the Kolmogorov backward equation which is given by
1
∂P
∂t
+µ(S, t)
∂P
∂S
+
1
2
σ
2
(S, t)

2
P
∂S
2
= 0, (8.2)
1
See for example proposition 5.11 of Bj¨ ork (2004)
CHAPTER 8. EXPLAINING THE STOCK PINNING PHENOMENON 157
where µ(S, t) is the drift of the process and σ(S, t) the volatility. For the model of
(8.1) this corresponds to solving the system
∂P
∂t
+
_
µS −nE
∂∆
∂t
_
∂P
∂S
+
1
2
σ
2
S
2

2
P
∂S
2
= 0, (8.3a)
P(S, T) =
_
_
_
1, if S = K;
0, otherwise.
(8.3b)
Furthermore, we assume for simplicity (and to be consistent with the original paper)
that the delta is given by the delta of a call option, which can calculate directly as
∂∆
∂t
=
_
log(S/K) −
_
r +
1
2
σ
2
_
(T −t)
2σ(T −t)
3
2


_
exp
_

_
log(S/K) +
_
r +
1
2
σ
2
_
(T −t)
_
2

2
(T −t)
_
.
(8.4)
Avellaneda and Lipkin (2003) showed that, for the special case µ = 0 and r+
1
2
σ
2
= 0,
the system (8.3) admits an exact solution given by
P(S, t) = 1 −exp
_

nE
σ
_
2π(T −t)
exp
_

_
log(S/K)
_
2

2
(T −t)
__
. (8.5)
Figure 8.1 shows the solution to equation (8.5) from which it is clear that there is
a greater pinning probability when nE is increased. For the case when µ ,= 0, and
more importantly r +
1
2
σ
2
,= 0 the authors showed that there still exists a positive
probability of pinning. To determine this probability however we are required to solve
(8.3) numerically. Doing so we see that an increase in r results in an increased pinning
probability below the strike price and, correspondingly, a decreased probability above;
this might be expected since, for an increase in r, the process will drift upwards more
on average.
Subsequent to the work of Avellaneda and Lipkin (2003), Jeannin et al. (2006) com-
mented on the similarities of the model with those outlined in this thesis. In fact,
the above model can be seen as simply an approximation to the form of price impact
considered in this thesis with any terms from the quadratic variation of the process
and the effects on the volatility ignored. This can be seen more clearly by considering
CHAPTER 8. EXPLAINING THE STOCK PINNING PHENOMENON 158
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
0.7 0.8 0.9 1 1.1 1.2 1.3
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
S
P
nE increasing
Figure 8.1: The pinning probability (8.5) for values of nE = 0.5, 1, . . ., 5. T −t = 0.1,
K = 1, and σ = 0.2.
the following
dS
S
= µdt +σdW
t
−nEd∆(S, t)
= µdt +σdW
t
−nE
_
∂∆
∂t
dt +
∂∆
∂S
dS +
1
2

2

∂S
2
(dS)
2
_
=
1
1 +nES
∂∆
∂S
_
µ −nE
_
∂∆
∂t
+
σ
2
S
2
2
_
1 +nES
∂∆
∂S
_
2

2

∂S
2
__
dt +
σdW
t
1 +nES
∂∆
∂S
,

dS
S
= ˆ µ(S, t)dt + ˆ σ(S, t)dW
t
. (8.6)
Hence the model of Avellaneda and Lipkin (2003) only includes the time derivative
term of the change in delta, whereas the model outlined above includes the time
derivative and the delta convexity term.
2
Jeannin et al. (2006) solve the associated
Kolmogorov equation (numerically) to determine the pinning probabilities for the
more accurate model (8.6) and showed that the pinning probability was higher in
this case than the corresponding Avellaneda and Lipkin (2003) model. This can
be attributed to the fact that not only does the price impact affect the drift of
the process it also affects the volatility, which for the case investigated above (i.e.
hedging a long call option position) is decreased in the region of the strike. The
2
Note that for (8.6) the problems associated with the vanishing of the denominator highlighted
in this thesis are not present, since 1 +nES
∂∆
∂S
> 0 in the entire domain; this is due to the net long
option position assumption.
CHAPTER 8. EXPLAINING THE STOCK PINNING PHENOMENON 159
combined effect is that the drift pushes the underlying towards the strike and the
reduced volatility effectively keeps the underlying in the vicinity of the strike. Figure
8.2 shows comparisons of the pinning probabilities for the model (8.6), obtained from
the associated Kolmogorov backward equation, and the Avellaneda and Lipkin (2003)
model, for the same value of nE.
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.8 0.85 0.9 0.95 1 1.05 1.1 1.15 1.2
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
S
P
Figure 8.2: Comparing the pinning probability associated with (8.6) (solid line) with
the model of Avellaneda and Lipkin (2003) (dotted line) for nE = 0.1, T − t = 0.1,
K = 1, σ = 0.2, and r +
1
2
σ
2
= 0.
8.2 Nonlinear price impact
Recently, empirical work by Kempf and Korn (1999) brought into question the reli-
ability of the assumption of linear price impact using empirical evidence on German
index futures. This motivated several studies to determine quantitatively how a mar-
ket order of a given size would affect the price of the underlying. Furthermore, Plerou
et al. (2002) showed that this relationship is sublinear (i.e. concave) and further still,
Bouchaud et al. (2002) studied the distribution of the order flow and the resulting
average order book, finding that the average order book has its maximum away from
the best bid (or ask), possibly helping to explain the concavity of the price impact
function. Lillo et al. (2003) concluded that price impact is well described by a power
CHAPTER 8. EXPLAINING THE STOCK PINNING PHENOMENON 160
law where the change in price (dS) caused by an order of volume w is given by
dS(w) ∼ w
p
where p is found to be between 0.1 and 0.5; again a concave function. However the
value of p is greatly contested in the literature and there has been many attempts to
determine its value. Almgren et al. (2005) proposed a 3/5 power dependence whereas
Gabaix et al. (2003) hypothesised that p = 1/2. In addition, recent work by Potters
and Bouchaud (2003) suggested that this relationship may be better described by a
logarithmic price impact function. This still remains an open question in the empirical
literature.
In recent years a number of computer-simulated, artificial financial markets have been
constructed; see LeBaron (2000) for a review of work in the field. These agent-based
models aim to reproduce the main stylized facts observed in real financial markets,
such as fat-tailed distributions of returns and volatility clustering. Jeannin et al.
(2006) proposed such an agent-based model (based on a double auction) in an attempt
to model stock pinning whilst also incorporating the aforementioned nonlinear price
impact. Simulations of the model give the same qualitative effect on the drift as
the model described by (8.6) but with increased volatility around strike rather than
decreased, which is at odds with their numerical solutions of the model (8.6).
More recently, Avellaneda et al. (2007) attempted to incorporate the empirical evi-
dence of nonlinear price impact into the linear model first introduced in Avellaneda
and Lipkin (2003). They do so by assuming a price impact of the form
dS
S
∼ sgn
_
∂∆
∂t

¸
¸
¸
∂∆
∂t
¸
¸
¸
¸
p
dt
hence they assume the stochastic process for the underlying in the presence of delta
hedgers hedging a long call position to take the form
dS
S
=
_
µ −nE sgn
_
∂∆
∂t

¸
¸
¸
∂∆
∂t
¸
¸
¸
¸
p
_
dt +σdW
t
.
CHAPTER 8. EXPLAINING THE STOCK PINNING PHENOMENON 161
It is clear that the pinning probability under such assumptions will be given by the
solution to the following Kolmogorov backward equation
∂P
∂t
+
_
µS −nE sgn
_
∂∆
∂t

¸
¸
¸
∂∆
∂t
¸
¸
¸
¸
p
_
∂P
∂S
+
1
2
σ
2
S
2

2
P
∂S
2
= 0, (8.7a)
P(S, T) =
_
_
_
1, if S = K;
0, otherwise,
(8.7b)
in conjunction with the previously calculated delta (8.4). Avellaneda et al. (2007)
showed that there is a zero probability of pinning if p ≤
1
2
and conversely a non-zero
probability if p >
1
2
. Figure 8.3 shows the numerical solution to (8.7) for five values
of the exponent p, it can be clearly seen that the pinning probability is monotonic
increasing in p.
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.8 0.85 0.9 0.95 1 1.05 1.1 1.15 1.2
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
S
P
p = 1
Figure 8.3: Solution to (8.7) for p = 0.8, 0.9, . . . , 1.2, T − t = 0.1, K = 1, σ = 0.2
and r +
1
2
σ
2
= 0.
8.3 A new nonlinear price impact model
The aim of this section is to suggest a possible extension to the model which would
incorporate the empirically observed power-law price impact into the more accurate
(linear) price impact model (8.6). The most consistent way to extend the model
CHAPTER 8. EXPLAINING THE STOCK PINNING PHENOMENON 162
would be to assume a price impact of the form
dS
S
∼ (d∆)
p
dS
S

_
∂∆
∂t
dt +
∂∆
∂S
dS +
1
2

2

∂S
2
(dS)
2
_
p
however clearly this makes little mathematical sense. We instead choose to model
nonlinear price impact as
3
dS
S
= sgn(ˆ µ) [ˆ µ[
p
1
dt + sgn(ˆ σ) [ˆ σ[
p
2
dW
t
where ˆ µ(S, t) and ˆ σ(S, t) are given by (8.6) and the parameters p
1
and p
2
model the
degree of nonlinearity. Note that for p
1
= p
2
= 1 this reduces to the model of Jeannin
et al. (2006), namely (8.6). The corresponding Kolmogorov backward equation is thus
given by
∂P
∂t
+ sgn(ˆ µ) [ˆ µ[
p
1
∂P
∂S
+
1
2
sgn(ˆ σ) [ˆ σ[
2p
2

2
P
∂S
2
= 0, (8.8a)
P(S, T) =
_
_
_
1, if S = K;
0, otherwise.
(8.8b)
Figure 8.4 shows the solution to equation (8.8) for various combinations of p
1
and p
2
.
It appears that p
2
has a greater affect on the solution than p
1
; further investigation
of this model, however, is left as the subject of future research.
3
Note that this is effectively assuming that the change of the log price with respect to time and
the Brownian motion is given by
d log S
dt
∼ sgn(ˆ µ) | ˆ µ|
p1
,
d log S
dW
t
∼ sgn(ˆ σ) |ˆ σ|
p2
.
CHAPTER 8. EXPLAINING THE STOCK PINNING PHENOMENON 163
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.8 0.85 0.9 0.95 1 1.05 1.1 1.15 1.2
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
P
S
p
1
= 0.8
p
1
= 1
p
1
= 1.2
p
2
=
0
.
8
p
2
=
1
p
2
=
1
.
2
(a) p
2
= 1, p
1
= 0.8, 1 and 1.2.
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.8 0.85 0.9 0.95 1 1.05 1.1 1.15 1.2
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
P
S
p
1
=
0
.
8
p
1
=
1
p
1
=
1
.
2
p
2
= 0.8
p
2
= 1
p
2
= 1.2
(b) p
1
= 1, p
2
= 0.8, 1 and 1.2.
Figure 8.4: Solution to equation (8.8) (solid line) compared to (8.5) (dotted line) for
T = 0.1, K = 1, σ = 0.2, and r +
1
2
σ
2
= 0.
Chapter 9
The British Option
The most important questions of life are, for the most part, really only
problems of probability.
- Pierre Simon Laplace (1749-1827)
Th´eorie Analytique des Probabilit´es (1812)
In this chapter we aim to investigate the mathematical properties and financial mo-
tivations of the newly introduced British option (see Peskir and Samee, 2008a,b), a
new non-standard class of early exercise option; such options can help to mediate the
illiquidity effects discussed in the preceding chapters.
9.1 Introduction
The no-arbitrage price of an early-exercise option uses the implicit assumption that
the holder of the option will act optimally in the sense of following the optimal
strategy of exercising upon first hitting the rational exercise free boundary (cf. section
1.3.5). If the holder of the option chooses to deviate from this strategy, then the
expected discounted payout (under the risk-neutral measure) will be less than the
amount the writer received for the option at the start of the contract.
164
CHAPTER 9. THE BRITISH OPTION 165
Recall that the risk-neutral pricing measure is used to determine the no-arbitrage
price of the option, since the writer of the option can completely hedge away risk.
Indeed, if we make the assumption that the writer of an early-exercise option will
hedge away the risk exposure associated with selling such an option, then from the
writer’s perspective at least, the exercise strategy followed by the holder is irrelevant.
For the purposes of this chapter, we shall assume that writers of early-exercise options
perfectly hedge their positions, hence eliminating any risk associated with the options.
The holder of such an option is assumed not to be hedging the position; instead, he
is interested in maximising profit given his view on the market. Peskir and Samee
(2008b) define such investors as true buyers, i.e. those who have no ability or desire
to sell the option; in short holders of ‘naked’ (unhedged) options. In this case, the
exercise strategy for the true buyer is of paramount importance. Furthermore, since
the true buyer has no interest in hedging his position, the real world drift of the
underlying will play a role in determining the rational exercise strategy.
Let us suppose initially that the holder of an early-exercise option knows with cer-
tainty the true drift of the underlying µ, and that it differs from the risk-neutral
drift rate r. In such a situation, the optimal exercise boundary for the true buyer
would deviate from the optimal exercise boundary under the assumption of a risk-free
drift. In fact, the true buyer’s rational exercise boundary would be given by the free
boundary of the following optimal stopping problem
1
V (S, t; µ) = sup
t≤γ≤T
E
P
S,t
_
e
−r(γ−t)
(K −S
T
)
+
¸
,
recall that the indices of the expectation denotes that the process is started at S at
time t and that the expectation is taken under the real world probability measure
P. Furthermore, such a buyer would presumably not invest in a put option unless
the true drift µ were less than the risk-free interest rate r, otherwise the true buyer
would purchase a call option.
1
Note that here we are making the assumption of a risk-neutral investor (in the utility sense).
CHAPTER 9. THE BRITISH OPTION 166
Unfortunately, the drift of a stochastic process is notoriously difficult to measure, and
so investors would not be able to know the true drift with any degree of certainty.
They can however have an estimate of the true drift, or a ‘view’ on the future direction
of the underlying, which they wish to take advantage of by buying such options. In
this case the true buyer has become a speculator in the sense of seeking to maximise
gains or minimise losses given his particular sentiment of future market conditions.
In other words a speculator who chooses to invest in an early-exercise option must
be under the belief that the true drift of the underlying process is less than the
risk-neutral drift r.
The British option, recently proposed by Peskir and Samee (2008a,b), is a new class of
early-exercise option that attempts to utilise the idea of optimal prediction in order to
provide the true buyer with an inherent protection mechanism should the true buyer’s
beliefs on the future price movements not transpire. More specifically, at any time γ
during the term of the contract, the investor can choose to exercise the option, upon
which he receives the best prediction of the European put payoff (K − S
T
)
+
(given
all the information up to the stopping time γ) under the assumption that the drift
of the underlying is µ
c
, the so-called contract drift, for the remaining term of the
contract. Hence the (now time-dependent) payoff profile of the early-exercise British
put option is given by
G(S, γ; µ
c
) = E
R
_
(K −S
T
)
+
[T
γ
¸
,
where the expectation is taken with respect to a new probability measure R, under
which the stock price evolves according to
dS
t
= (µ
c
−D)S
t
dt +σS
t
dW
R
t
,
where we have included (in anticipation of what will follow) a constant dividend yield
D. The value of the contract drift is chosen by the holder of the option at the start of
the contract and is selected to represent the level of protection (from adverse realised
drifts) that the holder requires; a higher µ
c
corresponds to a lower level of protection.
CHAPTER 9. THE BRITISH OPTION 167
9.2 The no-arbitrage price
Let us fix a probability space (Ω, T, Q), where Ω describes a financial market with a
filtration (T
t
)
t≥0
, which represents the information structure of the financial market
(see Harrison and Kreps, 1979) with the unique risk-neutral measure Q. Assume that
S
t
is an T
t
-adapted stochastic process that describes the stock price process.
Analogous with the American option defined in subsection 1.3.5, the no-arbitrage
price of the British put option is given by the supremum over all stopping times γ
(adapted to the filtration T
t
generated by the process S
t
) of the expected discounted
future payoff. In contrast with an American option, the future payoff is now itself an
expectation, i.e.
V (S, t) = sup
t≤γ≤T
E
Q
S,t
_
e
−r(γ−t)
E
R
_
(K −S
T
)
+
[T
γ
¸¸
.
Recall that the future payoff is defined as the best prediction of the European payoff,
conditional on all the information available up to the stopping time γ. There are
numerous approaches to evaluating this expectation, for example we could directly
use the probability density function of the process under the measure R, to give
E
R
_
(K −S
T
)
+
[T
γ
¸
=
_

0
(K −z)
+
f
R
(S, γ; z, T)dz,
where f
R
(S, γ; z, T) is the transitional probability density function of the process
started at time γ at the position S and finishing at time T at the position z and is
given by
2
f
R
(S, γ; z, T) =
1
σz
_
2π(T −γ)
exp
_

_
log
_
z
S
_

_
µ
c
−D−
1
2
σ
2
_
(T −γ)
_
2

2
(T −γ)
_
.
Tackling the above integral would provide us with the required expectation; however,
we shall adopt an alternative approach in order to give some intuition behind the
resulting expression. We can evaluate the expectation using direct integration with
respect to the probability measure R over the probability space Ω, i.e.
E
R
_
(K −S
T
)
+
[T
γ
¸
=
_

(K −S
T
)
+
dR.
2
See appendix C for a derivation.
CHAPTER 9. THE BRITISH OPTION 168
The random variable is a real valued function whose domain is given by S
T
∈ [0, ∞)
and so the integral can be written as
_

0
(K −z)
+
dR(z) =
_

0
(K −z)
+
R(dz) =
_

0
(K −z)
+
R(z ∈ dz[T
γ
),
where the probability is now conditional on the filtration of information up to the
stopping time γ. Further simplification gives
_
K
0
(K −z)R(z ∈ dz[T
γ
).
In order to evaluate this integral we rewrite the function K−z as an integral to give
_
K
z=0
_
K−z
y=0
dyR(dz) =
_
K
y=0
_
K−y
z=0
R(dz)dy,
where we have also changed the order of integration. We can now exploit the fact
that (see appendix C)
_
K−y
0
R(z ∈ dz[T
γ
) = P
R
[z ≤ K −y[T
γ
] ,
= Φ
_
_
log
_
K−y

_

_
µ
c
−D −
1
2
σ
2
_
(T −γ)
σ

T −γ
_
_
,
where Φ denotes the standard normal distribution function
Φ(z) =
1


_
z
−∞
e

1
2
y
2
dy.
Finally we have our expression for the conditional expectation
E
R
_
(K −S
T
)
+
[T
γ
¸
=
_
K
0
Φ
_
_
log
_
K−y

_

_
µ
c
−D−
1
2
σ
2
_
(T −γ)
σ

T −γ
_
_
dy
= S
γ
_ K

0
Φ
_
log u −
_
µ
c
−D −
1
2
σ
2
_
(T −γ)
σ

T −γ
_
du,
where at the final step we have made the substitution u =
K−y

. The British option
value is thus given by
V (S, t) = sup
t≤γ≤T
E
Q
S,t
_
e
−r(γ−t)
S
γ
_ K

0
Φ
_
log z −
_
µ
c
−D −
1
2
σ
2
_
(T −γ)
σ

T −γ
_
dz
_
.
CHAPTER 9. THE BRITISH OPTION 169
Defining the function
G(S, t) = S
_ K
S
0
Φ
_
log z −
_
µ
c
−D −
1
2
σ
2
_
(T −t)
σ

T −t
_
dz,
we have that the problem now reads
V (S, t) = sup
t≤γ≤T
E
Q
S,t
_
e
−r(γ−t)
G(S, γ)
¸
.
This is the standard form of an American-type option (cf. equation 1.11) and so we
can directly see the links with the existing American option theory.
3
It remains to
find an analytical expression for G(S, t) which can be done easily with integration by
parts to give
G(S, t) = KΦ
_
log
_
K
S
_

_
µ
c
−D−
1
2
σ
2
_
(T −t)
σ

T −t
_
−Se
(µc−D)(T−t)
Φ
_
log
_
K
S
_

_
µ
c
−D +
1
2
σ
2
_
(T −t)
σ

T −t
_
.
Alternatively this can be written as
G(S, t) = KΦ
_
d
1
(S, t; µ
c
)
_
−Se
(µc−D)(T−t)
Φ
_
d
2
(S, t; µ
c
)
_
, (9.1)
where
d
1
(S, t; µ
c
) =
log
_
K
S
_

_
µ
c
−D −
1
2
σ
2
_
(T −t)
σ

T −t
, (9.2a)
d
2
(S, t; µ
c
) =
log
_
K
S
_

_
µ
c
−D +
1
2
σ
2
_
(T −t)
σ

T −t
= d
1
(S, t; µ
c
) −σ

T −t. (9.2b)
Note that the dependency on the contract drift rate µ
c
has been stated explicitly.
General optimal stopping theory can now be applied to this problem analogous with
the American option problem (cf. section 1.3.5) we have that
( = ¦(S, t) : V (S, t) > G(S, t)¦ (continuation set),
T = ¦(S, t) : V (S, t) = G(S, t)¦ (stopping set),
with the optimal stopping time defined as
γ

= inf¦t ∈ [0, T] : S
t
∈ T¦,
3
For the standard American put option the gain function is simply the (time homogeneous)
payoff profile i.e. G
A
(S, t) = (K −S)
+
.
CHAPTER 9. THE BRITISH OPTION 170
i.e. the first time that the stock price enters the stopping region. It can be shown (see
Peskir and Samee, 2008b) that the stopping and continuation regions are separated
by a smooth function b(t), the free boundary, and hence ( = ¦(S, t) : S ∈ (b(t), ∞)¦.
Now applying standard optimal stopping and Markovian arguments, again analo-
gous to the American put option, the problem can be conveniently expressed as the
following free-boundary problem:
_
¸
¸
¸
¸
¸
¸
¸
¸
¸
¸
_
¸
¸
¸
¸
¸
¸
¸
¸
¸
¸
_
V
t
+
1
2
σ
2
S
2
V
SS
+ (r −D)SV
S
−rV = 0 for S ∈ [b(t), ∞),
V (S, t) = G(S, t) on S = b(t),
V
S
(S, t) = G
S
(S, t) on S = b(t) (smooth fit),
V > G in (,
V = G in T,
(9.3)
with the gain function G(S, t) given by equation (9.1). Before we continue, let us
first take a closer look at the gain function.
9.2.1 The gain function
This section briefly comments on the links between the gain function G(S, t) and the
analytical expressions of the corresponding European option values. Note that the
Black-Scholes European put value is given by
V
P
E
(S, t) = Ke
−r(T−t)
Φ
_
d
1
(S, t; r)
_
−Se
−D(T−t)
Φ
_
d
2
(S, t; r)
_
,
where d
1
(S, t; r) emphasises the dependence on the parameter r and is given by
equation (9.2a) for µ
c
= r. Note that this looks very much like the gain function
and indeed if µ
c
= r, then it is clear that
G(S, t)[
µc=r
= e
r(T−t)
V
P
E
(S, t).
This is intuitive as the payoff is the best prediction received now and so involves no
discounting, unlike the European option value. The above identity can also be used
to check that we are calculating G(S, t) correctly. Also note that as t → T we have
that Φ(d
2
) → Φ(d
1
) → 0 for S > K and conversely Φ(d
2
) → Φ(d
1
) → 1 for S < K
CHAPTER 9. THE BRITISH OPTION 171
which indicates that in this limit the gain function takes on the form of the standard
put payoff condition, namely
G(S, T) = (K −S)
+
,
which is consistent with the fact that at t = T clearly the best prediction of the put
payoff will be the payoff itself.
In addition, this suggests that the British option may be considered as a compound
option, i.e. an option on an option. This type of option has been studied extensively,
compare Geske (1977), Geske (1979), Whaley (1982) and Hodges and Selby (1987),
and often leads to trivial solutions. For example, a standard American option writ-
ten on an underlying European option has simply the same value as the underlying
European option, i.e. there exists no optimal early-exercise region. However the in-
novation with the British option considered here is that the two options are priced
under different measures, resulting in non-trivial solutions.
9.3 Numerical treatment
The (nonlinear) system (9.3) can be solved numerically via a number of different
methods. By far the easiest to implement is the Projected Successive Over Relax-
ation (PSOR) algorithm, which attempts to solve the appropriately discretised and
linearised system (typically based on a Crank-Nicolson discretisation scheme), subject
to the constraint
V (S, t) ≥ G(S, t)
at every node and iteration. In addition it is advantageous to make the transformation
τ =

T −t, (9.4)
which has the effect of concentrating the grid points close to expiry, the region where
the solution is changing most rapidly. Furthermore, transforming to log-space via
the transform
ˆ
S = log
_
S
K
_
will simplify the resulting equations. In fact, the entire
CHAPTER 9. THE BRITISH OPTION 172
system (9.3) can be non-dimensionalised via an appropriate set of transformations,
which for the interested reader can be found in appendix B. Non-dimensionalising
makes the system more parsimonious, but to retain financial intuition, in what follows
we choose to retain the dimensional form.
Despite the PSOR algorithm’s ease of implementation, its major drawback (for the
purposes of this exposition) is that in order to determine the location of the free
boundary accurately, some form of interpolation is needed, and further if a more
accurate estimate of the free-boundary location is needed, then the number of grid
points must be increased, increasing the computation time at a disproportionate rate
to the increased accuracy gained in the free-boundary estimate. For these reasons a
more sophisticated method, the body-fitted coordinate system, was employed for the
results given in the present chapter. Body-fitted coordinates where first proposed
by Landau (1950) and later applied to finite-difference schemes by Crank (1957).
More recently Widdicks (2002) adapted the scheme to solve the standard American
option problem and Johnson (2007) to more complex options (involving multiple free
boundaries). The idea behind this technique is to make the transform (in addition
to the time change (9.4)),
ˆ
S =
S
b(τ)
. (9.5)
This effectively maps the continuation region S ∈ [b(τ), ∞) onto the fixed domain
ˆ
S ∈ [1, ∞), where the free boundary now becomes an additional variable in the prob-
lem. Making these changes of variables yields the following modified fixed boundary
problem
_
¸
¸
¸
¸
¸
¸
¸
¸
¸
¸
_
¸
¸
¸
¸
¸
¸
¸
¸
¸
¸
_
1

V
τ

1
2
σ
2
ˆ
S
2
V
ˆ
S
ˆ
S

_
r +
1
2τb(τ)
∂b(τ)
∂τ
_
ˆ
SV
ˆ
S
+rV = 0 for
ˆ
S ∈ [1, ∞),
V (
ˆ
S, t) = G(
ˆ
S, t) on
ˆ
S = 1,
V
ˆ
S
(
ˆ
S, t) = G
ˆ
S
(
ˆ
S, t) on S = 1 (smooth fit),
V > G for
ˆ
S ∈ (1, ∞),
V = G for
ˆ
S ∈ [0, 1],
(9.6)
where the gain function must also be transformed via (9.4) and (9.5). The drawback
of this method is that we now have a more complicated equation to solve, but it
CHAPTER 9. THE BRITISH OPTION 173
is now in a fixed domain and standard finite-difference methods for such problems
are well understood and easily applicable. Note that this method provides highly
accurate results for the free-boundary locations, since no interpolation to calculate
the free boundary is required.
0.5
0.6
0.7
0.8
0.9
1
1.1
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
S
t
µ
c
increasing
Figure 9.1: The British put option free boundary for varying values of the contract
drift. T = 1, K = 1, σ = 0.4, r = 0.1, D = 0, and µ
c
= 0.11, 0.115, 0.12, . . ., 0.16.
0.65
0.7
0.75
0.8
0.85
0.9
0.95
1
1.05
1.1
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
S
t
σ increasing
Figure 9.2: The British put option free boundary for varying volatilities. T = 1,
K = 1, µ
c
= 0.125, r = 0.1, D = 0, and σ = 0.05, 0.1, . . ., 0.5.
Figure 9.1 shows the location of the British put option free boundary for varying val-
ues of the contract drift µ
c
and in addition figure 9.2 the variation with the volatility
CHAPTER 9. THE BRITISH OPTION 174
(for a fixed µ
c
). Note that some parameters (such as volatility) have been chosen
artificially high in order to illustrate the distinct behaviour of the British option free
boundaries. It can be seen that as the contract drift parameter increases the free
boundary (and its value at expiry) collapses downwards monotonically to zero. In
fact the exact location to which the free boundary asymptotes and its behaviour close
to expiry is determined in section 9.5. Also the volatility appears to have a significant
influence on the shape of the free boundary.
The most striking difference with the American option free boundary is that, for some
values of the contract drift at least, the boundary behaviour is no longer monotonic.
This non-monotonic behaviour can lead to complications in the convergence of the
numerical schemes employed and in addition can result in subtle difficulties when
trying to prove the regularity and smoothness of the free boundary (see Peskir and
Samee, 2008b). In what follows, in particular in the asymptotic analysis, regularity
and smoothness shall be implicitly assumed.
Another interesting point to note is that for a given investor at t = 0 with current
stock price S
0
, there exists a value of µ
c
below which all British option free boundaries
at t = 0 lie above the current stock price, i.e. b(0) > S
0
and so the investor is
automatically placed in the exercise region at the initiation of the contract, hence the
optimal investor would choose to exercise immediately.
Finally, numerical investigations showed that varying µ
c
but keeping the difference
between µ
c
and interest rate r constant resulted in distinct free boundaries. Further-
more, varying µ
c
and keeping the ratio of the contract drift to interest rate constant,
i.e.
r
µc
= const., also resulted in differing free boundaries, although in the latter case
all free boundaries asymptoted to the same value at expiry. More information about
the relationship between the parameters could be gleaned from a consideration of
the fully non-dimensionalised problem (see appendix B) but this shall be left as the
subject of future research.
CHAPTER 9. THE BRITISH OPTION 175
9.4 Free boundary analysis far from expiry
Far away from expiry, i.e. T −t →∞(effectively the perpetual limit), the numerical
results showed in figure 9.1 suggest that the free boundary for the British put option
either tends to infinity or tends to zero in this limit, dependent on the choice of the
parameter µ
c
. The following analysis will try to shed some light on these two distinct
regimes of behaviour. First we introduce the following function
H(S, t) = L
_
G(S, t)
_
= G
t
+
1
2
σ
2
S
2
G
SS
+ (r −D)SG
S
−rG, (9.7)
which will be of use in our analysis, since it is a known analytic function which we
shall calculate shortly. It is a standard result from optimal stopping theory that the
free boundary cannot be contained in the region in which H(S, t) > 0.
4
This can
be easily seen by directly applying Itˆ o’s formula to the discounted gain function and
taking expectations to obtain
E
Q
_
e
−r(γ
B
−t)
G(S
γ
B
, γ
B
)
¸
= G(S, t) +E
Q
__
γ
B
−t
0
e
−ru
H(S
t+u
, t +u)du
_
, (9.8)
where γ
B
is defined as
γ
B
= inf¦t ∈ [t, T] : (S
t
, t) / ∈ B¦,
i.e. the first exit time of the process from the domain B defined as an arbitrary
small half-circular domain around the point (S, t). From (9.8) it is clear that the
expected future gain (the left-hand-side) must be greater than the current gain G(S, t)
if H(S, t) > 0, indicating it would not be optimal to stop at (S, t) and so the free
boundary cannot be located in the region where H(S, t) > 0. As such the solution to
H(S
h
, t) = 0 will act as an analytical proxy for the free boundary, or at least provide
an upper bound on the location of the free boundary at any given instant. Since this
section is concerned with the large time to expiry behaviour of the free boundary, we
will ultimately be interested in the behaviour of S
h
in this limit. Making extensive
use of the identity,
Φ

(d
2
) =
K
S
e
−(µc−D)(T−t)
Φ

(d
1
), (9.9)
4
See for example Peskir and Shiryaev (2006).
CHAPTER 9. THE BRITISH OPTION 176
where primes denote derivatives, we can directly compute each term in the H-function
as
G
t
= −
σKe

1
2
d
2
1
2
_
2π(T −t)
+ (µ
c
−D)Se
(µc−D)(T−t)
Φ(d
2
), (9.10)
G
S
= −e
(µc−D)(T−t)
Φ(d
2
),
G
SS
=
Ke

1
2
d
2
1
σS
2
_
2π(T −t)
,
which after substitution into (9.7) yields
5
H(S, t) = µ
c
Se
(µc−D)(T−t)
Φ(d
2
) −rKΦ(d
1
). (9.11)
This pleasingly simple expression for the H-function can now be used to provide
us with an upper bound on the location of the free boundary. To do this we are
interested in the solution to the equation
µ
c
S
h
e
(µc−D)(T−t)
Φ
_
d
2
(S
h
, t)
_
−rKΦ
_
d
1
(S
h
, t)
_
= 0 (9.12)
for S
h
= S
h
(t), and furthermore in the limit T − t → ∞. It is hypothesised that
if S
h
→ 0 as T − t → ∞ then since the free boundary must lie below S
h
(t) then
the free boundary must also tend to zero as T − t → ∞. Note that the converse
is not necessarily true. Figure 9.3 shows the solution of equation (9.12) obtained
using standard Newton-Raphson iteration. The first point to note is that S
h
is not
monotonic for some values of the contract drift µ
c
, the same qualitative behaviour
that can be seen for the true free boundary. It can also be seen that for large enough
values of the contract drift, S
h
(t) appears to tend to zero with no visible turning point,
suggesting a critical value of µ
c
which separates two distinct regions of asymptotic
behaviour of S
h
(t), namely tending to infinity or to zero. This is an important point,
since if we can show under what circumstances the value of S
h
(t) tends to zero for
large times to maturity, we are able to infer that the free boundary must also tend
to zero in that limit.
Guided by numerical differentiation it appears that the solution for S
h
for large values
5
Note also that the dividends do not occur anywhere but in the exponents.
CHAPTER 9. THE BRITISH OPTION 177
0
0.5
1
1.5
2
0 10 20 30 40 50
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
S
h
t
µ
c
increasing
Figure 9.3: The zero of the H-function, i.e. S
h
(t), for varying values of the contract
drift. µ
c
= 0.102, 0.104, . . . , 1. T = 50, K = 1, r = 0.1, D = 0, and σ = 0.4.
of T −t takes on an exponential form, i.e.
S
h
(t) ∼ Ae
β(T−t)
as T −t →∞. (9.13)
Therefore making this ansatz we can see that
d
1,2
(S
h
, t) =
log
_
K
A
_

_
µ
c
−D ±
1
2
σ
2
+ β
_
(T −t)
σ

T −t
,
which as T −t →∞ the second term dominates giving
lim
T−t→∞
d
1,2
(S
h
, t) = −
1
σ
_
µ
c
−D ±
1
2
σ
2

_

T −t.
The equation for S
h
(t) in the limit T −t →∞ thus becomes
µ
c
Ae
(µc−D+β)(T−t)
Φ
_


c
−D +
1
2
σ
2
+β)
σ

T −t
_
= rKΦ
_


c
−D −
1
2
σ
2
+β)
σ

T −t
_
.
(9.14)
For convenience in what follows we shall define
ν
±
=
µ
c
−D ±
1
2
σ
2

σ
.
Now it is clear that in the limit T − t → ∞, the functions d
1,2
will tend to ±∞
depending on the sign of the parameter ν
±
. In order to provide an appropriate
CHAPTER 9. THE BRITISH OPTION 178
balancing of terms in the following analysis we assume that both functions d
1,2
→−∞
in the limit. This can only be achieved if ν
±
> 0, i.e. if
β >
1
2
σ
2
−µ
c
+D > −
1
2
σ
2
−µ
c
+D, (9.15)
a condition which can (and will) be checked a posteriori.
Next we use the well known result (see for example Abramowitz and Stegun, 1968)
that for large negative values of the arguments z, the cumulative normal distribution
function Φ(z) has the following asymptotic expansion
Φ(z) = −
e

1
2
z
2
z


_
1 −
1
z
2
+
3
z
4
+. . . +
(−1)
n
1.3 . . . (2n −1)
z
2n
+. . .
_
; (9.16)
note that a similar expression exists for large positive z. Equation (9.16) gives to
leading order that
Φ
_
−ν
±

T −t
_
=
e

1
2
ν
2
±
(T−t)
ν
±
_
2π(T −t)
+. . . ,
therefore equation (9.14) becomes
µ
c
Ae
(µc−D+β)(T−t)
ν
+
_
2π(T −t)
e

1
2
ν
2
+
(T−t)
=
rK
ν

_
2π(T −t)
e

1
2
ν
2

(T−t)
+. . . . (9.17)
Finally considering the exponent of the exponentials on the left-hand-side we can see
that
µ
c
−D +β −
1
2
ν
2
+
= µ
c
−D +β −

c
−D +
1
2
σ
2
+β)
2

2
= −

c
−D −
1
2
σ
2
+β)
2

2
= −
1
2
ν
2

,
which remarkably allows us to cancel through all exponential terms leaving the much
simpler equation
µ
c
A
ν
+
=
rK
ν

. (9.18)
This, however, only provides us with one equation for two unknown constants A and
β. In order to determine their value uniquely we can obtain another equation by
differentiating (9.12), noting that S
h
is a function of t, to obtain
µ
c
e
(µc−D)(T−t)
_
dS
h
dt
−(µ
c
−D)S
h
_
Φ(d
2
) +KΦ

(d
1
)
_

c
−r)
∂d
1
∂t
+
σµ
c
2

T −t
_
= 0.
CHAPTER 9. THE BRITISH OPTION 179
Once again making the ansatz (9.13) and performing a similar analysis to the above,
we can arrive at the following expression, again provided ν
±
> 0
µ
c
ν
+

c
−D +β) A =
K
2
_

c
−r)ν

+σµ
c
_
. (9.19)
Now eliminating the unknown A from equations (9.18) and (9.19) leads to the fol-
lowing
2r (µ
c
−D +β) = (µ
c
−r)ν
2

+σµ
c
ν

,
⇒2r (µ
c
−D +β) = (µ
c
−r)
_
µ
c
−D −
1
2
σ
2

_
2
+σµ
c
_
µ
c
−D−
1
2
σ
2

_
.
(9.20)
Finally solving the (quadratic) equation (9.20) for β yields
β =
1
2
σ
2
_
µ
c
+r
µ
c
−r
_
−µ
c
+D (9.21)
where we have taken the positive root in order not to violate the assumption (9.15).
Also note that since
µc+r
µc−r
> 1 for µ
c
> r, the positive root, i.e. equation (9.21) is
consistent with the initial assumption (9.15), adding credence to the obtained result.
Also note that this result is consistent with the fact that as µ
c
→r the free boundary
appears to be tending to infinity at an increasing rate, suggesting that it is always
optimal to early exercise immediately. Equation (9.21) is also consistent with the
observation (as seen in figure 9.2) that the volatility appears to greatly affect the
behaviour of the free boundary. Finally, substitution of the found value for β, (9.21),
back into equation (9.18) gives immediately that A = K, and so to summarise we
have found that for T −t →∞ the zero of the H-function, i.e. S
h
, will behave as
S
h
(t) = Ke
β(T−t)
where β is given by equation (9.21).
The more useful corollary of this result however is that clearly if β > 0 then S
h
(t) →
∞for large values of T −t and conversely if β < 0 then S
h
→0. The critical value of
the parameter µ
c
which separates these two distinct regimes is given by the solution
to the equation
β =
1
2
σ
2
_
µ

c
+r
µ

c
−r
_
−µ

c
+D = 0,
CHAPTER 9. THE BRITISH OPTION 180
hence
µ

c
=
1
2
σ
2
_
µ

c
+r
µ

c
−r
_
+D,
or
µ

c
=
1
2
_
r +D +
1
2
σ
2
_
+
1
2
_
_
r +D +
1
2
σ
2
_
2
+ 4r
_
1
2
σ
2
−D
_
_1
2
. (9.22)
If D <
1
2
σ
2
then we are required to take the positive square root in order to obtain
a positive µ

c
. If D >
1
2
σ
2
then we could have two positive solutions, however only
the positive root will be greater than r. In addition the square root will always stay
positive for all value of D and so we will always have a critical value.
Knowledge about the large time to expiry behaviour of the H-function is not only
useful in determining different regimes of behaviour of the free boundary, but can also
be used to improve the efficiency of the numerical calculations of the option value
and its corresponding free-boundary location. The large time to expiry behaviour
can be used to make an appropriate transformation that removes the observed blow
up to infinity of the free boundary for large T − t. We have shown that in the limit
S
h
(t) takes on the form Ke
β(T−t)
, suggesting that the transformation
ˆ
S = Se
−β(T−t)
(9.23)
may help remove any exponentially growing behaviour. In fact as the function S
h
(t)
provides an upper bound for the location of the free boundary, it is clear that in (
ˆ
S, t)-
space, all free boundaries, regardless of the value of the contract drift µ
c
, will tend
to finite or zero values. Furthermore any numerical treatment of the free-boundary
problem in (
ˆ
S, t)-space will be better behaved in the absence of any numerical break-
downs.
9.5 Analysis close to expiry
Also of great interest is the behaviour of the free boundary close to expiry. We must
determine the value to which the free boundary asymptotes and also the functional
CHAPTER 9. THE BRITISH OPTION 181
form in which it asymptotes to that value. In addition to being interesting in its own
right, knowledge of the free boundary behaviour close to expiry can be exploited to
improve the efficiency of numerical schemes used in determining the free boundary.
For example when using the body-fitted coordinate system described in section 9.3,
providing the correct location of the free boundary at expiry can be crucial in the
scheme’s success.
When investigating the small time to expiry behaviour of free boundaries arising from
derivative securities with early-exercise features, there are a multitude of approaches
that can be taken. For example the analysis of Kuske and Keller (1998), which in-
vestigates the standard American put option, exploits the Green’s function for the
heat equation to convert the resulting boundary value problem to an integral equa-
tion, which is then solved asymptotically for times close to expiry. Alternatively the
differential form of the free-boundary problem can be tackled directly and matched
asymptotic expansions can be used to investigate the solution behaviour close to
expiry, for example see Wilmott et al. (1995), Johnson (2007) or the recent survey
article by Howison (2005).
The value to which the British option free boundary asymptotes can be obtained
simply via a cursory inspection of the H-function defined in the previous section and
given by (9.11). Recall that the region in which H(S, t) > 0 cannot contain the free
boundary. Using this information as t → T we have that the H-function is trivially
zero for S > K, and for S < K is given by
H(S, T) = µ
c
S −rK.
Hence we have that
S
h
(T) =
rK
µ
c
,
and that the H-function is positive in the region S >
rK
µc
and so we can conclude that
the free boundary must lie at or below this value. In order to convince ourselves that
it should in fact coincide with S
h
(T) we consider a situation in which the process is
an arbitrarily small time away from expiry and that the current price is below the
CHAPTER 9. THE BRITISH OPTION 182
value
rK
µc
. In this region H(S, t) < 0 and so the investor is accumulating negative
gain, with no possibility of the process reaching the region in which H(S, t) > 0,
since the process is extremely close to expiry; hence the optimal investor would stop
in this region leading to the conclusion that
b(T) =
rK
µ
c
. (9.24)
Note that the inclusion of dividends does not affect the location to which the free
boundary asymptotes as one might expect; this fact is easily confirmed numerically.
The above result can be shown using a different approach which we shall briefly
outline below. One of the hallmarks of the existence of an early-exercise region is
the existence of a region in which the value of the early-exercise option’s European
counterpart (i.e. with no early exercise) lies below the payoff function (gain function).
Close to expiry this amounts to determining if the dynamics of the PDE move the
option price below the gain function at a small time prior to expiry. More specifically
if the quantity

∂t
_
V (S, T −δt) −G(S, T −δt)
_
ever becomes positive. A simple Taylor expansion leads to

∂t
_
V (S, T −δt) −G(S, T −δt)
_
≈ V (S, T) −G(S, T) +δt
_
∂V
∂t
(S, T) −
∂G
∂t
(S, T)
_
.
By definition V (S, T) = G(S, T) and we can also directly evaluate the expression for
G
t
, namely (9.10), at t = T. In addition rearranging the governing PDE directly to
obtain an expression for V
t
and using the fact that V (S, T) = (K −S)
+
leads to

∂t
_
V (S, T −δt) −G(S, T −δt)
_
≈ δt(rK −µ
c
S)
for S < K and trivially zero otherwise. Hence there exists a (possible) early-exercise
region when
rK −µ
c
S > 0 ⇒S <
rK
µ
c
,
in agreement with (9.24).
CHAPTER 9. THE BRITISH OPTION 183
However, of more interest is the functional form in which the free boundary ap-
proaches (9.24). It transpires that the answer is pleasingly simple, the leading-order
behaviour is identical to that of the standard American put option with dividends,
the proof of which is given below.
If we make a subtle change of variable, namely
ˆ
S = Se
(µc−D)(T−t)
, (9.25)
then the governing PDE becomes
V
t
+
1
2
σ
2
ˆ
S
2
V
ˆ
S
ˆ
S
+ (r −µ
c
)
ˆ
SV
ˆ
S
−rV = 0,
and the gain function is transformed to
G(
ˆ
S, t) = KΦ
_
d
1
(
ˆ
S, t)
_

ˆ

_
d
2
(
ˆ
S, t)
_
,
with
d
1
(
ˆ
S, t) =
log
_
K
ˆ
S
_
+
1
2
σ
2
(T −t)
σ

T −t
,
d
2
(
ˆ
S, t) = d
1
(
ˆ
S, t) −σ

T −t.
Notice that the parameter µ
c
has been taken out of the gain function (and hence
the boundary conditions) and placed into the PDE, where it appears as a pseudo-
dividend. Also note that the actual dividend yield D has been completely removed
from the problem by the scaling (9.25), indicating that dividends have a rather benign
affect on the dynamics of the British put option.
Since we are interested in the behaviour of the free boundary as we approach expiry,
we are therefore interested in the behaviour of the gain function as we approach
expiry, i.e. for small values of T − t. The first point to note is that in this limit
d
2
→d
1
and so it will suffice to determine the behaviour of d
1
in this limit. It is clear
that as T −t →0 (i.e. t →T) the first term in d
1
(
ˆ
S, t) will dominate giving
lim
t→T
d
1
(
ˆ
S, t) = lim
t→T
1
σ

T −t
log
_
K
ˆ
S
_
.
CHAPTER 9. THE BRITISH OPTION 184
Since log
_
K
ˆ
S
_
< 0 for
ˆ
S > K, then in this region it is clear that d
1
→−∞ as t →T
and conversely for
ˆ
S < K then d
1
→+∞as t →T. In the region
ˆ
S > K if d
1
→−∞
then we can exploit the asymptotic expansion of the cumulative normal distribution
function (9.16) to give
Φ(d
1
) = −
e

1
2
d
2
1
d
1


+. . . ,
⇒Φ(d
1
) = −σ
_
T −t

_
log
_
K
ˆ
S
__
−1
exp
_

1

2
(T −t)
_
log
_
K
ˆ
S
__
2
_
+. . . .
Similarly for the region
ˆ
S < K where d
1
→+∞ we can use the symmetry of Φ() to
obtain
Φ(d
1
) = 1 −
e

1
2
d
2
1
d
1


+. . . ,
⇒Φ(d
1
) = 1 −σ
_
T −t

_
log
_
K
ˆ
S
__
−1
exp
_

1

2
(T −t)
_
log
_
K
ˆ
S
__
2
_
+. . . .
Using the above and further the fact that Φ(d
1
) →Φ(d
2
) as t →T, the gain function
can be approximated by
G(
ˆ
S, t) = (K−
ˆ
S)
+
−σ
_
T −t

_
log
_
K
ˆ
S
__
−1
exp
_

1

2
(T −t)
_
log
_
K
ˆ
S
__
2
_
(K−
ˆ
S)+. . .
(9.26)
in the region close to expiry. Note that the second-order term in (9.26) decays as
(T − t)
1
2
e

A
T−t
in the limit t → T, where A must be a positive constant. Clearly
this decays much faster than the terms arising from the asymptotic (power series)
expansion of the PDE and consequently the gain function can be approximated to
6
G(
ˆ
S, t) =
_
K −
ˆ
S
_
+
,
i.e. the standard put option payoff.
Hence to leading order as t → T we have that the British put option free-boundary
problem (9.3), under the transformation (9.25), is identical to the standard American
put option free-boundary problem with dividends, where the dividend amount (yield)
6
Note that there is a breakdown if S < Ke
−B

T−t
or S > Ke
+B

T−t
, which as t →T tend to 0
and ∞ respectively, such that these breakdowns do not interfere with the free boundary at expiry.
CHAPTER 9. THE BRITISH OPTION 185
is given by the contract drift rate µ
c
. Hence the behaviour of the British put option
free boundary will coincide with that of the American Put option with dividends.
Fortuitously the asymptotic form of the American put with a constant dividend yield
close to expiry has been studied extensively, see for example Evans et al. (2002), and
the leading order behaviour is given by
b(t) ∼
rK
ˆ
D
_
1 −σα
0
_
2(T −t)
_
for constant dividend yield
ˆ
D > r, where the constant α
0
is the solution to the
transcendental equation
α
3
0
e
α
2
0
_

α
0
e
−u
2
du =
1
4
_

2
0
−1
_
,
which can be calculated to give α
0
≈ 0.4517. Therefore the asymptotic form of the
British put free boundary, after transforming back to the original variables via (9.25),
is given by
b(t) ∼
rK
µ
c
_
1 −σα
0
_
2(T −t)
_
e
−(µc−D)(T−t)
, (9.27)
i.e. the free boundary approaches expiry parabolically. Note, however, that to lead-
ing order the behaviour of the free boundary remains unchanged by the transform
(9.25). Figure 9.4 shows the above approximation compared with the free boundary
obtained via a full numerical treatment using the techniques described in section 9.3.
In addition, numerical investigations performed by the author indicate that (9.27)
becomes a better approximation (over the same scale) as the volatility is decreased.
This is most likely due to the fact that for larger σ the turning point of the free bound-
ary occurs closer to expiry and the free boundary would diverge from the parabolic
approximation over a shorter timescale.
Note that if we are interested in higher-order asymptotics then the behaviour will
differ to that of the American put with dividends. This is due to the various terms
we have neglected as t → T from the gain function and also from the exponential
transform. Also note that for the American put the free boundary takes on a very
different functional form for different values of the dividend parameter, i.e. for
ˆ
D = r
CHAPTER 9. THE BRITISH OPTION 186
0.775
0.78
0.785
0.79
0.795
0.8
0 0.002 0.004 0.006 0.008 0.01
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
b
(
t
)
t
Figure 9.4: The asymptotic approximation for the British put option free boundary
close to expiry, i.e. (9.27) (dotted line) compared with fully numerical value (solid
line). T = 0.01, σ = 0.4, r = 0.1, µ
c
= 0.125, and D = 0.
or
ˆ
D < r, however for the British put option we have the natural restriction that
µ
c
> r and so the parabolic regime is the only one of interest. Furthermore, the
value of the dividend D does not qualitatively change the asymptotic behaviour of
the British put free boundary since the scaling (9.25) has removed the parameter
completely from the system.
9.6 Financial analysis of the British put option
The protection feature of the British option that was so crucial in motivating its in-
troduction led Peskir and Samee (2008a,b) to investigate further the motivations of a
British option investor, in particular the potential return on investment in the British
(and other) options. Here we reproduce this analysis in more detail by exploiting the
advanced numerical techniques employed to obtain relative-return surfaces of the op-
tions. Any speculator (as opposed to a hedger) who chooses to invest in a put-style
option will inevitably hold the view that the underlying will experience downward
price movements at some time in the future, or more specifically that the realised
drift will be less than the risk neutral rate r. Indeed, it was with these very traders
CHAPTER 9. THE BRITISH OPTION 187
in mind that the British option was developed. Furthermore, as noted by Peskir
and Samee (2008a,b), the British option provides an instrument that can be used to
‘milk’ profits from the speculators view of future price movements, whilst maintaining
a protection feature should these price movements not transpire.
To further illustrate possible situations in which a British option might be favourable
over other options available in the market, let us construct an idealised market con-
sisting solely of a European, American and British put option written on the same
underlying, with the same expiry date, say one year and strike price K which for
simplicity we shall assume is equal to the current stock price and scaled to unity, i.e.
S
0
= K = 1 and hence all options are ‘at the money’. Now an investor in such a
market has the choice of investing in either of the three options and as such has to
pay the corresponding option price. Of great interest from the point of view of such
an investor is the expected return on their investment for all possible future stock
prices at any point in time prior to maturity.
The rational strategy of such an investor would be to choose the option that has
the greatest return under the future price movements that are most in-line with the
sentiment of that particular investor. For example, if an investor believes that the
stock price will fall by approximately 20% in the next 6 to 9 months, then which
available option will provide the greatest return on the price paid for the option,
defined as
R(S, t) =
money received at (S, t)
option price paid at t = 0
100%.
The idea of this section is to produce a return surface for all the available options in
the market, given the current stock price S
0
. The option price of all three options
is easily calculated at t = 0 given the current price S
0
, but there is some ambiguity
in the value of the money received at a future time. For a European option we are
unable to exercise the option until expiry and so there can be no payout of the option
at any time prior to maturity. Alternatively for an American option we can choose
to exercise at any time prior to maturity and receive the payoff (K −S
t
)
+
, however
any rational investor would never choose to exercise the option ‘out of the money’,
CHAPTER 9. THE BRITISH OPTION 188
i.e. if S
t
> K for any time before maturity. However, despite the option having a
zero gain function in such a situation, it still has some intrinsic value, precisely the
no-arbitrage price of the American option at that particular price and time. For this
reason the most consistent measure of the expected return on an American option is
given by
R
A
(S, t) =
max
_
(K −S)
+
, V
A
(S, t)
_
V
A
(S
0
, 0)
100%,
hence we are allowing the investor to sell the option in the market and receive the
current ‘no-arbitrage’ value of the option in addition to allowing for the exercise of
the option upon which the payoff is received. Note that this assumption assumes that
the investor has access to the market in order to sell and that he incurs no transaction
or liquidation costs. In some sense this corresponds to a ‘best case’ scenario for the
American and European option, since if the investor is exposed to market frictions
then they will inevitably obtain a worse price than the no-arbitrage values used in
the above calculations. The British put on the other hand will not incur such costs
(in the exercise region) as there is no need for the investor to enter the market. Also
note that for these purposes we are assuming the investor to behave rationally in the
sense that the option should be exercised at a stock price in the rational exercise
region and to sell the option at a stock price in the continuation region. Similar
assumptions allow us to define the return on the British option as
R
B
(S, t) =
max
_
G
B
(S, t), V
B
(S, t)
_
V
B
(S
0
, 0)
100%,
and the return on the European option as
R
E
(S, t) =
V
E
(S, t)
V
E
(S
0
, 0)
100%,
hence the European option investor’s only choice is to sell the option at times prior
to maturity.
We note that at maturity the return on all three investments are not equal, the money
received will be the same, i.e. (K−S
T
)
+
, but that the initial price paid for the option
will have varied, more specifically we must have V
A
(S
0
, 0) > V
B
(S
0
, 0) > V
E
(S
0
, 0).
CHAPTER 9. THE BRITISH OPTION 189
This is natural since if an investor waits until maturity to exercise an early-exercise
option, then they have ‘wasted’ the early-exercise premium priced into the American
and British option prices. Figure 9.6 shows the difference in returns of the British
put option and the American put option, i.e. R
B
(S, t) −R
A
(S, t), for a contract drift
of µ
c
= 0.125. This surface indicates the differences in the returns (as a percentage
of the initial investment) should the investor close out their position by exercising or
selling, whichever provides the greatest return (or is permitted). Similarly figure 9.7
compares the return of the British put to the European put and finally for reference
figure 9.8 compares the American and European put option. For comparison the
rational exercise boundaries can be found in figure 9.5.
0.65
0.7
0.75
0.8
0.85
0.9
0.95
1
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
b
(
t
)
t
µ
c
= 0.125
µ
c
=
0
.
1
3
5
Figure 9.5: Location of the free boundary for the British (solid line) and American
(dotted line) put option under investigation in figures 9.6, 9.7 and 9.8. T = 1, K = 1,
σ = 0.4, r = 0.1, µ
c
= 0.125, and D = 0.
The most striking feature of figure 9.6 is that the British put option appears to be
providing a greater expected return in the majority of the stopping regions. The
American option only provides the investor with a better return on their investment
if it transpires that the investor chooses to stop and close out their position in a
‘wedge’ shaped region below the current stock price and extending just beyond half
way to maturity. Even then the difference in the American put return is no greater
than 20%, whereas in some regions the British put option can provide up to 60%
CHAPTER 9. THE BRITISH OPTION 190
0
0.2
0.4
0.6
0.8
1
1.2
1.4
1.6
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
-20
0
20
40
60
80
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
t
S
Figure 9.6: The difference in the percentage return of the British put option and
the American put option at every possible stopping location. The solid lines denote
contours at increments of 10% from -10% to 60%. The dotted line represents the zero
contour. S
0
= 1, T = 1, K = 1, σ = 0.4, r = 0.1, D = 0, and µ
c
= 0.125.
0
0.2
0.4
0.6
0.8
1
1.2
1.4
1.6
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
-20
0
20
40
60
80
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
t
S
Figure 9.7: The difference in the percentage return of the British put option and the
European put option. Again the solid lines denote contours at increments of 10%
from 0% to 70%. The dotted line represents the zero contour. S
0
= 1, T = 1, K = 1,
σ = 0.4, r = 0.1, D = 0, and µ
c
= 0.125.
CHAPTER 9. THE BRITISH OPTION 191
0
0.2
0.4
0.6
0.8
1
1.2
1.4
1.6
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
-80
-60
-40
-20
0
20
40
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
t
S
Figure 9.8: The difference in the percentage return of the American put option and
the European put option. The solid lines denote contours at increments of 10% from
-70% to 30%. The dotted line represents the zero contour. S
0
= 1, T = 1, K = 1,
σ = 0.4, r = 0.1, and D = 0. Note the change of orientation.
extra return over the American put option (although these regions are many stan-
dard deviations away from the current price of the underlying). More importantly,
numerical investigations have shown that the return profile seen in figure 9.6 and
indeed the region in which the expected return on the American is greater than the
British put option remains relatively constant in shape and size for varying values of
the contract drift µ
c
. Note that the above observations are in total agreement with
Peskir and Samee (2008a,b).
When comparing the British with the corresponding European put option (figure
9.7) the return differentials are the greatest for low values of the stock price and large
times to expiry, as we might expect. However it can be seen that rather surprisingly
the British put option will provide a greater return for the vast majority of stopping
locations below strike K; with the only exception being relatively close to maturity
where the European option would provide (at most) a 10% greater return.
Figure 9.9 attempts to encapsulate all of the above observations into schematic form.
It plots the regions in which the ordering of the expected returns (given any stopping
CHAPTER 9. THE BRITISH OPTION 192
0
0.2
0.4
0.6
0.8
1
1.2
1.4
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
R
B
> R
A
> R
E
R
B
> R
E
> R
A
R
A
> R
B
> R
E
R
E
> R
B
> R
A
t
S
Figure 9.9: Schematic representation of the regions in which at-the-money European,
American and British put option would provide the greatest return on an investment.
The dotted lines represent the free boundaries of the American and British put option
for reference. T = 1, K = 1, σ = 0.4, r = 0.1 and D = 0.
location) for the British, American and European put option are different.
7
The free-
boundary location of the British and American put have been included for reference.
It appears that there is a region, centred around the American early-exercise bound-
ary in which the American option would provide a greater return on the initial invest-
ment than the other two options. This region gets smaller as maturity approaches
and disappears at approximately three-fifths of the way to maturity.
This also highlights what could be described as an ‘unexpected’ additional benefit of
the British option, which is somewhat counter to the protection feature for which the
option was originally created. If the stock price falls sharply, then the British option is
able to ‘milk’ more money out of such a situation than the holder of the corresponding
American option. In fact any stopping location below strike in the second half of the
contract will inevitably result in a higher return for the British option holder, over the
American option holder. Considering this fact, in conjunction with the the empirical
observation that the majority of American options are exercised in the second half of
7
The three curves correspond to the zero contours of the three figures 9.6, 9.7, and 9.8 obtained
for the parameter value µ
c
= 0.125, although the same qualitative behaviour is seen for other values.
CHAPTER 9. THE BRITISH OPTION 193
the contract’s term,
8
the British option can be considered an attractive alternative.
In addition, if the options are far out of the money, i.e. S
t
¸K then the European
option would provide the greatest return, however the values of all three options are
so small in this region that any comparison becomes a purely academic issue.
Finally, figure 9.10 shows how the location of the wedge-shaped region (in which the
American put option provides greater returns over the British put option) changes
as the initial value of the stock price is varied, whilst keeping the strike constant. In
other words as we increase the moneyness of the option. Figure 9.10(a) shows that
as we increase the moneyness by decreasing the ratio S
0
/K from 1 to 0.7 in steps of
0.1 this region becomes progressively smaller until it actually disappears for a ratio
of 0.6, at which point the British option is guaranteed to provide a greater return
on an investment. Figure 9.10(b) shows the shape of this region when we continue
to increase the moneyness by changing the ratio from 0.5 down to 0.2. In this case
the region grows steadily, however this time any immediate downwards stock price
movements will result in the British option providing the greatest return, whereas
an upward movement would be better served by an American put option. This is
the opposite of the behaviour seen in figure 9.10(a). It should be noted that for the
majority of the values of S
0
/K presented in figure 9.10 the option holder is placed
immediately in the exercise region, and so should ‘optimally’ exercise. However, the
comparisons are still of interest, since the investor need not follow the optimally
strategy.
9.7 The British call option
We now turn our attention to the British call option (cf. Peskir and Samee, 2008a).
Unlike the American call option (without dividends) the British call option (with
or without dividends) no longer has a trivial solution; there exists an early-exercise
8
See for example Diz and Finucane (1993), who investigate the early-exercise behaviour of options
on the the S&P 100 index. They show that over 82% of all call options and 77% of all put options
that are exercised are done so during the final week before maturity (inclusive of maturity).
CHAPTER 9. THE BRITISH OPTION 194
0
0.2
0.4
0.6
0.8
1
1.2
1.4
0 0.2 0.4 0.6 0.8 1
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
t
S
Increasing Moneyness
(a)
S0
K
= 1, 0.9, 0.8 and 0.7.
0
0.2
0.4
0.6
0.8
1
1.2
1.4
0 0.2 0.4 0.6 0.8 1
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
t
S
Increasing Moneyness
(b)
S0
K
= 0.5, . . ., 0.2.
Figure 9.10: Figures representing the region in which American put options would
provide a greater expected return that its British option counterpart, for increasing
moneyness. T = 1, K = 1, σ = 0.4, r = 0.1 and D = 0.
boundary for all µ
c
< r. The no-arbitrage pricing procedure is identical to that of the
British put described in section 9.2 and in fact leads to the following free-boundary-
problem representation of the British call option price:
_
¸
¸
¸
¸
¸
¸
¸
¸
¸
¸
_
¸
¸
¸
¸
¸
¸
¸
¸
¸
¸
_
V
t
+
1
2
σ
2
S
2
V
SS
+ (r −D)SV
S
−rV = 0 for S ∈ (0, b(t)],
V (S, t) = G(S, t) on S = b(t)
V
S
(S, t) = G
S
(S, t) on S = b(t) (smooth fit)
V > G in (
V = G in T
(9.28)
where now the gain function is given by
G
C
(S, t) = K
_
Φ
_
d
1
(S, t; µ
c
)
_
−1
¸
−Se
(µc−D)(T−t)
_
Φ
_
d
2
(S, t; µ
c
)
_
−1
¸
(9.29)
where all of the notation is as previously defined. Note the relationship between the
call and put option gain functions
G
C
(S, t) = Se
(µc−D)(T−t)
−K +G
P
(S, t)
where G
C
and G
P
denote the gain functions of the British call and put respectively.
9
Again we can note that the gain function approaches the standard call option payoff
as t →T, i.e.
G(S, T) = (S −K)
+
.
9
Notice the similarity of this expression with the put-call parity relationship described in section
4.1, i.e. V
C
E
= Se
−D(T−t)
−Ke
−r(T−t)
+V
P
E
.
CHAPTER 9. THE BRITISH OPTION 195
Figure 9.11 shows the variation of the free boundary for varying values of the contract
drift µ
c
showing again a monotonic collapse of the free boundary as µ
c
is increased
to r. Again note that the free boundary of the British call option, like the British
put, is no longer monotonic. Figure 9.12 also shows its variation with the volatility
parameter σ, again showing that the nature of the free boundary is highly dependent
the volatility of the underlying stock.
0.8
1
1.2
1.4
1.6
1.8
2
2.2
2.4
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
b
(
t
)
t
µ
c
increasing
Figure 9.11: The British call option free boundary for varying values of the contract
drift. T = 1, K = 1, σ = 0.4, r = 0.1, D = 0, and µ
c
= 0.05, 0.055, 0.06, . . ., 0.09.
0.8
0.9
1
1.1
1.2
1.3
1.4
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
b
(
t
)
t
σ increasing
Figure 9.12: The British call option free boundary for varying volatilities. T = 1,
K = 1, µ
c
= 0.08, r = 0.1, D = 0, and σ = 0.05, 0.1, . . ., 0.5.
CHAPTER 9. THE BRITISH OPTION 196
9.7.1 Analysis far from expiry
For the British call we can apply the same analysis as for the British put in order to
determine the large time from expiry behaviour of the free boundary. For the British
call the H-function can be shown to be
H(S, t) = µ
c
Se
(µc−D)(T−t)
[Φ(d
2
) −1] −rK [Φ(d
1
) −1] , (9.30)
and hence we are interested in the large T−t behaviour of the solution to H(S
h
, t) = 0,
hence
µ
c
S
h
e
(µc−D)(T−t)
_
Φ
_
d
2
(S
h
, t)
_
−1
¸
−rK
_
Φ
_
d
1
(S
h
, t)
_
−1
¸
= 0. (9.31)
Again making the ansatz that the solution for S
h
(t) behaves as
S
h
(t) =
¯
Ae
¯
β(T−t)
as t →T we wish to solve for the constants
¯
A and
¯
β. Substitution into the equation
(9.30) yields
µ
c
¯
Ae
(µc−D+
¯
β)(T−t)
_
Φ
_
−¯ ν
+

T −t
_
−1
_
= rK
_
Φ
_
−¯ ν


T −t
_
−1
_
,
where we have defined
¯ ν
±
=
µ
c
−D ±
1
2
σ
2
+
¯
β
σ
for convenience of algebra. We wish to look at the asymptotic behaviour as T −t →
∞ and it transpires that there are three different regimes in which the solution is
quantitatively different. If ¯ ν
±
> 0 then both the cumulative normal distributions
tend to zero in this limit and the leading order terms become
µ
c
¯
Ae
(µc−D+
¯
β)(T−t)
= rK +. . . ,
and since in this regime
¯
β >
1
2
σ
2
− µ
c
+ D, the exponent of the exponential term
must be positive, indicating that there can be no solution to this equation for
¯
β in the
limit, hence our ansatz for the form of the solution does not permit
¯
β >
1
2
σ
2
−µ
c
+D.
The second regime corresponds to a situation when ¯ ν
+
> 0 and ¯ ν

< 0, i.e. when

1
2
σ
2
−µ
c
+D <
¯
β <
1
2
σ
2
−µ
c
+D ⇒−
1
2
σ
2
<
¯
β <
1
2
σ
2
;
CHAPTER 9. THE BRITISH OPTION 197
in this regime the first cumulative normal distribution function tends to zero but the
second tends to unity in the limit, hence the leading-order terms become
µ
c
¯
Ae
(µc−D+
¯
β)(T−t)
=
rKe

1
2
¯ ν
2

(T−t)
¯ ν

_
2π(T −t)
+. . . ,
where we have used the approximations for Φ() introduced earlier. Again it is clear
that there can be no balancing in this regime as T −t →∞, and so there can be no
solution for
¯
β. Finally we have that ¯ ν
±
< 0, in this regime the leading-order terms
become
µ
c
¯
Ae
(µc−D+
¯
β)(T−t)
¯ ν
+
_
2π(T −t)
e

1
2
¯ ν
2
+
(T−t)
=
rK
¯ ν

_
2π(T −t)
e

1
2
¯ ν
2

(T−t)
+. . . ,
which is identical to equation (9.17). Furthermore the large T − t behaviour of the
time derivative of equation (9.31) under the assumption that ¯ ν
±
< 0 is identical to
(9.19) and so it is is clear that a balancing of terms does exist for the call option in
the limit T −t →∞ and moreover that
¯
β will be given by
¯
β =
1
2
σ
2
_
µ
c
+r
µ
c
−r
_
−µ
c
+D,
i.e. the same behaviour as for the British put. Recall that for a British call we must
have that µ
c
< r and all parameters must be positive so we have that
µ
c
+r
µ
c
−r
< −1,
which confirms our original assumption
¯
β < −
1
2
σ
2
−µ
c
+D, i.e. that ¯ ν
±
< 0.
An interesting corollary to this result is that when the dividend yield D is zero, we
have that
¯
β < 0 for all possible values of µ
c
, hence the function S
h
(t) for the British
call must always decay to zero for large times to expiry in this regime. However this
is not helpful from the viewpoint of determining the behaviour of the free boundary
in this limit, since for the British call option the H-function is positive below S
h
(t),
and so in this regime we cannot say anything about the free-boundary behaviour for
large times to maturity. On the other hand, if D ,= 0 then the function S
h
(t) will
tend to infinity (and so must the free boundary) provided that the dividend is greater
than some critical value, i.e.
D > D
crit
= µ
c
+
1
2
σ
2
_
r + µ
c
r −µ
c
_
.
CHAPTER 9. THE BRITISH OPTION 198
If the dividend is greater than this value, the function S
h
(t) can show positive expo-
nential growth for large times to expiry, more specifically if the contract drift is less
than the critical value µ

c
given by (9.22).
9.7.2 Analysis close to expiry
The close to expiry analysis for the British call option is identical to that of the
British put option. Using the same transformation we can transform the British call
option to the standard American call option problem with dividends (in the limit
t →T). Again the results of Evans et al. (2002) state that the American call option
with dividends behaves as
b(t) ∼
rK
ˆ
D
_
1 +σα
0
_
2(T −t)
_
,
where α
0
is as before. Hence the British call free boundary behaves as
b(t) ∼
rK
µ
c
_
1 +σα
0
_
2(T −t)
_
e
−(µc−D)(T−t)
. (9.32)
Figure 9.13 once again shows the accurately of the approximation (9.32) when com-
pared with the fully numerical free boundary.
So far we have been unable to determine the large time to expiry behaviour of the
British option free boundary directly. The best we have done is to use the behaviour
of the H-function in this limit as an analytical proxy of the free boundary and infer
that the free boundary must tend to zero in certain parameter regimes. As a step
to determining the asymptotic behaviour of the free boundary itself, the following
considerations may prove to be useful.
9.8 Integral representations of the free boundary
9.8.1 The American put option
The value of an American option can be written using the so-called early-exercise
premium representation, due to Kim (1990), Jacka (1991) and Carr et al. (1992)
CHAPTER 9. THE BRITISH OPTION 199
1.25
1.255
1.26
1.265
1.27
1.275
1.28
1.285
0 0.002 0.004 0.006 0.008 0.01
P
S
f
r
a
g
r
e
p
l
a
c
e
m
e
n
t
s
b
(
t
)
t
Figure 9.13: The asymptotic approximation for the British call option free boundary
close to expiry, i.e. (9.32) (dotted line) compared with fully numerical value (solid
line). T = 0.01, K = 1, σ = 0.4, r = 0.1, µ
c
= 0.08 and D = 0.
amongst others; for a full exposition of this representation (including existence and
uniqueness results) see Peskir and Shiryaev (2006). This representation is given by
V (S, t) = E
Q
S,t
_
e
−r(T−t)
G(S
T
, T)
¸
+rK
_
T−t
0
e
−ru
P
Q
S,t
[S
t+u
≤ b(t +u)] du, (9.33)
where G(S
T
, T) is the gain function of the American option, i.e. G(S
t
, t) = (K−S
t
)
+
for a put, and P
Q
S,t
[S
t+u
≤ b(t +u)] is the probability that the process is below the
free boundary at time t + u (conditional on the information available up to time
t). Identifying the first term in the equation as the European put value (without
any early exercise), the second term can be seen intuitively as the extra value of the
option due to the ability to exercise early. An explicit expression for the probability
in the integral is well known and furthermore is derived in appendix C and using this
expression (with D = 0 for simplicity) reduces the above representation to
V (S, t) = V
E
(S, t) +rK
_
T−t
0
e
−ru
Φ
_
_
log
_
b(t+u)
S
_

_
r −
1
2
σ
2
_
u
σ

u
_
_
du. (9.34)
Note that in order to evaluate the integral above and hence determine the option
value we require knowledge of the location of the free boundary b(t). To determine
the location of the free boundary we evaluate equation (9.34) at S = b(t) for which
CHAPTER 9. THE BRITISH OPTION 200
we know the value of the option (by definition) must be equal to K − b(t). This
leads to the so-called free-boundary equation which completely characterises the free
boundary
K −b(t) = V
E
_
b(t), t
_
+rK
_
T−t
0
e
−ru
Φ
_
_
log
_
b(t+u)
b(t)
_

_
r −
1
2
σ
2
_
u
σ

u
_
_
du. (9.35)
Note that this is a Volterra integral equation (of the second type) and solving this
(implicit) equation for b(t) will give the location of the free boundary. To illustrate
that this equation does indeed lead to the location of the free boundary, we shall
consider the simple case of a perpetual American put option, hence we are interested
in the behaviour of equation (9.35) in the limit T −t →∞.
Firstly we note that in the limit T −t →∞ the value of a European option trivially
tends to zero (due to discounting). Setting V
E
(b(t), t) = 0 still leaves an implicit
equation for b(t), however it can be reduced to an explicit equation by exploiting the
fact that the American free boundary at large times to expiry tends to a constant
value. Therefore we would expect the ratio b(t + u)/b(t) to be equal to one. for all
values of u ∈ [0, ∞), since if we are at time t then the free boundary at any time in
the future will be the same as it is now. Hence
lim
T−t→∞
log
_
b(t +u)
b(t)
_
= 0
This is effectively the same as making the assumption (or ansatz) that the free bound-
ary to be found is a constant, b(t) = b

say. The integral representation thus reduces
to
K −b(t) = rK
_

0
e
−ru
Φ
_

2
−2r)

u

_
du.
This integral can be solved (with a little work) by firstly setting s = k
1

u where
k
1
=
σ
2
−2r

leading to
K −b(t) =
2rK
k
2
1
_

0
se

rs
2
k
2
1
Φ(s)ds,
and further integrating by parts yields
K −b(t) =
2rK
k
2
1
_
k
2
1
4r
+
k
2
1
2r


_

0
e

1
2
+
r
k
2
1

s
2
ds
_
.
CHAPTER 9. THE BRITISH OPTION 201
Finally setting k
2
=
1
2
+
r
k
2
1
and using the identity
_

0
e
−k
2
s
2
ds =
1
2
_
π
k
2
,
we arrive at
b(t) =
K
2
_
1 −
1

2k
2
_
.
In terms of the original parameters we can see that
k
2
=
1
2
_
σ
2
+ 2r
σ
2
−2r
_
2
,
and so substitution gives the location of the free boundary as
b(t) =
2rK
2r +σ
2
=
αK
α + 1
,
where α =
2r
σ
2
. This agrees exactly with the well known value of the perpetual
American put free boundary, equation (6.3), found in section 6.1.
9.8.2 The British put option
Analogous with the American option, the optimal stopping boundary of the British
option can be characterised as the unique solution of a nonlinear Volterra integral
equation of the second type (cf. Peskir and Samee, 2008a,b). In order to show this
we can apply Itˆ o’s formula to the discounted option value to obtain
e
−rs
V (S
t+s
, t +s) = V (S, t) +
_
s
0
L
St
_
e
−ru
V (S
t+u
, t +u)
_
du +M
t
,
where M
t
is a local martingale, L
St
is the infinitesimal generator of the process defined
by
L
St
=

∂u
+
1
2
σ
2
S
2

2
∂S
2
+ (r −D)S

∂S
,
Applying the operator to the discounted process we can simplify the above expression
to
e
−rs
V (S
t+s
, t +s) = V (S, t) +
_
s
0
e
−ru
(L
St
−r) V (S
t+u
, t +u)du +M
t
= V (S, t) +
_
s
0
e
−ru
L
_
V (S
t+u
, t +u)
_
du +M
t
,
CHAPTER 9. THE BRITISH OPTION 202
where we have used the fact that (L
St
−r) V (S, t) = L
_
V (S, t)
_
where L is the
Black-Scholes differential operator. The next step is to take expectations giving
E
Q
_
e
−rs
V (S
t+s
, t +s)
¸
= V (S, t) +
_
s
0
e
−ru
E
Q
_
L
_
V (S
t+u
, t +u)

du,
where we have taken the expectation under the integral sign and used the martingale
property that E[M
t
] = 0. Finally letting s = T − t and rearranging yields an
expression for the option value
V (S, t) = E
Q
_
e
−r(T−t)
V (S
T
, T)
¸

_
T−t
0
e
−ru
E
Q
_
L
_
V (S
t+u
, t +u)

du.
Now by definition V (S
T
, T) = G(S
T
, T) and also we have that L
_
V (S
t+u
, t +u)
_
= 0
in the continuation region and is only non-zero in the stopping region where we have
V (S
t+u
, t +u) = G(S
t+u
, t +u). This modifies the expression to
V (S, t) = E
Q
_
e
−r(T−t)
G(S
T
, T)
¸

_
T−t
0
e
−ru
E
Q
_
L
_
G(S
t+u
, t +u)
_
I
_
S
t+u
≤ b(t +u)

du
= E
Q
_
e
−r(T−t)
G(S
T
, T)
¸

_
T−t
0
e
−ru
E
Q
_
H(S
t+u
, t +u)I
_
S
t+u
≤ b(t +u)

du,
where we have used the definition of the H-function, I() is the indicator function
and b() denotes the location of the free boundary separating the continuation and
stopping regions. We now consider the expectation under the integral sign which can
be expressed as
E
Q
_
H(z, t +u)I
_
z ≤ b(t +u)

=
_

0
H(z, t +u)I
_
z ≤ b(t +u)
_
f(S, t; z, t +u)dz,
where f(S, t; z, t + u) is the transitional probability density function of the process
started at position S at time t and finishing at position z at time t +u given by
10
f(S, t; z, t +u) =
1
σz

2πu
exp
_

_
log
_
z
S
_

_
r −D −
1
2
σ
2
_
u
_
2

2
u
_
.
Hence we have the following representation of the British put option value,
V (S, t) = J(S, t) −
_
T−t
0
e
−ru
L(S, t, b(t +u), t +u)du (9.36)
10
For a derivation see appendix C.
CHAPTER 9. THE BRITISH OPTION 203
where we have defined
J(S, t) = E
Q
S,t
_
e
−r(T−t)
G(S
T
, T)
¸
,
= E
Q
S,t
_
e
−r(T−t)
(K −S)
+
¸
,
= V
P
E
(S, t),
i.e. the corresponding European put option value and
L(S, t, b(t +u), t +u) =
_

0
H(z, t +u)I
_
z ≤ b(t +u)
_
f(S, t; z, t +u)dz,
=
_
b(t+u)
0
H(z, t +u)f(S, t; z, t +u)dz.
with H(S, t) as defined by equation (9.11).
11
Now to determine the free boundary
we can evaluate equation (9.36) at the free boundary S = b(t) where we know that
V (b(t), t) = G(b(t), t), hence
G(b(t), t) = V
P
E
(b(t), t) −
_
T−t
0
e
−ru
L(b(t), t, b(t +u), t +u)du. (9.37)
For the proof of the uniqueness of the above representation see Peskir and Samee
(2008a,b). We can attempt to utilise the nonlinear integral equation (9.37) in order to
determine the large T −t behaviour of the free boundary, much in the same way as we
did for the function S
h
(t). The equations involved are clearly much more complicated
and so it will not be a trivial matter to extract such asymptotic behaviour. As such
this shall be left as the topic of future research.
11
At this stage we can see that using the gain function of the standard American put option, i.e.
G
A
(S, t) = (K − S)
+
will yield H(z, t + u) = −rK and the early-exercise premium representation
for the American put option, (9.33), immediately follows.
Chapter 10
Conclusions
In this thesis we have investigated a number of models which have been proposed to
incorporate finite liquidity of the underlying asset into the classical Black-Scholes-
Merton option pricing framework. Here, the powerful tool of asymptotic analysis
has been used to extract important information about the behaviour of such models
close to expiry. A feature common to a number of these models is that the over-
all dispersion term, involving the option gamma, diminishes in magnitude as the
gamma increases in magnitude (as indeed it must as standard payoff conditions are
approached). The upshot of this is that models of this general class cannot exhibit
fully differentiable solutions at times prior to expiry; instead, we must allow solutions
with discontinuous deltas. This is clearly a somewhat undesirable feature, which is
exacerbated by the possibility of negative option values for puts. Indeed, invariably
these solution features lead to completely spurious solutions if standard numerical
procedures are adopted. However, this analysis also gives guidance on how to tackle
these problems numerically at times away from expiry (the full problem), incorpo-
rating the appropriate discontinuities into the numerical scheme. Allied to this, the
vanishing of the denominator in the dispersion term can also be a serious issue. It
is concluded that there is insufficient financial modelling to describe the true price
dynamics in such situations.
It is clear that the period close to expiry is the most critical for option-pricing models
204
CHAPTER 10. CONCLUSIONS 205
and any model that successfully treats this regime should also successfully replicate
the option value dynamics for all time. The approach detailed in this thesis should
give guidance for the development of models incorporating finite liquidity without
the undesirable features observed in a number of the existing models. Several models
in the past have circumvented these difficulties close to expiry but generally using
ad hoc, rather than intuitively justifiable arguments. The hope is that the analysis
presented in this thesis will help in this respect; in addition, below we discuss briefly
some preliminary ideas about how this may be achieved in future research.
One problem with the modelling framework introduced in chapter 2, from a financial
viewpoint, is that the change in price dS becomes unbounded when the ‘forcing’ term
df becomes unbounded, and for the case in which f = ∆ this will happen when d∆
becomes unbounded. Unfortunately, for option contracts with non-smooth payoff
profiles, the unbounded nature of d∆ is unavoidable and so if we are to incorporate
these (common) situations into such modelling frameworks then it is suggested that a
nonlinear response of df to d∆ may well overcome such difficulties. We could choose
to incorporate such nonlinearity into our definition of the forcing term f. i.e. instead
of setting f = ∆ we could set the forcing term to be some function of ∆, i.e.
f = g(∆).
However it is not the function f which ultimately affects the price, but rather its
infinitesimal change df, hence it is the term λdf which we require to remain bounded
(irrespective of the trading strategy ∆). Furthermore, when considering option pric-
ing, the only term in df that filters through into the option price is the
∂f
∂S
dS term,
therefore it is desirable to bound
∂f
∂S
rather than f. This can be done if we model
the derivative of the forcing term (f) with respect to the asset price as a bounded
(nonlinear) function of the derivative of the trading strategy (∆), i.e.
∂f
∂S
= g
_
∂∆
∂S
_
(10.1)
where g() is bounded above. An example of such a function is the ratio of two
CHAPTER 10. CONCLUSIONS 206
n
th
-order polynomials such as
g(x) =
α
n
x
n

n−1
x
n−1
+. . . +α
0
β
n
x
n

n−1
x
n−1
+. . . +β
0
,
which in the limit x → ∞ is bounded above by the ratio α
n

n
. If the aim is to
prevent the denominator from vanishing then we require this ratio to be 1/λ or below,
hence the function
g(x) =
x
λx +β
would suffice, where β can be chosen to obtain the desired shape of the response curve.
Note also that since the response function g(x) is concave, this model is consistent
with the empirical evidence of (nonlinear) price impact discussed in section 8.2. The
functional form of this dependence, however, has been chosen arbitrarily and so again
this extension to the model can be seen as merely an ‘ad hoc’ fix to the difficulties
associated with the vanishing of the denominator. It is possible, however, that the
ideas presented above could be sufficiently formalised with further research.
Another area of future research could be to exploit the links of the existing models
with the theory of linear and nonlinear elasticity (of solids).
1
Indeed, in some sense,
the models formulated in chapter 2 are analogous to Hooke’s law in linear elasticity,
the more we push the market the more it will move, and in a linear fashion. It may
be that this force/extension relationship can be approximated as linear, however it
is likely that this will only be the case provided the force remains within reasonable
limits. Hence, just as current models are analogous to Hooke’s law for elastic media,
there may also be an analogy to the ‘elastic limit’ of a material, i.e. the elastic limit
of the market, beyond which the market will respond in a nonlinear fashion. This
limit point might correspond to the current market depth, or a point much further
away. However, ultimately the affect on the price must be bounded, since there are
only a finite number of shares (and hence a finite force) available. It is hoped that if
the above considerations are incorporated into the current modelling framework then
the problems associated with the vanishing of the denominator may be overcome.
1
This is touched upon in the paper by Sch¨ onbucher and Wilmott (2000), in which it was suggested
that the problems of the vanishing denominator may disappear if some ‘elasticity’ is incorporated
into the response of the market price to large trades.
CHAPTER 10. CONCLUSIONS 207
Finally, it may be possible to preclude the denominator from vanishing if we utilise
the techniques outlined in Soner and Touzi (2007), who extended the ideas origi-
nally introduced in Broadie et al. (1998). These works deal with cases in which the
gamma of the replicating portfolio is bounded above (or below) by some trading
constraint. In such situations, not all options can be perfectly replicated due to the
inability of the replicating portfolio to replicate the option value in regions of large
gamma. However, the minimal super-replicating price can be defined as the cheapest
replicating strategy that dominates the option value in the entire domain. For the
classical Black-Scholes-Merton framework it can be shown that such a minimal super-
replicating price corresponds to the perfect-replicating price (i.e. with no constraints)
of the same option, but with a suitably ‘face-lifted’ payoff profile. Such a face-lifted
payoff profile corresponds ostensibly to a sufficiently smoothed payoff profile. It is
thought that applying the constraint V
SS
< 1/λ to the nonlinear PDE (4.1) may help
to regularise the solutions. However, it is not obvious that these techniques can be
extended to the illiquid situation, since the results rely on the stochastic representa-
tion of the option value (cf. equation (1.4)), a representation that does not exist for
the fully nonlinear equation (4.1). In addition, the super-replicating price is only one
possible paradigm for option pricing in incomplete markets, and so it is not clear cut
that this is the paradigm to use. Furthermore, it is a generally held consensus that
the premium paid to super-replicate (i.e. remain entirely risk-free) is, in practise, too
high.
If it transpires that the problems associated with the vanishing of the denominator
cannot be remedied by the above suggestions, or by some other means, then it is
asserted that, of the three models that were shown to admit well-posed solutions
close to expiry, the Bakstein and Howison (2003) model is one that would be the most
desirable alternative model; the reason for this is two-fold. Firstly, whilst remaining
well-posed close to expiry the option price behaviour also remains sufficiently different
from that of the corresponding Black-Scholes (liquid) option. Secondly, in the limit
of no price slippage, this model reduces to the model of Cetin et al. (2004) which has
CHAPTER 10. CONCLUSIONS 208
become a popular model for liquidation costs in recent years.
An alternative would be to specify an entirely new framework for incorporating price
impact onto option pricing theory. The aims of such a model would be: (i) to fix
the problem with the denominator vanishing, resulting in well-posed problems for
standard payoff profiles, and (if possible) (ii) to incorporate the empirical evidence of
nonlinear price impact. Criteria such as consistency with empirical data, flexibility
in application and also computational aspects (such as the regimes close to expiry
considered in this thesis) would be crucial to the success of such a model.
Also in this thesis, and on a related theme, we have investigated the properties of the
newly introduced British option;
2
a new non-standard class of early exercise options.
Such options help to mediate the effects of a finitely liquid market since the contract
does not require the holder to enter the market and hence incur liquidation costs.
Here, once again, the powerful tool of asymptotic analysis, coupled with advanced
numerical methods have been used to shed light on the behaviour of the early-exercise
boundary for both large and small times from expiry. Furthermore, a pleasingly sim-
ple variable transform was found that helped to reduce the associated free-boundary
problem to that of the standard American option (with dividends) in the regime close
to expiry.
Finally, most researchers in quantitative finance have an opinion on the direction
of future research in the field, some more outspoken than others. Wilmott and
Rasmussen (2002) hypothesise that future models will move away from the simplicity
of traditional stochastic models and their assumptions about probabilistic behaviour.
They also suggest that future models will inevitably draw from a wider range of
mathematical tools. Lipton (2001) goes further to suggest that future research needs
to pay much more attention to the issue of determining the spot price and to predict
its short term evolution, in other words, to provide a sufficiently formal framework in
which to study the market microstructure including supply and demand and liquidity
2
See Peskir and Samee (2008a,b).
CHAPTER 10. CONCLUSIONS 209
effects. In addition, eminent physicist turned ‘quant’ Emanual Derman states in his
blog
3
that hopefully future work will aim to narrow the gap between the invisible
microstructure of markets and the observable macroscopic properties such as market
prices, a gap which at present is particularly large. It is hoped that this thesis is at
least a step in that direction.
3
See http://www.wilmott.com/blogs/eman/.
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Appendix A
Maximum Principles
Maximum principles are extremely useful tools to investigate the properties of the
solutions to partial differential equations, such as monotonicity in parameters, unique-
ness and convexity. These principles date back to as early as 1839 and for a readable
overview of their history and a more in-depth exposition see Protter and Weinberger
(1984).
Nirenberg (1953) states (and proves) the maximum principles applied to equations
that can be written in the form
1
L(V ) +cV = D
where
L(V ) =
n

i,j=1
a
ij
V
S
i
S
j
+
m

α,β=1
b
αβ
V
τατ
β
+
n

i=1
a
i
V
S
i
+
m

α=1
b
α
V
τα
.
If we restrict ourselves to the one dimensional case, i.e. when m = n = 1, this reduces
to
L(V ) = a
11
V
SS
+b
11
V
ττ
+a
1
V
S
+b
1
V
τ
,
and hence we can apply the maximum principles to equations of the form
AV
SS
+BV
ττ
+aV
S
+bV
τ
+cV = D(S, τ). (A.1)
1
Also see, for example, Evans (1998) and Protter and Weinberger (1984).
223
APPENDIX A. MAXIMUM PRINCIPLES 224
In order to do this we require the differential operator L to be elliptic in the S-
variables and parabolic in the τ-variables. Therefore we require
n

i,j=1
a
ij
η
i
η
j
> 0,
hence positive definite and
m

α,β=1
b
αβ
ξ
α
ξ
β
≥ 0
hence positive semi-definite for any real vectors η, ξ ,= 0. In the case m = n = 1 this
reduces to
a
11
η
2
1
> 0 ⇒a
11
> 0 ⇒A > 0
and also
b
11
ξ
2
1
≥ 0 ⇒b
11
≥ 0 ⇒B ≥ 0.
Hence we can apply the maximum principle to equations of the form (A.1) provided
A > 0 and B ≥ 0 with no restriction on the sign of a and b. In what follows (for
simplicity) we shall assume that B = 0 and b = −1 to obtain a forward parabolic
(diffusion) equation of the form
AV
SS
+aV
S
−V
τ
+cV = D(S, τ), A > 0. (A.2)
Furthermore we make the assumption that c = 0 in the above. This last simplification
may seem a little restrictive but it should be noted that it is possible to reduce
equation (A.2) (for any c) to one in which c = 0 by making the transformation
V = e

u to arrive at an equation of the form
L(u) = Au
SS
+au
S
−u
τ
= e
−cτ
D(S, τ) =
ˆ
D(S, τ), (A.3)
which we now wish to apply the maximum principle to. Before we state the maximum
principle we can formally define the solution domain as Ω ∈ R
+
and assume that it
is open, connected and bounded. Let

T
= Ω (0, T],
where T > 0 and also define



T
= ∂Ω¸Ω ¦T¦,
APPENDIX A. MAXIMUM PRINCIPLES 225
hence for a one-dimensional rectangular domain, ∂


T
corresponds to the boundaries
τ = 0, S = 0 and S = S
max
. We are now ready to formally state the maximum
principle applied to equations of the form (A.3).
The maximum principle states that if
ˆ
D(S, τ) ≥ 0 and A > 0 everywhere in the
closure of the domain, Ω
T
, and furthermore that the coefficients of equation (A.3)
are bounded in Ω
T
, then the maximum of the solution (which is assumed to be C
2,1
in the interior of Ω
T
) must occur on the boundary ∂


T
, i.e.
sup

T
u = max
∂Ω
T
u = max



T
u.
By analogy we can find the minimum principle by making the substitution ˆ u = −u
to obtain
L(−ˆ u) = −Aˆ u
SS
−aˆ u
S
+ ˆ u
τ
=
ˆ
D(S, τ),
⇒Aˆ u
SS
+aˆ u
S
− ˆ u
τ
= L(ˆ u) = −
ˆ
D(S, τ).
Hence the maximum principle states that if −
ˆ
D ≥ 0 or
ˆ
D ≤ 0 then ˆ u has its maximum
on the boundary and hence u = −ˆ u has its minimum on the boundary. To summarise,
applying the maximum (minimum) principle to the equation
L(u) =
ˆ
D(S, τ),
we have that, provided A > 0, then if
ˆ
D ≥ 0 then the maximum occurs on the
boundary ∂


T
, and alternatively if
ˆ
D ≤ 0 then the minimum must occur on the
boundary. Furthermore if
ˆ
D = 0 then both the maximum and minimum must occur
on the boundary.
An outline of the proof of such maximum principles is easily seen by considering the
heat equation operator
L(u) = u
SS
−u
τ
.
Suppose that u(S, τ) satisfies the inequality L(u) > 0 in the domain Ω
T
then u
cannot have a (local) maximum at any interior point, since at such a point u
SS
≤ 0
APPENDIX A. MAXIMUM PRINCIPLES 226
and u
τ
= 0, thereby violating L(u) > 0; for a more formal proof, see Protter and
Weinberger (1984).
Aside
As an interesting aside, it is possible to interpret the maximum principle from a
probabilistic point of view. Let us consider a process started at S and time t and
furthermore let M denote the maximum value of the function on the boundary and
m the minimum value. It follows immediately that
m ≤ G(S
γ

, γ

) ≤ M,
where γ

denotes the first exit time of the process from the domain Ω, and G(S, t) is
the value of the function on the boundary of the domain, i.e. ∂Ω¸Ω ¦0¦. Taking
expectations given that the process starts at S, i.e. S
t
= S we have that
m ≤ E[G(S
γ

, γ

) [S
t
= S] ≤ M,
⇒m ≤ u(S, t) ≤ M,
where u(S, t) will also satisfy a backwards parabolic PDE via the Feynman-Kac rep-
resentation theorem outlined in subsection 1.3.3. Hence u(S, τ) will satisfy a forwards
parabolic PDE and the solution to this differential equation must have it’s maximum
on the boundary ∂Ω¸Ω ¦T¦ = ∂

Ω.
A.1 Nonlinear equations
The maximum principles outlined above also hold for any nonlinear equation that
can be expressed in the form
L(u) =
ˆ
D(S, τ),
where the coefficients of the derivatives in the operator can now be functions of the
solution and its derivatives, in other words
L(u) = A(S, τ, u, u
S
, u
SS
)u
SS
+a(S, τ, u, u
S
)u
S
−u
τ
.
APPENDIX A. MAXIMUM PRINCIPLES 227
As an example, consider a general nonlinear PDE of the form
u
τ
= F(S, τ, u, u
S
, u
SS
).
We can apply the maximum principles provided that the function F is elliptic in all
values of its arguments in Ω
T
. In other words in general form
n

l,q=1
∂F(S
i
, τ, p, p
i
, p
ij
)
∂p
lq
ξ
l
ξ
q
> 0,
i.e. positive definite. For the one dimensional case (n = m = 1) we have
∂F(S, τ, p, p
1
, p
11
)
∂p
11
ξ
2
1
> 0 ⇒
∂F(S, τ, u, u
S
, u
SS
)
∂u
SS
> 0.
A.2 Uniqueness of PDEs
We can use the maximum principle to prove the uniqueness of the solution to a PDE
of the general form
V
τ
= F(S, τ, V, V
S
, V
SS
),
where we assume that ellipticity has been shown. Let V
1
and V
2
denote two solutions
of the above PDE, hence we have
V
1
τ
−V
2
τ
= F(S, τ, V
1
, V
1
S
, V
1
SS
) −F(S, τ, V
2
, V
2
S
, V
2
SS
). (A.4)
Using the the mean value theorem we can rewrite the right-hand-side of equation
(A.4) as a linear combination of V
1
− V
2
and its first and second derivatives with
respect to S. Doing so we obtain
(V
1
−V
2
)
τ
=
∂F
∂V
¸
¸
¸
¸
V
(V
1
−V
2
) +
∂F
∂V
S
¸
¸
¸
¸
V
S
(V
1
−V
2
)
S
+
∂F
∂V
SS
¸
¸
¸
¸
V
SS
(V
1
−V
2
)
SS
,
where V
2
< V < V
1
, V
2
S
< V
S
< V
1
S
and V
2
SS
< V
SS
< V
1
SS
. Hence the equation
takes the form
L(V
1
−V
2
) +c(V
1
−V
2
) = D(S, τ), (A.5)
APPENDIX A. MAXIMUM PRINCIPLES 228
where
A =
∂F
∂V
SS
¸
¸
¸
¸
V
SS
,
a =
∂F
∂V
S
¸
¸
¸
¸
V
S
,
c =
∂F
∂V
¸
¸
¸
¸
V
.
Finally, recall that this can be reduced to an equation of the form
L(u) = 0
by making the transform u = e
−cτ
(V
1
− V
2
) and so we can now apply the relevent
maximum principle.
We know that on the boundary V
1
−V
2
must equal zero, since both solutions must
satisfy the same boundary conditions, hence we must have that u = 0 on the bound-
ary. Therefore provided A > 0 and that the coefficients remain bounded, then the
maximum principle will ensure that
u ≡ 0 ⇒V
1
−V
2
≡ 0 ∈ Ω
T
,
hence V
1
≡ V
2
proving uniqueness.
A.2.1 The linear Black-Scholes equation
If we wish to apply the maximum principle to the Black-Scholes equation we have the
problem that the coefficient of the diffusion term will become degenerate at S = 0.
Fortunately we can make the change of variable x = log S which reduces the equation
to
V
τ
=
1
2
σ
2
V
xx
+rV
x
−rV = F(x, V, V
x
, V
xx
),
hence a constant coefficient linear PDE, which exhibits no such degeneracy. Evalu-
ating the derivatives of F, equation (A.5) becomes
1
2
σ
2
(V
1
−V
2
)
xx
+r(V
1
−V
2
)
x
−(V
1
−V
2
)
τ
−r(V
1
−V
2
) = 0.
APPENDIX A. MAXIMUM PRINCIPLES 229
and letting u = e
−rτ
(V
1
−V
2
) leads to
1
2
σ
2
u
xx
+ru
x
−u
τ
= 0.
Hence we can identify A =
1
2
σ
2
> 0 and
ˆ
D(S, τ) = 0 and so the application of the
maximum principle ensures that the maximum of the solution must occur on the
boundary and so we must have that u ≡ 0, hence V
1
≡ V
2
giving uniqueness.
A.2.2 The nonlinear (illiquid) Black-Scholes equation
The problem of the degeneracy of the diffusion coefficient at S = 0 is also present
in the fully nonlinear equation (4.1) but again making the same log transform as for
the Black-Scholes case will remove such a degeneracy. For simplicity we shall make
a further transform to the forward prices for the stock and the option, i.e. we make
the transform S = e
x−rτ
and V = ue
−rτ
, which reduces equation (4.1) to
u
τ
=
σ
2
(u
xx
−u
x
)
2
_
1 −λe
−2x+rτ
(u
xx
−u
x
)
_
2
= F (x, τ, u
x
, u
xx
) , (A.6)
and we are now in a situation where the equation is no longer degenerate. The
next step is to check that the function F in (A.6) is elliptic in all values of its
argument, hence to see under which situations we can apply the maximum principles.
Differentiating F with respect to the second derivative gives
∂F
∂u
xx
=
σ
2
_
1 +λe
−2x+rτ
(u
xx
−u
x
)
_
2
_
1 −λe
−2x+rτ
(u
xx
−u
x
)
_
3
(A.7)
which can be seen to be strictly positive (and hence elliptic) if and only if we have
[u
xx
−u
x
[ <
e
2x−rτ
λ
∈ Ω
T
.
Transforming the above back to the original variables it is clear that this corresponds
to [V
SS
[ < 1/λ for all (S, τ), in other words the restriction that the denominator in
equation (4.1) cannot vanish (cf. Frey, 1998). The consequence of this is that we are
not able to use maximum principles in the regime where the denominator is allowed
to vanish. This is natural since, if the denominator is allowed to vanish then we
APPENDIX A. MAXIMUM PRINCIPLES 230
have unbounded coefficients of the equation, which also contradicts the requirement
for the applicability of such maximum principles. In addition, smoothness of the
solution can also not be determined a priori if the denominator is allowed to vanish.
However, we shall proceed to prove uniqueness of the solution, and investigate other
properties, of (4.1) in the regime where [V
SS
[ < 1/λ everywhere within the domain.
Next, we wish to provide an alternative uniqueness proof for equation (4.1) to that
proposed by Frey (1998). This can be done simply by using (A.7) in which case
equation (A.5) becomes
σ
2
(1 +λe
−2x+rτ
(u
xx
−u
x
))
2
_
1 −λe
−2x+rτ
(u
xx
−u
x
)
_
3
(u
1
−u
2
)
xx
−(u
1
−u
2
)
τ
= 0,
from which it can be seen that (provided the denominator does not vanish) then we
will have that A > 0. Applying the maximum principle to the above equation yields
the required uniqueness result, V
1
≡ V
2
in Ω
T
, since uniqueness is preserved under
the inverse transforms required to convert equation (A.6) back into equation (4.1).
Note that this result still stands for any functional form of the liquidity parameter
λ(S, τ), provide we do not allow the denominator to vanish.
A.3 Monotonicity in λ
Having proved uniqueness we now wish to determine the dependence of the solution to
equation (4.1) on the liquidity parameter λ. We can do so by differentiating (directly)
the transformed equation (A.6) with respect to λ. Doing so and setting w =
∂u
∂λ
leads
to the following second order (linear) PDE for w
σ
2
(1 +λe
−2x+rτ
(u
xx
−u
x
))
2
_
1 −λe
−2x+rτ
(u
xx
−u
x
)
_
3
(w
xx
−w
x
) −w
τ
=
σ
2
e
−2x+rτ
(u
xx
−u
x
)
2
_
1 −λe
−2x+rτ
(u
xx
−u
x
)
_
3
. (A.8)
It is advantageous at this point to rewrite the above using the following inverse
transform
u
xx
−u
x
= S
2
u
SS
= e
2x−2rτ
u
SS
= e
2x−rτ
V
SS
= e
2x−rτ
Γ,
APPENDIX A. MAXIMUM PRINCIPLES 231
where we have defined Γ := V
SS
, and thus equation (A.8) becomes
σ
2
(1 +λΓ)
2 (1 −λΓ)
3
w
xx

σ
2
(1 +λΓ)
2 (1 −λΓ)
3
w
x
−w
τ
= −
σ
2
e
2x−rτ
Γ
2
(1 −λΓ)
3
. (A.9)
Since the initial condition of any option contract will be independent of the liquidity
parameter λ, we must have
w(x, 0) = 0
and more generally w = 0 on the boundary ∂


T
. Now applying the maximum
principle, or more specifically the minimum principle since the right-hand-side of
(A.9) is negative, gives that the solution w must have its minimum on the boundary,
i.e. w ≥ 0 in the interior of the domain Ω
T
, in other words
∂u
∂λ
≥ 0 ⇒
∂V
∂λ
≥ 0 ∈ Ω
T
,
hence the solution is an increasing function of λ. It should be emphasised that this
result only holds in the regime [V
SS
[ < 1/λ, i.e. when the denominator is not allowed
to vanish.
Appendix B
Non-dimensionalisation of the
British Put
The free-boundary formulation of the British put option value (9.3) can be non-
dimensionalised by making the following substitution
1
S = Ke
x−(µc−D)(T−t)
,
t = T −

σ
2
,
V (S, t) = K
_
e

2r
σ
2
τ
v(x, τ) + 1 −e
x
_
.
The resulting non-dimensional system becomes
v
τ
−v
xx
+ (1 −ρ
1

2
)v
x
= e
ρ
1
τ

2
e
x
−ρ
1
) ,
v(x, τ) = e
x+ρ
1
τ
Φ
_
x +τ


_
−e
ρ
1
τ
Φ
_
x −τ


_
on x = x
f
,
∂v
∂x
(x, τ) = e
x+ρ
1
τ
Φ
_
x +τ


_
on x = x
f
,
v(x, τ) = (e
x
−1) e
ρ
1
τ
as x →∞,
v(x, 0) = (e
x
−1)
+
,
where ρ
1
=
2r
σ
2
and ρ
2
=
2(µc+D)
σ
2
. In addition we have the condition that
x
f
(0) = log
_
r
µ
c
_
if µ
c
≥ r, which it trivially must satisfy due to the specifies of the option contract.
1
Note that the strike price K is scaled out of the problem (completely) by a simple linear scaling.
232
Appendix C
The Probability Density Function
In order to determine the probability density function under the risk neutral measure
Q we adopt the following procedure. We are given the stochastic process
dS
t
= (r −D)S
t
dt +σS
t
dW
Q
t
which is the process under the measure Q. This process has the closed form solution
S
t+u
= S
t
exp
_
σ(W
t+u
−W
t
) +
_
r −D −
1
2
σ
2
_
u
_
(C.1)
where we have assumed the process was started at position S
t
. Hence we have that
the probability that S
t+u
, i.e. the value of the stock price at time t +u given that it
started at S
t
is under some value z is given by
P
Q
[S
t+u
≤ z] = P
Q
_
S
t
exp
_
σ(W
t+u
−W
t
) +
_
r −D −
1
2
σ
2
_
u
_
≤ z
_
= P
Q
_
exp
_
σ(W
t+u
−W
t
) +
_
r −D −
1
2
σ
2
_
u
_

z
S
t
_
= P
Q
_
σ(W
t+u
−W
t
) +
_
r −D −
1
2
σ
2
_
u ≤ log
_
z
S
t
__
,
⇒P
Q
[S
t+u
≤ z] = P
Q
_
_
W
t+u
−W
t

log
_
z
St
_

_
r −D −
1
2
σ
2
_
u
σ
_
_
.
233
APPENDIX C. THE PROBABILITY DENSITY FUNCTION 234
It is known, from the normally distributed independent increment property of the
Wiener process W
t
, that W
t+u
−W
t
follows the same law as

uW
1
hence we have
P
Q
[S
t+u
≤ z] = P
Q
_
_
W
1

log
_
z
St
_

_
r −D −
1
2
σ
2
_
u
σ

u
_
_
,
⇒P
Q
[S
t+u
≤ z] = Φ
_
_
log
_
z
St
_

_
r −D −
1
2
σ
2
_
u
σ

u
_
_
. (C.2)
where we have used the standard result that P[W
1
≤ y] = Φ(y). The transitional
probability density function is given by the derivative of the above with respect to z,
this can be seen from the definition,
P
Q
[S
t+u
≤ z[S
t
= S] =
_
z
0
f(S, t; y, t +u)dy,
where f(S, t; y, t +u) is the transitional probability density function of the process at
time t +u and position y, given that it started at S at time t, hence

∂z
_
P
Q
[S
t+u
≤ z[S
t
= S]
_
=

∂z
_
z
0
f(S, t; y, t +u)dy
= f(S, t; z, t +u).
Now directly computing the derivative of (C.2) with respect to z yields
f(S, t; z, t +u) =
1
σz

2πu
exp
_

_
log
_
z
S
_

_
r −D −
1
2
σ
2
_
u
_
2

2
u
_
under the measure Q.

Contents
Abstract Declaration Copyright Statement Acknowledgements Dedication 1 Introduction 1.1 1.2 1.3 Evidence of increased interest in liquidity . . . . . . . . . . . . . . . . A brief history . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Derivative pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.3.1 1.3.2 1.3.3 1.3.4 1.3.5 1.3.6 1.3.7 1.4 1.5 European options . . . . . . . . . . . . . . . . . . . . . . . . . Arbitrage pricing . . . . . . . . . . . . . . . . . . . . . . . . . The Feynman-Kac representation theorem . . . . . . . . . . . From Feynman-Kac to Black-Scholes . . . . . . . . . . . . . . American options . . . . . . . . . . . . . . . . . . . . . . . . . Optimal stopping problems . . . . . . . . . . . . . . . . . . . 11 12 13 14 15 16 17 19 20 21 22 24 25 27 29 30 32 34 35 36 38

Free-boundary problems . . . . . . . . . . . . . . . . . . . . .

Supply and demand economics . . . . . . . . . . . . . . . . . . . . . . Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.5.1 1.5.2 Defining liquidity . . . . . . . . . . . . . . . . . . . . . . . . . Measuring liquidity . . . . . . . . . . . . . . . . . . . . . . . .

1.6

Price formation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

1.7 1.8 1.9

Option pricing in illiquid markets: a literature review . . . . . . . . . Introduction to perturbation methods . . . . . . . . . . . . . . . . . . Layout of the thesis . . . . . . . . . . . . . . . . . . . . . . . . . . . .

40 45 46 48 53 53 54 56 56 57 58 58 59 59 60 61 61 64 67 72 77 83 86 87 87 90 92 93 97 99

2 The Modelling Framework 2.1 Technical asides . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.1.1 2.1.2 2.2 Markovian processes . . . . . . . . . . . . . . . . . . . . . . . Applicability of Itˆ’s formula . . . . . . . . . . . . . . . . . . . o

Alternative models . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2.1 2.2.2 2.2.3 Transaction-cost models . . . . . . . . . . . . . . . . . . . . . Reaction-function (equilibrium) models . . . . . . . . . . . . . Reduced-form SDE models . . . . . . . . . . . . . . . . . . . .

2.3

A unified framework . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3.1 2.3.2 2.3.3 2.3.4 2.3.5 Cetin et al. (2004) . . . . . . . . . . . . . . . . . . . . . . . . Platen and Schweizer (1998) . . . . . . . . . . . . . . . . . . . Mancino and Ogawa (2003) . . . . . . . . . . . . . . . . . . . Lyukov (2004) . . . . . . . . . . . . . . . . . . . . . . . . . . . Sircar and Papanicolaou (1998) . . . . . . . . . . . . . . . . .

3 First-order Feedback Model 3.1 3.2 3.3 Analysis close to expiry: European options . . . . . . . . . . . . . . . Analysis close to expiry: American put options . . . . . . . . . . . . . The vanishing of the denominator . . . . . . . . . . . . . . . . . . . .

4 Full-feedback Model 4.1 4.2 4.3 4.4 4.5 4.6 4.7 Put-call parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A solution by inspection . . . . . . . . . . . . . . . . . . . . . . . . . Similarity solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . Perturbation expansions . . . . . . . . . . . . . . . . . . . . . . . . . Numerical solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . Analysis close to expiry . . . . . . . . . . . . . . . . . . . . . . . . . . Numerical results - full problem . . . . . . . . . . . . . . . . . . . . . 4.7.1 A second solution regime . . . . . . . . . . . . . . . . . . . . . 3

5 Smoothed Payoffs - Another Breakdown 5.1

102

Local analysis about the singularities . . . . . . . . . . . . . . . . . . 106 5.1.1 5.1.2 5.1.3 5.1.4 5.1.5 5.1.6 5.1.7 Asymptotic matching . . . . . . . . . . . . . . . . . . . . . . . 108 Properties of the inner solution . . . . . . . . . . . . . . . . . 110 Introduction to phase-plane analysis . . . . . . . . . . . . . . 111 Deriving an autonomous system . . . . . . . . . . . . . . . . . 114 Behaviour of the fixed points Structure of the phase portrait . . . . . . . . . . . . . . . . . . 116 . . . . . . . . . . . . . . . . . 120

Other fixed points . . . . . . . . . . . . . . . . . . . . . . . . . 122 127

6 Perpetual Options 6.1

Analytic solutions and perturbation methods . . . . . . . . . . . . . . 131 137

7 Other Models 7.1 7.2 7.3 7.4

Frey (1998, 2000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137 Frey and Patie (2002) . . . . . . . . . . . . . . . . . . . . . . . . . . . 139 Sircar and Papanicolaou (1998) . . . . . . . . . . . . . . . . . . . . . 140 Bakstein and Howison (2003) . . . . . . . . . . . . . . . . . . . . . . 141 7.4.1 7.4.2 Non-smooth solutions to the Bakstein and Howison (2003) model146 New non-smooth solutions to the Black-Scholes equation . . . 147

7.5

Liu and Yong (2005) . . . . . . . . . . . . . . . . . . . . . . . . . . . 149 7.5.1 Vanishing of the denominator . . . . . . . . . . . . . . . . . . 150

7.6

Jonsson and Keppo (2002) . . . . . . . . . . . . . . . . . . . . . . . . 152 7.6.1 Connections with the other modelling frameworks . . . . . . . 154 155

8 Explaining the Stock Pinning Phenomenon 8.1 8.2 8.3

Linear price impact . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156 Nonlinear price impact . . . . . . . . . . . . . . . . . . . . . . . . . . 159 A new nonlinear price impact model . . . . . . . . . . . . . . . . . . 161 164

9 The British Option 9.1 9.2

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164 The no-arbitrage price . . . . . . . . . . . . . . . . . . . . . . . . . . 167

4

. . . . . . . . . .7 The gain function . . . . . . . . . .2. . . . . . . . . 198 The British put option .1 9. . . . . . . . . .1 The linear Black-Scholes equation . . 201 204 223 10 Conclusions A Maximum Principles A.8 Integral representations of the free boundary . . .2. 198 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 9. . . . . . . . . . . . . . . . .5 9. .1 Nonlinear equations . . . . . . . . . . . . 180 Financial analysis of the British put option . . . . . . . . . . . .4 9. . . . . . . . 175 Analysis close to expiry . . . . . . . . 227 A. . . . . . . . . . . . . . . . . . . . . 193 9. . . . . . . . . . . . . . . . . 198 9. .8. . . . . 228 A. 226 A. . . . . . . . . . . . . .7. . 170 Numerical treatment . . . . . . . . . . . . 229 A. . . . . . . . . . . .7. . . . . . . . . . . . . . . . . . . . . .1 9. . . . . . . .2. . . . . . . 230 B Non-dimensionalisation of the British Put C The Probability Density Function 232 233 Word count 69834 5 . .2 Analysis far from expiry . . . . . . . . . .3 Monotonicity in λ . . . . . . . . . . . . . . . . . . .1 9. . . .9. . . . . . .2 The nonlinear (illiquid) Black-Scholes equation . . . . . . . . . 171 Free boundary analysis far from expiry . . . . . . . . 186 The British call option .2 The American put option .8. . . . . . . . . . . . . . . . . . . . . . .6 9. .2 Uniqueness of PDEs . . . . . . . . . . . 196 Analysis close to expiry . .

3. . .01. .2. . . 5. . . . 2. .7. . Compare the location of the vanishing denominator 3.4 Asymptotic Matching. .2. σ = 0. . . . . . . 1. r = 0.9 The second derivative (Γ) of the Black-Scholes equation (3. 0. the variation with λ appears to be monotonic. . . . .04. . 2. . .2. 79 6 . . . . . . location of free boundary (as τ → 0) with λ. . . . Inner solution minus the payoff for put and call options. . 0. .15.9) with λ = 0. . . . . 0. . . 78 76 73 72 66 70 66 The first derivative (∆) of the Black-Scholes equation (3. .2.List of Figures 3. . . r = 0. 0.015. . . .015. . . . . . . . . . σ = 0. . . .3 3. r = 0.5 Value of American put options.. . . 0.2. . 1. .6 First-order feedback put (with early exercise). . K = 1) for λ = 0. . . . . . r = 0. . Compare the location of the vanishing denominator 3. .01. . . r = 0. . K = 1 and for λ = 0.9) (solid line) for τ = 0. . . .. . . .04 and σ = 0. . . σ = 0. 10. .2.. 0. 5. .7 Location of the vanishing of the denominator of (2. . . .8 . K = 1) for λ = 0. .04. . . K = 1. . . . . .7.2 Value of European put options with first-order feedback (T = 1. . 2. K = 1. . σ = 0. . . .1. . 3.05.2) (dotted line) and the first order feedback PDE (2.04.9) (solid line) for τ = 0.2) (dotted line) and the first order feedback PDE (2. . . . 79 3. 0. . T = 1. . 3. . .4. r = 0. . . . 3. . . 3. 3. . the variation with λ appears to be monotonic. the variation with λ appears to be monotonic.2.04. .04. . 10. . . K = 1 and for λ = 0. 1. 5. . . . . . .1 Value of European call options with first-order feedback (T = 1. . . 10.1.05. . . . σ = 0. . .

2 and λ = 0.2 and λ = 0.075.04. . . .2. K = 1. . . τ = 0. . . . . .2.2. τ ) to the Black-Scholes (i. . . For r = 0. 0. K = 1 and λ = 0. . .95.25. . . .15. . . . . .04. . . . . . . . . . .24). . . . .04. . . λ = 0. . . . . . . . . . . . . 0. . . .1 and T = 1. . .2. . .04 and σ = 1. . . .6 Full feedback call. 0.04. . . . .1 The leading order correction term V1 (S. K = 1. . .09 (solid line) and λ = 0. . λ = 0) European put option for various time to expiry. . . . . . . . . . . . ρ = 0. K = 1. r = 0. . . . . . . . . . . . . . . . . . .2. K = 1. 3 cf. . .1.3 Local (τ → 0) solution of a full-feedback put. . .10 First-order feedback put option value for two different values of λ at various times to expiry.1 (dotted line). . . . .1 Phase portrait of the autonomous system (5. σ = 0. . . . . . . . . 1. 128 6. . .1. T = 1 and τ = 0. r = 0. τ = 0. . . . 0. 1. .1. .2. . . . λ = 0. .e. . .2 Deltas for full-feedback (European) put. . . . . . . . K = 1. . σ = 0. 100 4. r = 0. . .15 (smoothed payoff). . σ = 0.0375.2. . free-boundary location as indicated. . . . . . . . . .04.1.01. .04. . 4. 4.0125. 1.2 Perpetual full-feedback American put. . σ = 0. . 0. . . . . . . . . . . .1 and τ = 0. . λ = 0. . . . . . r = 0. . . . 101 5. . . K = 1. r = 0. σ = 0. . r = 0. modified numerical scheme. . .2 and λ = 0. . . . . . . . . σ = 0. . .04. . . smoothed payoff. 120 Full feedback American put. . . . . . . modified numerical scheme.. λ = 0. r = 0. .1. . . σ = 0. . . 4. . . 10. . . . .04. equation (5. . . . .5 Full feedback put. . Note that we are in the regime λ < 2ρ and so we should expect no singular behaviour. . 4. .7 Full feedback put. . . K = 1. . . . .1. λ = 0. . . . K = 1.7. .31). The dotted line rep- resents an analytic envelope for the phase portrait close to the singular line v = 6. σ = 0. 0.1. σ = 0. . . . . . . . . . . . . . 130 7 .1 5u . Compare with figure 3. . . . 4. . . Note the fixed point at u = 243 80 1 3 81 92 93 96 99 99 . .4 Full feedback put. . r = 0. . . . . v = 0 and the field direction lines. . .1. r = 0. . K = 1. .3.04. 4. . . . . 0. modified numerical scheme.

. . . α = 1. -0.04. . . . . σ = 0.04. . .4 5.2. . .9 Local (τ → 0) call solution of the Jonsson and Keppo (2002) model K = 1. .6 7. .. . and a = −1. . . . . . . . . 1. . .2 Local (τ → 0) call solution of the Sircar and Papanicolaou (1998) ˆ model K = 1. 1 × 106 . . . . . . 5. . .2 and λ = 0. . . .7 Non-smooth solution of the Black-Scholes equation. σ = 0. K = 1. .2. ..9. . 0. σ = 0. . . . . .2.04. . . . . . . . . .3 Local (τ → 0) put solution of the Sircar and Papanicolaou (1998) Solution to equation (7. . 0. . . 149 7. . r = 0. r = 0. .. . . . 2000) (solid line) and Sch¨nbucher and Wilmott (2000) (dotted line) model o with λ = 0.5.01. 1. . . ..2. . . . . . . . . K = 1. . K = 1. . -0. 1. .2. . and β = 1 × 105 . . 0. . . . r = 0. . r = 0.5 Local (τ → 0) put solution of the Bakstein and Howison (2003) model Local (τ → 0) call solution of the Bakstein and Howison (2003) model ˆ K = 1. .. . 1.04. .6. and α = 1. . 148 σ = 0. .04 and σ = 0. σ = 0. . r = 0. . 0. 139 7. λ = 0. 153 7. .2 and λ = 0. . . . σ = 0. . . . . .5. . . . . ˆ model K = 1. . . . . .1.10 Local (τ → 0) put solution of the Jonsson and Keppo (2002) model K = 1. . . 142 7. . . . r = 0. .8 Location of the vanishing of the denominator for the Liu and Yong (2005) model for various value of β.5. . 147 ˆ K = 1. . . .04. . . .4 The first order correction to the Black-Scholes perpetual American put option (solid line) compared to the difference of the fully numerical option value with the Black-Scholes (dotted line) for various values of λ. . . . . and λ = −5. . 0. . . .04. . .1. . . . and a = −1. . . . . 2 × 105 . .2.04. .2. α = 1. 5. σ = 0.5. .3. σ = 0. .9. . 136 7. . -4. . . . . . . . K = 1. . 141 7. . .. . . . .04. . . . σ = 0. . 136 6. K = 1. and λ = −5. 8 . . . . r = 0. . . . . r = 0. . . .9) for a put option with λ = 0. K = 1. . .2. . . .1. . 151 7. . .1 Location of the vanishing of the denominator of the Frey (1998. . σ = 0. . 144 7. and λ = 0 0. . .2. -4. . and λ = 0. ..75. σ = 0.75. r = 0. 153 7.05. . . . .2.3 The first order correction to the Black-Scholes perpetual American put option (solid line) compared to the difference of the fully numerical option value with the Black-Scholes (dotted line). r = 0. . .2. . .1.04. . . .05. . . .5. .

173 9. 1. .8. .e. r = 0.2. 0. . . . ..1. . . .7 and 9. The dotted line represents the zero contour. . . 9. . . . . .4. . . .12. for varying values of the contract drift. K = 1. . . ..2 Solution to equation (8. .16. . . . . . . . . . . T − t = 0. .6) (solid line) with the model of Avellaneda and Lipkin (2003) (dotted line) for nE = 0. . . D = 0. .4. . µc = 0. .5.3 The zero of the H-function. .1. . and µc = 0. . . . . . . . and σ = 0. . . 0. 186 9. . . . . 0. . . . . r = 0. . i. .27) (dotted line) compared with fully numerical value (solid line). σ = 0. 161 2 1 for T = 0.05.6. 177 9. . .8) (solid line) compared to (8.5. . . . 159 2 8. . . .1. . T − t = 0. . .125. K = 1.1. . . T = 1. . D = 0. .8. . σ = 0. . .125. T = 1. . . and D = 0.1. . . . 190 9 . . . . . . . . . . .4. . .6 The difference in the percentage return of the British put option and the American put option at every possible stopping location. .5 Location of the free boundary for the British (solid line) and American (dotted line) put option under investigation in figures 9.4. . 5. . .2.3 Solution to (8. . . r = 0. . . .4 9. . . . . . . . . .4. . . T − t = 0. .8. . . . . σ = 0.1. 0. T = 0. . . . . . . r = 0.1 The pinning probability (8. . K = 1. . . . . . . . r = 0. and σ = 0. . . T = 50. . .01. . σ = 0.2 8. .11. . . . and r + 2 σ 2 = 0. . . . µc = 0. . . 163 8.5) for values of nE = 0. 0. K = 1.1. . µc = 0.7) for p = 0. . K = 1. . and µc = 0. .9. Sh (t). σ = 0. . . 0.5) (dotted line) and r + 1 σ 2 = 0. 1.e. . S0 = 1. . . . . . . . . . . . D = 0.104. . i.1. . σ = 0. . . K = 1. . .1. . σ = 0. . . . . 189 9. T = 1. . 173 9. . . .102. D = 0. . . . . and r + 1 σ 2 = 0. . . .115. . . . r = 0. µc = 0. . .1.1. .125.2. . . .2. . . K = 1. . .. . . The solid lines denote contours at increments of 10% from -10% to 60%. . 0. . and D = 0. . . 158 Comparing the pinning probability associated with (8.125. . T = 1. . . and σ = 0. . . . . . .2 The British put option free boundary for varying volatilities. . . .1. . . . 1. .1 The British put option free boundary for varying values of the contract drift. . . K = 1. . (9. K = 1.4 The asymptotic approximation for the British put option free boundary close to expiry. . .

8 The difference in the percentage return of the American put option and the European put option. . . . . .11 The British call option free boundary for varying values of the contract drift. . .13 The asymptotic approximation for the British call option free boundary close to expiry. K = 1.1. . and µc = 0. . . (9. 195 9. . σ = 0. . . 199 194 10 . and µc = 0. . K = 1. D = 0. .e. . . σ = 0.32) (dotted line) compared with fully numerical value (solid line). .7 The difference in the percentage return of the British put option and the European put option. µc = 0. . . r = 0. . . . σ = 0. . . . . . . K = 1. .9. . S0 = 1. 0. 191 9. . . . . and D = 0.055. . . 195 9. . 0. . . . r = 0. . . . .4. . . . . The dotted line represents the zero contour. . . . .1 and D = 0. . . . . . i. .01. 0. . . Note the change of orientation.1. . r = 0. r = 0. K = 1. K = 1. 192 9. . σ = 0.05. . Again the solid lines denote contours at increments of 10% from 0% to 70%. S0 = 1. American and British put option would provide the greatest return on an investment. . . T = 1.1.4.. . . . . K = 1.08 and D = 0. . 0. r = 0. . . . T = 0. . . . . . . . . σ = 0. . . . . . . . ..08. . .4. for increasing moneyness. .05. . r = 0. .1. . . D = 0.4. . .06. . . . . 9. . T = 1. . . The dotted lines represent the free boundaries of the American and British put option for reference. . T = 1.1.5. . . . . . . . . . The dotted line represents the zero contour. . σ = 0. . T = 1. . and σ = 0.125. . .9 Schematic representation of the regions in which at-the-money European. . . . . . . r = 0.1. D = 0. . . . . . .4.4. . . . . . µc = 0. T = 1. .12 The British call option free boundary for varying volatilities. . . 190 9. . K = 1.1 and D = 0. . . . .10 Figures representing the region in which American put options would provide a greater expected return that its British option counterpart. . . 0. . . . . The solid lines denote contours at increments of 10% from -70% to 30%. . T = 1. .09. . . .

since the contract does not require the holder to enter the market and hence incur liquidation costs. It is concluded in this case is that the model irretrievably breaks down and there is insufficient ‘financial modelling’ in the pricing equation. In both classes. 2008 This thesis examines two distinct classes of problem in which nonlinearities arise in option pricing theory. which for the most part result in highly nonlinear partial differential equations (PDEs). In particular. The repercussions for American options are also considered.The University of Manchester Kristoffer John Glover Doctor of Philosophy The Analysis of PDEs Arising in Nonlinear and Non-standard Option Pricing October 23. Here we choose to focus on the interesting nonlinear behaviour of the early-exercise boundary. In the second class of problem. o show how many of the proposed existing models in the literature can be placed into a unified analytical framework. which can help to mediate the effects of a finitely liquid market. Detailed analysis reveals that the form of the nonlinearities introduced can lead to serious solution difficulties for standard (put and call) payoff conditions. detailed asymptotic analysis. and perhaps even more disturbingly. 2008a. we investigate a model studied by Sch¨nbucher and Wilmott (2000) and furthermore. negative option values. 11 .b). expiry. coupled with advanced numerical techniques (informed by the asymptotics) are exploited to extract the relevant dynamics. a new non-standard class of early exercise option. we consider the effects of the inclusion of finite liquidity into the Black-Scholes-Merton option pricing model. One is associated with the infinite gamma and in such regimes it is necessary to admit solutions with discontinuous deltas. A second failure (applicable to smoothed payoff functions) is caused by a singularity in the coefficient of the diffusion term in the option-pricing equation. we investigate the properties of the recently introduced British option (Peskir and Samee. specifically for times close to. In the first class. and far from.

12 .Declaration No portion of the work referred to in this thesis has been submitted in support of an application for another degree or qualification of this or any other university or other institute of learning.

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our friendships can continue to flourish. both old and new. To my close friends. despite the distances between us.Acknowledgements I am extremely grateful to my supervisors Professor Peter W. I hope. to Goran Peskir for his time and enthusiasm for the subject. Duck and David P. I thank Hannah for everything. Newton for their expert guidance and continued support throughout the course of this Ph. Thank you to my colleagues and friends for their invaluable advice and numerous enlightening discussions. EPSRC funding is gratefully acknowledged. I thank you for creating the good times and for being there through the bad. and David for his caring supervision and his confidence in my abilities. Sebastian Law and Vicky Thompson. and in particular to Jonathan Causey. In particular. Helen Burnip. In particular. I hope we both find what we’re looking for. Finally. In addition. enthusiasm and efficiency. 14 .D. I thank Peter for his boundless knowledge. John Heap. Philip Haines. and to Erik Ekstr¨m for o his insight and friendship. I thank my parents for their love and unwavering support for which these mere expressions of gratitude do not suffice.

Dedication To Gran. in loving memory. 15 .

this does not preclude us from trying to quantify the financial markets and to utilise the powerful tools of mathematics in order to better understand such markets. but the nature of man and his markets. As we shall show later. much of the work undertaken in mathematical finance has been aimed at relaxing a number of the modelling assumptions. such that trading had no impact on the price of the underlying. Since the definitive papers of Black and Scholes (1973) and Merton (1973). then we see some rather interesting and possibly counterintuitive behaviours. If we relax this assumption. this is partly due to the fact that any model incorporating such a feature will inevitably lead to nonlinear behaviour (feedback). we shall be concerned for the most part with nonlinear partial differential equations (PDEs) arising from the study 1 Termed underlying in the sequel. one is not trying to model Mother Nature and her laws. In particular. . There are no laws of nature just waiting to be discovered. However.Oscar Wilde (1854-1900) The Picture of Dorian Gray (1891) Mathematical finance is not a branch of the physical sciences.Chapter 1 Introduction Nowadays people know the price of everything and the value of nothing. One of the more subtle was that the market in the underlying asset1 was infinitely (or perfectly) elastic. 16 .

the exogenous processes required tend to be difficult to handle mathematically. In addition. This has resulted in trading volumes . These models involve optimisation over all possible values of volatility. An alternative approach (and e that to be followed in this thesis) is to retain one the simplest stochastic process. but to provide an endogenous mechanism by which the dynamics differ from this standard geometric Brownian motion. just enough for the unfamiliar reader to understand the contributions of the following chapters.CHAPTER 1. The aim of modelling the behaviour of the underlying is to capture the dynamics of the observed market prices as faithfully as possible. INTRODUCTION 17 of finitely elastic markets. In this chapter we introduce the basic ideas and concepts and review the results of the classical Black-Scholes-Merton option pricing theory used in later chapters. One approach to incorporate these dynamics is to find a stochastic process that fits most closely the distribution of returns of the underlying. It is by no means a complete treatment of the relevant theories. (1995) in the study of uncertain volatility models. for example L´vy processes. geometric Brownian motion. and as such provides little insight into which of the many factors affecting the price dynamics are actually the most important. Work that has led to this class of PDEs in finance to date includes Whalley and Wilmott (1993) in relation to transaction costs.1 Evidence of increased interest in liquidity Recent worries about the health of the modern financial system have deterred people from getting involved in the derivatives markets. In addition. and has the advantage of being consistent with the bulk of the literature over the past thirty-five years. This is an exogenous strategy. there is the so called Black-Scholes-Barrenblatt equation introduced by Avellaneda et al. This provides much greater insight into how prices are actually formed in the market. 1. which was one of the first nonlinear PDEs to arise in the field of mathematical finance. and as a result are also highly nonlinear.

In August 2007 the Financial Times is quoted as saying that4 . 3 2 . Further.com.com. 5 Quoted in Science in Finance IV: The feedback effect Paul Wilmott. Paul J Davies.as market turmoil rises financial problems are no longer simply confined to a risky corner of the US mortgage market. January 29 2008.. Clearly. blog entry at http://www.the sharp slowdown in these [derivative] markets is a serious warning sign of the growing problems in the financial world as they are usually highly liquid. November 23 2007.. wilmott.. August 1 2007. Gillian Tett. David Oakley of the Financial Times2 warns that . Rachel Lomax.the largest ever peacetime liquidity crisis.com.. This stems from another key theme now haunting the markets: namely that liquidity is evaporating from numerous corners of the financial world. FT. Chris Giles. the Bank of England’s Deputy Governor goes on to describe the recent financial turmoil in the wake of the American sub-prime mortgage problems3 as .CHAPTER 1. as both investors in hedge funds and the banks that lend to them try to cut and run from recent losses. David Oakley. which may in turn help banks and regulators to ensure that See Derivative liquidity crisis ‘to continue’. in times of crisis. liquidity becomes an ever important issue.. February 27 2008... Quoted in Bank deputy downbeat on economy. 4 See Liquidity alarm bells sound.com/blogs/paul/. In a recent blog entry regarding the sub-prime induced liquidity crisis Paul Wilmott states that5 . The current liquidity crisis can be traced back to the collapse of the US sub-prime mortgage market.this should spur on the implementation of mathematical models for feedback. FT. FT. INTRODUCTION 18 decreasing and hence increased liquidity problems. Joanna Chung and Stacy-Marie Ishmael. turning over vast amounts of trade every day.. motivating further investigation into the effects of reduced liquidity on all aspects of the financial markets...

For a translated version with commentary and a foreword by Paul Samuelson see Davis and Etheridge (2006).CHAPTER 1. The work of Richard P. In addition. the ubiquitous nature of Brownian motion can be seen as the dynamic counterpart of the ubiquitous nature of the normal distribution. Meanwhile. Note that this was five years before Einstein’s seminal paper outlining the theory of Brownian motion. which rests ultimately on the Central Limit Theorem. introduced the Wiener measure into the heart of quantum theory. as quantum mechanics emerged in the 1920s it began to become clear that the quantum picture is both inescapable at the subatomic level and intrinsically probabilistic. INTRODUCTION 19 the press that derivatives are currently getting is not as bad as it could be. which gives a stochastic See for example Jacod and Protter (2003). Feynman’s work was made mathematically rigorous by Mark Kac (1914-1984) and the so-called Feynman-Kac formula. and it was not until the 1920s that the rigorous mathematical underpinnings of the theory of Brownian motion was provided by Norbert Wiener (1894-1964). a Scottish botanist. 1. whose aggregate effect was (apparently) random. In e e it he proposed to model the movement of stock prices with a diffusion process or Brownian motion. 7 6 .6 The origins of much of financial mathematics trace back to a dissertation (entitled Th´orie de la sp´culation 7 ) published in 1900 by Louis Bachelier (1870-1946). Feynman (1918-1988) in the late 1940s on quantum mechanics using path integrals. observed the apparently random motion of pollen particles suspended in water and subsequently during the 19th century it became clear that the pollen particles were being bombarded by a multitude of molecules of the surrounding water. In fact.2 A brief history In 1828 Robert Brown (1773-1858). wherever we look we see a random world and therefore Brownian motion (named in honour of Robert Brown) is an invaluable tool for describing this randomness.

a stochastic process for the underlying is likewise specified and then Itˆ’s formula for a function of the underlying stochastic o process is used to derive a PDE involving the coefficients of the underlying process. In 1944 Kiyoshi Itˆ (1915-) went on to develop stochastic calculus. was introduced (see section 1. A more comprehensive overview of the early years of mathematical finance can be found in Jarrow and Protter (2004). in the PDE approach. However. the so-called martingale approach and the PDE approach.3) and it should be noted that both approaches can be used for complete . work for which the surviving members (Scholes and Merton) received the Nobel Prize for economics in 1997. In the former. Scholes and Merton wrote down their famous equation for the price of a European call and put option in 1969. a stochastic process for the underlying is specified and an equivalent probability measure is found that turns the discounted underlying into a martingale.3). The price of the derivative is then defined as the conditional expectation of its discounted payoff under this new (risk-neutral) measure. In continuous-time modelling there are two main approaches to calculating the price of a given derivative security. 1. the machinery o needed in order to use Brownian motion to model stock prices successfully.CHAPTER 1. Alternatively.3 Derivative pricing When we discretise a problem it becomes easier to define or understand but much harder to solve without the use of continuous time calculus. The two approaches are deeply linked via the famous Feynman-Kac formula (outlined in section 1. this thesis deals solely with continuous time models. and which would later become an essential tool of modern finance. INTRODUCTION 20 representation for the solution to certain classes of PDEs. o After this it was not long until Black. it was not until 1965 that economist Paul Samuelson (1915-) resurrected Bachelier’s work and advocated Itˆ’s geometric Brownian motion model as a suitable model for stock price movements.3.3.

3. The derivative securities studied in this thesis. 8 (1. Thus. denoted K.CHAPTER 1. 1. In the latter case. see chapter 2. then the holder would not exercise. whereas using the PDE approach the choice of martingale measure is analogous to specifying the so-called market price of risk of the non-traded variable. an understanding of the behaviour of such stochastic processes is a valuable prerequisite for the study of derivative pricing. The fair price of a derivative security (and all other financial instruments) is determined by the expected discounted value of some future payoff. A brief overview of the types of contracts referred to in the main body of the thesis will be considered next. is worth more then K then the (rational) holder would exercise the option and make a profit ST −K. to buy the underlying at some pre-determined date. and at some predetermined price. without exception.1 European options European options are the simplest type of options contract and within this class the most common are call options and put options. the value of the call option at expiry (T ) is given by V C (ST . T ) = (ST − K)+ := max{ST − K. this section attempts to provide such an understanding. 0}. but not the obligation. The holder of a call option written on a certain underlying asset (usually a stock) has the right. ST . the future value of the underlying is not known a priori.8 i. INTRODUCTION 21 and incomplete markets.1) Under suitable restrictions. then this arbitrariness is reflected in the choice of equivalent martingale measure. If the underlying at time t = T . resulting in the option expiring worthless. and price processes are often modelled by stochastic processes. are options contracts. Therefore. if ST is less than K. Alternatively. . both the martingale approach and the PDE approach should arrive at the same price. arriving at a unique price for a derivative requires additional assumptions. denoted T . Of course. If one is using the martingale approach. which is itself dependent on the future value of the underlying asset.e. Since the models introduced in this thesis result in complete markets. all sources of risk are traded.

3. Indeed we shall return to them shortly in section 1. buying and selling financial instruments) in such a way that the initial investment (at t = 0) is zero and the wealth at time T is non-negative with a non-zero probability of a strictly positive wealth. 0}.2) are called payoff profiles and will be referred to as such throughout this thesis. T . (1.3. More specifically if the option allows exercise at any time prior to expiry such an option is referred to as an American option.CHAPTER 1. with stochastic price dynamics dSt = µSt dt + σSt dWtP . the holder of a put option has the right to sell the underlying for the exercise price K. These options are very popular in practise. and one risky asset. it is the opportunity to construct a trading strategy (i. 1. In an efficient market there should be no such arbitrage opportunities and indeed the seminal work by Black and Scholes (1973) and Merton (1973) used the no-arbitrage principle to arrive at a unique price for the fair value of an option contract.2) The functions (1.1) and (1. To state their results. and will play an important role in much of this thesis. this results in tractability in many situations. many different options contracts with more general payoff profiles. and not on the path of the price prior to maturity. There are.e. Note that these contracts dependent only on the price of the underlying at expiry. INTRODUCTION 22 Similarly. h(ST ) say.5.2 Arbitrage pricing An arbitrage opportunity corresponds to a risk-free profit. More formally. (1. For an option to be described as European. resulting in the value of the put option: V P (ST . we have a market consisting of a bank account which grows according to the (deterministic) dynamics dB = rBdt. T ) = (K − ST )+ := max{K − ST . ST .3) . of course. its contract must specify that exercise is only possible at a single maturity time. Options that allow exercise at times prior to expiry are said to have an early-exercise feature.

t (1.5) Note that the dynamics of St under the risk-neutral measure Q are the same as the dynamics under the real-world measure P . Q. The fair value or price of a European option contract V (S. Consequently. t) = EQ e−r(T −t) h(ST ) .4) in words. t) with payoff profile h(ST ) can be shown to be given by V (S.10 The model analysed above is an example of a complete market model. this fact undoubtedly contributed to the widespread application of the Black-Scholes-Merton pricing methodology in the years subsequent to its publication. since in practise the drift parameter is notoriously difficult to measure from past time series of the underlying process. (1. 000 years to obtain such an estimate. In this model. INTRODUCTION 23 where r is the positive (constant) interest rate. the stock price process (1. WtP denotes a standard Brownian motion under the probability measure P . as opposed to the real world measure. Liptser and Shiryaev (2001) show that the expected waiting time to obtain an estimate of the drift (via the naive approximation St /t) that is within of the true drift is proportional to −2 . S. P .9 The risk-neutral measure is defined as the unique measure equivalent to P under which the discounted price process is a martingale. Prior to this.3) can then be described in terms of a standard Q-Brownian motion WtQ as dSt = rSt dt + σSt dWtQ .CHAPTER 1. µ the drift and σ the volatility of the underlying price process. defined by the process (1. The simplest definition of a complete market is one in which every derivative security can be replicated by a self-financing trading strategy in the stock and bond. the expected discounted future payoff. The indices indicate that the process for St is started at S at time t and also that the expectation is calculated under the so-called risk-neutral probability measure.01 it would take ∼ 10. expectations had been taken under the real world measure P .3). except that the drift of St under Q is equal to the interest rate r instead of µ. any security whose payoff h(ST ) is known at time T (where h(ST ) is any FT -measurable This subtlety was the main innovation of option pricing research in the 1970s. Consequently the drift parameter µ does not appear anywhere in the pricing formula for European options. 9 . For example if = 0. 10 In fact.

Thus. 1. are linked to the solution of (linear) parabolic partial differential equations (PDEs) via the famous Feynman-Kac representation theorem. t)dt + σ(St . ∂t 2 ∂S ∂S Suppose we are given the PDE for the unknown function u(S. t)dWtP . a characterisation of the arbitrage-free principle is that there exists a unique equivalent martingale measure Q. Expected values of solutions to stochastic differential equations (SDEs). σ(S.6) subject to the final condition u(S.7). For more on this characterisation see the original works of Harrison and Kreps (1979) and Harrison and Pliska (1981. Finally. u(S. The Feynman-Kac formula tells us that the solution can be written as an expectation. this thesis focuses primarily on the latter. (1. T ) = h(S). with a P -Brownian .3. where µ(S. 1983).4). In the following section we describe the Feynman-Kac representation theorem.7) The indices on the expectation indicates that the process St is started at S at time t and in addition the superscript indicates that the expectation is taken under the probability measure P . under which the discounted prices of traded securities are martingales. t) = 0.CHAPTER 1. t) (1. This equation is sometimes called the Kolmogorov backward equation.3 The Feynman-Kac representation theorem ∂2u ∂u ∂u 1 2 + σ (S. t) 2 + µ(S. t) and h(S) are known functions and T a parameter. t).t where St is a stochastic process given by the equation dSt = µ(St . we note that in a complete market. the price of a European option can be studied using both stochastic methods and parabolic PDE methods. t) = EP [h(ST )] S. such as the pricing equation (1. corresponding to the stochastic process (1. INTRODUCTION 24 random variable with E [h2 (ST )] < ∞) can be replicated by some unique self-financing trading strategy.

t) ∂u dWtP . Consider an unknown function u(S. for example. conversely. t) = e−r(T −t) u(S. T ) − u(St . as the solution to a second-order linear parabolic PDE. T )] = EP [h(ST )] . t) t ∂u dWtP . taking expectations and reorganising a little we arrive at T u(S. t) . representing the price of a European option. by assumption the O(dt) terms above are zero if u(S. S. it can be shown that the expectation of an Itˆ integral with respect to a o Brownian motion is zero (see.t t σ(S. t) ∂u dWtP . we can now use it to represent the expectation given in (1. t) = σ(S.4) involves discounting and so it is useful to make the transformation V (S.4 From Feynman-Kac to Black-Scholes Having satisfied ourselves of the validity of the Feynman-Kac representation theorem. Integrating the above equation we obtain T t T du = u(ST . Applying Itˆ’s formula we have o du = ∂u 1 2 ∂2u ∂u + µ(S.6). The first point to note is that (1. t) = EP S. This useful representation allows us to solve deterministic PDEs via stochastic methods and. t) = EP [u(ST . t). Proof. 4. 2004) resulting in the o required result u(S. t) + σ (S.t 1.CHAPTER 1.3. ∂S Finally. T )] − EP S. t) is assumed to be the solution of the PDE (1. The proof of the Feynman-Kac representation is fairly straightforward and so we shall outline the basic idea here.t S. prop. ∂S Next. t) 2 ∂t ∂S 2 ∂S dt + σ(S. INTRODUCTION 25 motion WtP .t [u(ST . expectations of functions of stochastic processes via deterministic PDEs.4 of Bj¨rk. ∂S Now.4).

4) is taken under the risk-neutral measure Q and so the corresponding PDE representation of (1. Remarkably. ∂t 2 ∂S ∂S with the following condition V (S. (1. Moreover.10) with the same boundary conditions as previously.9a) (1. t) = h(0)e−r(T −t) . Note that in what follows this shall be referred to as in the Black-Scholes equation (which should also be credited to Merton). S. t) → h(S)e−r(T −t) as S → ∞. this problem is often glossed over or simply not mentioned in the literature.8) where we have used the risk-neutral process (1. INTRODUCTION 26 in equation (1. t) 2 + µ(S.6) to obtain the PDE 1 ∂2V ∂V ∂V + σ 2 (S. However.e. . (1. ∂t 2 ∂S ∂S which we have shown can be represented as the conditional expectation V (S. t) = EP e−r(T −t) h(ST ) . i. ∂t 2 ∂S ∂S (1.7). then the corresponding (generalised) Black-Scholes equation obtained via the Feynman-Kac formula is given by11 LBS (V ) = ∂V 1 ∂2V ∂V + σ 2 (S. assumptions that are often not satisfied by many models used in practise. if we assume a stochastic process of the much more general form (1.9b) (1. V (S.4) is given by ∂V 1 ∂2V ∂V + σ 2 S 2 2 + rS − rV = 0. T ) = h(S).5). it can be shown that standard Feynman-Kac type results only hold under (quite restrictive) analytic conditions on the coefficients of the SDE and PDE. What follows is a brief overview of the some of these analytic conditions.t However.9c) (1. t). t) − rV = 0.9). In some sense the 11 Again note the independence of the real-world drift µ(S. V (0. note that the expectation in (1.CHAPTER 1. t) 2 + rS − rV = 0.

|σ(S.e. In addition. t)| ≤ C|S1 − S2 | for some C > 0. i.3. where Ω is the domain of the process St . i. In order for the conditional expectation (1. it must be locally Lipschitz. T ]. we have the restriction that σ 2 (S. t)| ≤ D(1 + |S|) for some constant D > 0. t) = 0. for example Ω = {S > 0} for geometric Brownian motion. t) = σ which is no longer degenerate.9) then the diffusion coefficient σ(S. we are no longer in a regime where standard results from SDE and PDE theory can be applied. here the non-Lipschitz nature of the coefficients means that the solutions to the corresponding SDE need no longer remain continuous. jumps may be seen at the location where the diffusion coefficient becomes singular. t) ∈ Ω × [0. 12 . t) > 0 ∀(S.10) with the conditions (1. Specifically limS→0 σ(S. meaning (in this one-dimensional situation) that the coefficient σ(S. Hence. t) must be sufficiently regular. t) − σ(S2 . such as geometric Brownian motion where σ(S.3.CHAPTER 1.e. |σ(S1 . and also satisfy a linear growth condition in S. 1. More precisely. We can avoid this difficulty here (and also in many other more general situations) by making the change of variable x = log S giving σ(x. Note that even in the simplest cases. t) cannot degenerate be zero. these conditions are no longer satisfied. The time γ at which The stochastic process derived in chapter 2 can be seen to exhibit singular behaviour and.5 American options Unlike European options discussed in section 1. In other words. the volatility term degenerates in certain regions of state space. T .12 Another condition is that the operator LBS must be uniformly elliptic. INTRODUCTION 27 behaviour of the models presented in this thesis can be attributed to the failure of the coefficients of the relevant equations to satisfy the conditions outline below. the diffusion coefficient σ 2 (S. t).4) to be the unique classical solution to the Black-Scholes equation (1. as such. American options have the extra feature that they can be exercised at any time prior to expiry. t) = σS.1.e. i. t) must be strictly positive at every point in the solution domain (S.

t t≤γ≤T (1. S. and the holder of the American option decides to exercise early then she receives the amount h(Sγ ) at time γ. one more complex (that could be exercised early) and one much simpler (that could only be exercised at expiry). t) ≥ h(S) (1.e. One of his industry contacts explained to him that there were two types of options available. the information contained in the filtration Ft ). If the payoff profile is given by h.CHAPTER 1.11) we have the inequality V (S. he used the European and American prefixes but reversed the ordering. the supremum of the expected value of the discounted payoff over all random times γ that are stopping times with respect to the filtration generated by the Brownian motion used to specify the dynamics of the underlying process for St . The terms European and American were first coined in Samuelson (1965) and the story behind their naming is noteworthy. INTRODUCTION 28 the option is exercised is called the exercise time and because the market cannot be anticipated. This is a rather intuitive definition of the American option price. . the holder of the option needs to decide whether to exercise at each point in time based only on the information up to time t ≤ T (i. Merton.11) i. Immediately from the definition (1. Using the theory of optimal stopping (cf. 2006). In response. t) < h(S) then there would be an obvious instant arbitrage at time t. This is a natural condition since if V (S.12) since the stopping time γ = t is included in the supremum.e. Samuelson visited many practitioners on Wall Street prior to writing his paper. Peskir and Shiryaev. t) = sup EQ e−r(γ−t) h(Sγ ) . when Samuelson (an American) wrote the paper. The practitioner commented that only the more sophisticated European mind (as opposed to the American mind) could understand the former. the unique no-arbitrage price of an American option can be shown to be given intuitively by V (S. According to a private communication with Robert C.

INTRODUCTION 29 In addition. strictly higher than the price of the corresponding European put option. It can also be shown that the price of an American put option is. When faced with an optimal . However. 2004). which can be done for their European counterparts. for example. the price of an American call reduces to the price of a European call.3. In o other words. where V E (S. set the interest rate to zero. in general.11) is attained for the stopping time γ = T when considering the payoff function of a call option. t) is the corresponding European option price. this is intuitive. 1. We therefore use a put option as our canonical example of an American option throughout the remainder of this thesis.12). it can be shown by no-arbitrage arguments that. since an American option gives its holder more rights than the corresponding European option with the same payoff function and expiration date. which does have an explicit formula. first derived by Black and Scholes (1973). the price of an American call option is the same as its corresponding European option (see. for nonnegative interest rates and no dividends.2) for sufficiently small S. t). 7.14 of Bj¨rk. Hence the value of the American contract cannot coincide with that of its European counterpart.6 Optimal stopping problems The observant reader may have noticed already that there is a strong link between pricing American options and optimal stopping problems. Again. Pricing American derivatives is mathematically more involved than the European case and closed-form expressions for American option prices are rarely obtained. choosing γ = T gives the further inequality V (S. violating the condition (1. prop.CHAPTER 1. the supremum in expression (1. t) ≥ V E (S. Thus. Indeed it can be seen (directly from its well-known analytic expression) that the European put option price crosses below the payoff function (1. without loss of generality. Another point to note is that when pricing American options we cannot.

3. the first time that the price of the American option drops down to the value of its payoff. Alternatively. u) = h(Su )}. Peskir and Shiryaev (2006) . i. 1.13 then the supremum is attained for the stopping time γ ∗ := inf{u ≥ t : V (Su .3. but first we state a key result from the theory of optimal stopping. there are two facets of the solution that we are most interested in. the price of American options can be shown to satisfy partial differential inequalities. If the function h is continuous. i. Clearly. For a nonnegative payoff function h. Determining the value function will be discussed shortly. if the value V (S. then it is not optimal to exercise the option. / The continuation region is so named due to the fact that in this region it is not optimal to exercise the option. in addition to some other technical conditions.e. t) > h(S)}. and more practically. The first is to determine the price of the option V (called the value function in optimal stopping terminology) and the second to determine the optimal strategy for the option holder. the price of an American 13 See. the optimal stopping time γ ∗ can be formulated as the first exit time from the continuation region defined by C := {(S. u) ∈ C}.CHAPTER 1. as γ ∗ := inf{u ≥ t : (Su . INTRODUCTION 30 stopping problem. t) : V (S. t) at some time t is strictly larger than the payoff profile h(S). for example. in other words to determine the stopping time that realises the supremum in (1.e.7 Free-boundary problems Analogous to the Feynman-Kac representation theorem for European options (outlined in section 1.3).11).

11) is given by the solution to the following linear complementarity problem: V (S. This implies that for S > Sf (t) the value V (S. V (S. T ) = (K − S)+ .13c) ∂V 1 2 2 ∂2V ∂V LBS (V ) = + σ S + rS − rV ≤ 0.13a) (1.13) can be formulated as the free-boundary problem 16 1 ∂2V ∂V ∂V + σ 2 S 2 2 + rS − rV = 0. t) = 0.14d) (1.14a) (1. This is alluded to in Peskir (2005b). t) must be at least C 1. T ) = h(S). S > Sf (t)}. we must apply the smooth pasting or smooth fit principle. (1.CHAPTER 1. and for S ≤ Sf (t) the In fact the principle of smooth fit in probability. to be solved in the entire domain {(S. t) must satisfy V (S. V (S. h(S. INTRODUCTION 31 option as defined in (1. t) is C 1. t) = K − Sf . but also over the boundary of the continuation regions. the principle of no arbitrage in finance and the conservation of energy law in the physical sciences can be seen as different formulations of the same principle. the free boundary. t) = −1.13b) (1.14c) (1. t) ≥ h(S. VS (Sf . in other words the boundary of the domain is to be solved as part of the problem. 15 At least for points at which the payoff profile h(S.1 differentiable. t) > (K − S)+ . denoted by ∂C.15 not only in the continuation regions.1 differentiable.14 This principle states that the value function V (S. it can be shown that the Black-Scholes equation holds at all points in the continuation region and that at the boundary of the continuation region. 0 ≤ t ≤ T } with the final condition V (S.14e) to be solved in the domain {(S. t) − V (S. (1. ∂t 2 ∂S ∂S V (Sf . t). t) → 0 as S → ∞. It also transpires that for a standard American put option there is an increasing function Sf (t).14b) (1. 16 See for example Karatzas and Shreve (1998) 14 . Further to this. ∂t 2 ∂S 2 ∂S LBS (V ). t) : 0 ≤ t ≤ T. t) : S > 0. compare Jacka (1991). separating the continuation region from the stopping region. As such the linear complementarity problem (1.

prices are determined solely by the interaction of demand and supply. Chen et al.CHAPTER 1. (2008) have recently proved the convexity of the resulting free boundary. In a free market. all being equal. we should expect an inverse relationship between price and quantity demanded. In addition. INTRODUCTION 32 value satisfies V (S.4 Supply and demand economics Many of the models presented in this thesis make assumptions about the structure of the markets and the intentions of the participants of these idealised markets. In a market. nothing less. the existence and uniqueness of the free-boundary problem (1. a market is a place where buyers (providing demand) and sellers (providing supply) meet. In the economics literature. This motivates a brief discussion of how prices are actually formed in these markets. nothing more. in short a discussion of supply and demand. The asymptotic behaviour of Sf (t) for times close to expiry can also be determined and indeed this shall be expounded upon in further detail in chapter 9. the price at which supply matches demand is often called the equilibrium price or market clearing price. t) = (K − S)+ . In addition. hence we should expect a positive relationship between price and supply. so called because it is at this price that all the surpluses are cleared from the market and the forces of demand and supply are not acting to change this equilibrium. 1. then the forces of demand and supply will . for put options without dividends. hence. an increase in price will usually lead to an increase in the number of people wishing to sell at that price. Furthermore. If disequilibrium exists. Conversely. Explicit solutions to parabolic free-boundary problems are rare. Jacka. Starting with the basics. 1991) that the American put option free boundary Sf (t) is a monotonically increasing function and that it approaches K as t approaches T .14) can be proved. however it can be shown (cf. there will be more demand for an asset at a lower price than at a higher price and. the backbone of a market economy. these relationships are often called the law of demand and the law of supply.

. xn ) the partial point elasticities are given by i = ∂(log y) ∂y xi = . whereas liquidity is concerned with the availability to trade the underlying asset at a given price. . Similarly. due to the surplus that exists. An important concept crucial to the models discussed in this thesis is that of elasticity. An important point to note at this stage is that elasticity and liquidity are not the same.e. With excess demand. PED < 1 implies that the good is price inelastic and when PED = 1 we have unit elasticity. INTRODUCTION 33 automatically adjust the market to equilibrium. hence there is much ambiguity in the connection between the two concepts. though there is a tendency to confuse the two. is defined as = dy x d(log y) dy/y = = . . dx/x dx y d(log x) i. At its heart this concept is a purely mathematical one which aims to measure the responsiveness of one variable to a change in another variable. PED > 1 implies that the good is price elastic. ∂xi y ∂(log xi ) Applied to the economics of supply and demand the price elasticity of demand (PED) is defined as PED = dq p dq/q = . dp/p dp q where q is the quantity demanded of an asset and p is the price per unit of that asset. prices will be forced downwards. The limiting cases PED = 0 and PED = ∞ imply that the asset is perfectly price inelastic and elastic respectively. and with excess supply. Elasticity defines a relationship between price and the quantity demanded (as defined above). . . x2 . The price elasticity of supply (PES) is defined similarly. given a function of more than one variable y = f (x1 . the ratio of percentage changes.CHAPTER 1. The next section explores the concepts of liquidity in much more detail. However (unlike elasticity) liquidity is not a well-defined concept. prices will be forced upwards due to the shortage that exists. The PED measures the responsiveness of the quantity demanded to the change in price. . More specifically given any functional relationship y = f (x) the point elasticity.

some markets are more liquid than others. . including Bank for International Settlements (1999) and Bank for International Settlements (2001). Of course. and the liquidity of a given market varies over time and in addition can dramatically dry up in times of crisis. For example. • Operational risk.5 Liquidity Risk can be classified into the following categories17 • Market risk. these standard models assume that the trader will not experience any liquidity risk. the stock market crises in October 1987 and 1989. implicitly assuming a level of liquidity that is without limits. • Credit risk. The standard models implicitly assume that the only risk experienced by a trader is that due to the uncertain nature of the market. Liquidity risk arises in situations where a party interested in trading an asset cannot do so because she cannot find a willing counter-party to that trade.CHAPTER 1. 17 See Protter (2006). Recent crises in the financial markets have triggered studies on the subject of market liquidity. In fact one of the most important attributes of financial markets is to provide immediate liquidity to investors. More relevant to this thesis. • Liquidity risk. since it affects their ability to trade. the Asian crisis in 1997 and the problems at Long-Term Capital Management Fund (LTCM) led the Committee on the Global Financial System to conduct several studies discussing the importance of liquid financial markets. • Model risk. Liquidity risk becomes particularly important to parties who are about to hold or currently hold an asset. INTRODUCTION 34 1.

trading cost. clearing and settlement systems. independent of all the other factors affecting the price dynamics. namely the tightness. Third.5. i. Howison (2005) states that market liquidity can manifest itself in three possible forms. orders are both numerous and large in volume with minimal impact on prices. Sarr and Lybek (2002) state that liquid markets exhibit five characteristics: tightness. namely. due to limited availability of a stock at the quoted price. In fact. this is often termed the liquidation cost. the price paid for trading the asset depends on the quantity traded. trading speed. immediacy. depth. Many researchers have attempted to do so but the best that can be done is to classify its many dimensions.e. there is a difference between the prices for buying and selling the asset.e.CHAPTER 1. Clearly. if not all. is that the action of a large trade may itself impact the price.e. INTRODUCTION 35 1. even for a highly liquid market. i. Kyle (1985) describes market liquidity in terms of three attributes. the speed with which orders can be executed. of the trade. new orders flow quickly to correct order imbalances. such as a small bid-ask spread as well as other implicit costs. breadth.1 Defining liquidity Market liquidity is often associated with the ability to quickly buy or sell a particular item without causing a significant movement in the price. trading quantity. i.e. liquidity is a tricky concept to define (let alone measure). since one asset could be more liquid along one dimension of liquidity while the other is more liquid in a different dimension. the concept of liquidity is multifaceted and ill-defined. the existence of abundant orders both above and below the price at which an asset currently trades. Liu (2006) identifies four dimensions to liquidity. Second. i. and price impact. and due to this multidimensional nature comparing individual assets liquidities is also problematic. One particular interpretation of liquidity in the literature fits nicely with the philosophy of this thesis. and most relevant to this thesis. depth and resilience of the market.e. trading beyond the quoted depth of the market usually results in a higher purchase price (or a lower selling price) for part. i. this is termed price impact. . having low transaction costs. reflecting the efficiency of the trading. Alternatively. the so-called bid-ask spread. However. and finally resiliency. First.

Measures of volume include numbers of trades and daily volume measured in dollars. Sarr and Lybek (2002) classify the existing liquidity measures into four categories. 18 The first is transaction cost measures that capture the costs of trading financial assets and trading frictions in secondary markets. selection bias and simultaneity bias are involved when using this measure. the advantage of this measure being that it is based on the actual observed price changes associated with trades. such as measurement error. or absolute price changes regressed on absolute volume. .5.CHAPTER 1. there is no single method for measuring it. However. various measures of the price impact of order flow. in this case the spread is called the realised spread. Measures of the price impact of order flow include price changes regressed on signed volume. Measures which are often used in the empirical literature on liquidity and asset pricing include the bid-ask spreads. INTRODUCTION 36 1. despite the advantages of using the price impact of order flow as a measure of liquidity. this is primarily used to measure the breadth and depth of the market. Trading volume is traditionally used to measure the existence of numerous market participants and transactions and is defined as Vol = i=1 18 n Pi Q i (1. In the second category are volume-based measures that attempt to distinguish liquid markets by the volume of transactions compared to the price variability. the latter being a better estimate of the actual transaction costs since trades may not take place at the actual quoted prices. tricky econometric issues.2 Measuring liquidity Because there are many dimensions of liquidity. One particularly intuitive measure of transaction costs is the percentage bid-ask spread. or daily changes regressed on daily volume.15) See Sarr and Lybek (2002) for a good review of many examples of each class of liquidity measure. where the ask price PA and bid price PB can be calculated from the quotes on the market or using a weighted average of actual executed trades over a period of time. Of all these measures. and various measures of order flow. the price impact of order flow is perhaps the most widely used. defined as BAS = 2 PA − P B PA + P B .

The resulting turnover rate gives an indication of the number of times the outstanding volume of the asset changes hands. such as Chalmers and Kadlec (1998). are market-impact measures that attempt to differentiate between price movements due to the degree of liquidity from other factors. This can be given more meaning by relating it to the outstanding volume of the asset. (1998) (who instead use the turnover rate) argue that liquidity is priced.15).CHAPTER 1. The fourth and final category. such as general market conditions or arrival of new information. However. INTRODUCTION 37 where Vol is the dollar volume traded.15). N is the outstanding stock of the asset and P is the average price of the n trades in (1. and the most relevant to the focus of this thesis. The turnover can thus be defined as TO = Vol NP where Vol is the trading volume defined in (1. these attempt to measure both elements of resiliency and speed of price discovery. Pi and Qi are prices and quantities of the i-th trade during a specified period. More recently Liu (2006) introduced a new measure of liquidity (called the standardised turnover-adjusted number of zero trading volumes over the prior 12 months) that . whereas others. There are many other volume-based measures. The third category of liquidity measures are equilibrium price-based measures that try to capture orderly movements towards equilibrium prices. Chen and Kan (1995) and Eleswarapu and Reinganum (1993) suggest that it is not. in the main these attempt to measure resiliency of the market. and as such there is no universally accepted measure of liquidity. One such question is whether liquidity is priced in asset returns. For example Amihud and Mendelson (1986) (who simply use the bid-ask spread) and Datar et al. which focuses on determining the processes by which information is incorporated into prices. In fact this problem of no universal liquidity measure has resulted in many unanswered questions in market microstructure theory. clearly no single measure can manage to fully capture the multifaceted nature of liquidity. Most of the existing literature attempting to measure liquidity has focused on the different dimensions of liquidity individually.

The market-maker accepts a certain level of risk in holding the financial instrument or commodity but hopes to be compensated by making a profit on the bid-ask spread. the new two-factor CAPM model is able to account for the book-to-market effect. Such models are not referred to specifically in this thesis and so it suffices to describe briefly the role of some of the more important market participants. In addition.6 Price formation We have alluded to the fact that the price of financial instruments may be considered as entirely dependent on supply and demand. known as specialists. Their main function being to provide the other side of trades when there are short-term buy-and-sell-side imbalances in customers orders. 1. price movements are caused primarily through the arrival of information.CHAPTER 1. INTRODUCTION 38 aims to capture multiple dimensions of liquidity. The dynamics by which this information is incorporated into the current price is addressed in the market microstructure literature. since we wish to see exactly whereabouts in the price formation process liquidity issues become important. for an overview of this topic see O’Hara (1995). These are individuals or firms that will take both long and short positions in a given security in order to facilitate trading. However knowledge about how these prices are actually formed in the market are of great interest. One of the most important members of any financial market are the so-called market makers. which the Fama and French (1996) three-factor model fails to explain. liquidity risk adjusted capital asset pricing model (CAPM) that well explains the cross-section of stock returns. . Using this measure Liu (2006) outlines a two-factor. From a market microstructure perspective. many markets have official market makers for each given security. (possibly) answering the question whether liquidity is priced. and thus add to the liquidity and depth of the market. where many models of price formation have been proposed. In the United States.

either to provide or to consume liquidity. The introduction of electronic markets has seen a sharp increase in another type of market participant. which is an order to buy or sell immediately at the best available price. In these markets. Further. This may be to exploit arbitrage opportunities such as index arbitrage (the misalignment of the price of an index and the sum of its constituent stocks) or to perform portfolio insurance. Here. which instead use an automated system called SETS).CHAPTER 1. in these order-driven markets liquidity now becomes self-organised. On the London Stock Exchange (LSE) there are official market makers for many securities (except for the largest and most heavily traded companies. most financial markets have become fully electronic and operate on what is called a matched bargain or order driven basis. The two main type of orders are the market order. It should. INTRODUCTION 39 In return. In traditional exchange floor markets the burden of providing liquidity is given to market makers or specialists. in the sense that any agent can choose. each catering to the different needs of different market participants. the specialist is granted various informational and trade execution advantages. when a buyer’s bid price meets a seller’s offer price the stock exchange’s matching system will decide that a deal has been executed. the automated execution of a deterministic . Alternatively we have limit orders which are not to be executed unless the specified price is met (or bettered) by current bids or asks. This is in contrast with much smaller order driven markets in which it can be extremely difficult to determine at what price one would be able to buy or sell any of the many illiquid stocks. each stock always has at least two market makers and they are obliged to deal. In an orderdriven market there are numerous types of orders that can be placed. Nowadays. we are not guaranteed execution but we are guaranteed price. however. providing liquidity by posting limit orders or consuming liquidity by issuing a market order. On the LSE one can always buy and sell stock. and as such gives no guarantee on the price but is guaranteed to be executed immediately. however. the program trader. at any instant of time. be noted that limit orders often incur higher commission fees. A program trader is one who uses a computer to automate his trades.

1987 market crash19 and to be responsible for an increased stock market volatility. Consequently. and noise traders whose demands are from hedging requirements. Program traders are thought to have been a contributing factor of the October 19. These large orders can contribute to the existing momentum of the market. Jacklin et al. thereby increasing market volatility. 1. Starting from a microeconomic o equilibrium and deriving a diffusion model for stock prices which endogenously incorporates the demand due to hedgers and in particular delta hedgers. general price levels fell sharply. They define information traders who believe in a fundamental value of the asset. Many of the models discussed in this thesis such as Platen and Schweizer (1998). one of the fundamental assumptions of the Black-Scholes-Merton model. Furthermore F¨llmer and Schweizer (1993) were the first to use a microeconomic o approach to construct diffusion models for asset price movements.7 Option pricing in illiquid markets: a literature review Authors such as Kreps (1979) and Bick (1987. since they quickly dump large orders on the market at critical times. Sircar and Papanicolaou (1998) and Sch¨nbucher and Wilmott (2000) were inspired by the temporary equio librium approach of F¨llmer and Schweizer (1993). (1992) argue that one of the causes was actually information about the extent of portfolio insurance-motivated trading suddenly becoming known to the rest of the market.CHAPTER 1. This shall be seen in a more mathematical framework in chapter 3. They derived equilibrium diffusion models for the asset price based on interaction between the two. This prompted the realisation that assets had been overvalued because the information content of trades induced by hedging concerns had been misinterpreted. 19 . Moreover Bick (1987. can be derived in a general equilibrium model with price-taking agents. INTRODUCTION 40 hedging strategy. 1990) have placed the classical BlackScholes-Merton formulation into the framework of a consistent model for market equilibrium with interacting agents having very specific investment characteristics (see section 1. 1990) showed how geometric Brownian motion.6).

in the presence of price impact. a detailed and readable account of which can be found in Williams (1995). An example of a market squeeze is the (alleged) soybean manipulation of 1989 for which more details can be found in Pirrong (2004). there have been many examples of such activities. 1994) provided a discrete-time model which allows the large trader to impact the market via some reaction function. is dependent on the large trader’s position in the underlying and the derivative asset. i. They concluded . The first involves the price impact due to a large trade. it is not clear that an option is still perfectly replicable. INTRODUCTION 41 The literature on liquidity falls broadly into two approaches. Moreover. Bank and Baum (2004) later extended Jarrow’s results to continuous time. hence it is no longer straightforward how to derive option prices from the prices of the underlying. and hence the price. However in the theoretical framework proposed by Jarrow (1992. A market corner is a successful effort of a trader to manipulate the price of a futures contract by gaining effective control over trading in the futures and the supply of the deliverable goods. Frey and Stremme (1997) studied the perturbation of volatility induced by a delta hedging strategy for a European option whose price is given by a classical Black-Scholes formula with constant volatility. but this cost. that the price mechanism must be independent of the history of the trades. especially in (less regulated) developing markets. Although price manipulation violates the Commodity Exchange Act. In a market squeeze. 1994) it was showen that to prevent any such manipulation the price impact mechanism must not exhibit any delay. Jarrow (1992.CHAPTER 1. In such models the large trader can move the price by his actions. the trader achieves control by disruption in the supply of the cash commodity. and only dependent on the current position of the trades. leading to nonlinearity. However in markets that allow large traders to impact the price of the asset there is the possibility of price manipulation and so called market corners and market squeezes. In addition a sufficient condition to exclude profitable market manipulation (in discrete-time) was given.e. He showed that the price of a derivative in this framework must be equal to the hedge cost. An example of a market corner is the Hunt silver manipulation of 1979-1980.

the aim being to reproduce. for which Frey (1998) gave existence and uniqueness results. Other continuous time models similar to Frey (1998) include Sch¨nbucher and Wilmott o (2000). In the discrete-time framework of Jarrow (1994). 2000) then showed that if feedback is taken into account in a more general hedging strategy (which we term full feedback ). both of which can be seen as undesirable restrictions. place a heavy restriction on the amount of market illiquidity that the model allows and rely on the terminal payoff being sufficiently smooth. whereby market liquidity drops if the stock price drops. They did show. more effectively. Sircar and Papanicolaou (1998) derived a slightly different nonlinear PDE that depends on the exogenous income process of the reference traders and the relative size of the program traders. Platen and Schweizer (1998) proposed a model using an approach that attempted to explain the volatility smile and its skewness endogenously and 20 For further discussion on these restrictions see chapter 4. The PDEs derived by these latter authors correspond to those derived in chapter 2 of the present study. and hence there is still risk associated with hedging in illiquid markets. however. In the continuous time framework of Frey (1998). Frey (1998. that increasing heterogeneity of the distribution of hedged contracts reduces both the level and price sensitivity of this un-hedged risk.20 Frey and Patie (2002) extended the work of Frey (2000) with an asset dependent liquidity parameter which attempts to incorporate so called liquidity drops.CHAPTER 1. however. who used a market microstructure equilibrium model to derive a modified stochastic process under the influence of price impact. . INTRODUCTION 42 that if a hedging strategy is used which does not take into account the feedback effect (which we term first-order feedback ). then it is possible to replicate an option perfectly (provided certain conditions on market liquidity and the nonlinearity of the payoff condition are satisfied). These results. this can be characterised more succinctly as the solution of a nonlinear PDE. the volatility smile. then it is not possible to replicate perfectly an option. the question as to whether options could be perfectly replicated in a finitely elastic market reduces to solving (recursively) a finite number of equations.

the actions of the traders do not influence the underlying stochastic process. The main difference with the first class of models is that these are now local in time models. Bakstein and Howison (2003) adopted a similar approach to Rogers and Singh (2006) but the former study leads to feedback effects. which the latter study was trying to avoid. Another model in this category is the work of Cetin et al. (2004). These models eliminate the feedback effects discussed above and. INTRODUCTION 43 Mancino and Ogawa (2003) proposed a very similar model in the same vein. who modelled the liquidation cost as dependent on the quadratic variation of the trading strategy which again leads to a nonlinear PDE when considered in continuous time. Motivated by empirical evidence.e. The second approach to liquidity seen in the literature involves the price impact due to the immediacy provisions of market makers. More recently. they are concerned more with the liquidation cost than permanent price impact. without long-term effects. In these models. The approach is relevant if an agent wishes to trade a large amount in a short time. i. These models have been considered by Rogers and Singh (2006) and Cetin and Rogers (2007). Other notable work in the area of liquidity and price impact includes Agliardi and Andergassen (2001) who extended the work of Sch¨nbucher and Wilmott (2000) and o Frey (1998) to include sink transaction costs as an additional source of illiquidity. Another ‘tweak’ of these models was made by Liu and Yong (2005) who attempted to regularise the PDE close to expiry. Lyukov (2004) then extended the model of Platen and Schweizer (1998) with more realistic assumptions about market equilibrium conditions (taking into account the presence of a market maker) and also obtained a very similar nonlinear PDE to that derived in chapter 2. who propose a series of independent auctions. Henry-Labord´re (2004) incorporated the feedback model of Sch¨nbucher e o and Wilmott (2000) into the portfolio optimisation of Markowitz (1959) to find that . Esser and Moench (2003) extended the work of Frey (2000) to incorporate stochastic liquidity into the price impact framework. supply and demand are equalised by the market maker in the short-term market. amongst others.CHAPTER 1. The majority of these models will be considered in more detail in chapter 7. as such.

Brennan and Schwartz (1989) also analysed the transformation of market volatility under the impact of portfolio insurance and under the assumption of CRRA utility. One of the few attempts to analyse the aforementioned models from an empirical standpoint was carried out recently by Sanfelici (2007) who considered the model of . There has also been some recent work using alternative pricing paradigms in place of portfolio replication. but only in the discrete-time framework. for a detailed discussion of how things can go wrong in continuous time see Sch¨nbucher o and Wilmott (2000). The first is the so-called free round trip phenomenon. Cvitanic and Ma (1996) and Cuoco and Cvitanic (1998) studied a diffusion model for price dynamics when the drift and volatility coefficient are functions of the large traders’ trading strategy. using a model with an exogenously defined exponential price effect function. 1994) gave sufficient conditions to exclude profitable market manipulation. then we must allow the actions of all large agents to affect the price and furthermore the effect of hedging a multitude of options on the underlying.CHAPTER 1. Finally Jonsson and Keppo (2002) derived a somewhat different nonlinear PDE. They showed an increase in Black-Scholes implied market volatility between 1% and 7% for values for the fraction of the market subject to portfolio insurance varying between 1% and 20%. Clearly this would result in an impossibly cumbersome problem. such as that by Bank (2006) who attempted to price options on illiquid underlyings using the utility indifference of the market maker. which can result in the possibility of market manipulation by a large agent. INTRODUCTION 44 portfolio optimisation has the effect of reducing market volatility and thus the price of options in that market. The second. According to Rogers and Singh (2006) and Cetin and Rogers (2007). Recall that Jarrow (1992. which is also inherently nonlinear. and by far the most important problem with these models is that if we allow the action of one large agent to affect the price. This approach leads to a stochastic optimisation problem and the Hamilton-Jacobi-Bellman equation. the price impact models of a large trader have numerous shortcomings.

comparing the results with other popular models. These techniques are primarily concerned with coordinate expansions. also known as asymptotic methods.CHAPTER 1. Coordinate expansions can also be used to investigate the behaviour of differential equations near any singular point x0 as x − x0 → 0 or for large values of the independent variable. Any other relevant literature will be discussed in the body of the thesis where it is appropriate. including their rich history. They are used extensively throughout this thesis and so a brief introduction. but not exclusively). Sanfelici concluded that the nonlinear models above can contribute to the explanation of the implied volatility smile but not as well as the other possible explanations. asymptotic expansions in which the independent variable. such as jumpdiffusion or stochastic volatility. as x → ∞. due in the most part to the models’ limited capability to reproduce skewed probability distributions. More recent developments in asymptotic theory have been associated with so called parametric expansions. The first. are a collection of mainly analytical techniques that can be used to solve (or simplify) mathematical problems involving a small or large parameter. Two phases in the history of asymptotics may be identified. INTRODUCTION 45 Mancino and Ogawa (2003) (amongst others) and attempted to calibrate the model to market data. x say. 1. often called classical asymptotics dates back to the work of Poincar´ (1886) on the far-field bee haviour of linear ordinary differential equations. both of which we exploit in this thesis. a theory in which the governing equations are highly nonlinear and as such have .8 Introduction to perturbation methods Perturbation methods.e. is outlined below. However. the study did find that the model of Mancino and Ogawa (2003) was more stable through time and consistent with market data. i. Taylor expansions are the most well known of this class of expansions. These ideas have been developed alongside the theory of fluid dynamics (especially. i.e. plays the role of the large or small parameter.

Chapter 2 provides an heuristic derivation of one of the more intuitive models attempting to incorporate liquidity into option pricing theory and in addition shows how the majority of models introduced in the current literature can be formulated in this framework. come at the expense of the approximate nature of the results. Nevertheless for many practical purposes the results obtained can be made sufficiently accurate. Cole (1968) and van Dyke (1964) to name but a few) and so the method of matched asymptotic expansions emerged.CHAPTER 1. An early attempt to tackle this problem was due to Prandtl (1904) in his paper on boundary-layer theory. under certain circumstances. 1. where the power series expansion solution sought no longer becomes an asymptotic series. which we now refer to as singular perturbations. and indeed can often provide invaluable insight into the qualitative behaviour of the problem under investigation. Exploiting the smallness of certain parameters and seeking a power series solution in the smallness parameter can often reduce the original system of equations to a much simpler asymptotic set of equations. Over the next half century these ideas were developed by many (Friedrichs (1954). During the first half of the twentieth century it was demonstrated that a number of problems involving small or large parameters developed a pathological behaviour. Kaplun and Lagersrom (1957). The relative simplicity of the asymptotic solution does. however.9 Layout of the thesis The remainder of this thesis is organised as follows. Kaplun (1967). INTRODUCTION 46 tractability only in the simplest of situations. whose solutions (both analytical or numerical) will often be much easier to find. This behaviour stemmed from the fact that in certain regions of the solution domain we have a so called asymptotic breakdown. Prandtl’s idea was to subdivide the solution domain into separate regions where different asymptotic forms apply. For a recent overview of how these techniques have been exploited in finance to date see Howison (2005). Chapter 3 investigates the so-called first-order feedback model (an exceptional case of a linear PDE) and .

INTRODUCTION 47 furthermore highlights interesting differences of both the option value and American option early-exercise boundary from the classical Black-Scholes-Merton case. In chapter 6 the perpetual options of the full feedback model are considered. Finally chapter 10 provides some concluding remarks and ideas for future research. Chapter 4 investigates the fully nonlinear full feedback model using both analytical and numerical techniques. Chapter 5 takes a closer look at this model in a regime in which it appears no classical solutions exist. here so-called phase plane analysis is found to be useful in determining such behaviour. . Chapter 8 considers briefly the so-called stock pinning effect which appears to be well explained by the models outlined in this thesis. which can provide an investor with protection against the liquidity issues discussed in the rest of the thesis. Chapter 7 takes a look at the existing models in the literature from a viewpoint of the results found in chapters 2-6. here we concern ourselves mainly with the behaviour of the free boundary which exhibits some interesting qualitative differences with the standard American option free boundary. Chapter 9 concerns itself with the related topic of the British option.CHAPTER 1.

Chapter 2 The Modelling Framework In the end. µ and σ are the (constant) drift and volatility respectively and Wt is a standardised Brownian motion. . but because researchers persuade one another that the theory is correct and relevant.Fischer Black (1938-1995) in 1986 In this chapter we present an heuristic derivation of one particular class of model for incorporating liquidity into option pricing theory.1) where S is the price of the underlying. a theory is accepted not because it is confirmed by conventional empirical tests. It is possible to add a forcing 48 . (2. In order to provide a derivation of the primary governing PDEs considered in this thesis. which are similar to those employed in Lipton (2001) and Liu and Yong (2005). we present the following arguments. We also attempt to highlight the links between the existing models and furthermore we transpose these models into a single intuitive analytical framework. We shall assume the underlying process to be a geometric Brownian motion (but this can be generalised to any stochastic process) dS = µSdt + σSdWt . This has not previously been done in the literature.

t) is a function of S and t only. t). t)dt + σ (S. 2 ∂S 2 (2. ∂t ∂S 2 ∂S 2 which substituting into (2.5) . f (S. σ (S. . it is possible to incorporate the additional contribution to the price dynamics into the drift and volatility coefficients µ and σ. which can be obtained by simply squaring equation (2. . even at this early stage in the derivation. Note that at this stage no assumptions need be made regarding the form of the functions λ(S. Substituting (2.6b) Note the term on the left-hand-side and how. t) and f (S. t) = ˆ 1 (2. Since f (S. We shall return to this issue numerous times throughout the remainder of the thesis.2) where λ(S. we arrive at the following stochastic process. (2. t). t) is an arbitrary function.6a) (2.e. we begin to observe possible singular behaviour. t)dWt . We commence by using Itˆ’s formula on the function f (S. dS = µSdt + σSdWt + λ(S. (2.CHAPTER 2. gives to leading order1 1−λ ∂f ∂S dS = µS + λ ∂f ∂t dt + λ ∂2f (dS)2 + σSdWt . t). .1): dS = µ(S. ˆ ˆ where ∂2f 1 ∂f 1 µS + λ ˆ + 2 σ2 2 ∂f ∂t ∂S 1 − λ ∂S σS . and particular financial interpretations can conveniently be postponed until certain manipulations are complete.4) where we have used the condition that (dWt )2 → dt as dt → 0. t) = ˆ ∂f 1 − λ ∂S µ(S.4) into (2. to obtain o df = ∂f 1 ∂2f ∂f dt + dS + (dS)2 + . (2. analogous to (2. as dt → 0 (dS)2 = σ 2 S 2 dt ∂f 1 − λ ∂S 2 + o(dt).3) to yield. and with a little rearranging. i.3). .2). t)df. . THE MODELLING FRAMEWORK 49 term.3) In order to proceed further we require an expression for (dS)2 . which is dependent on the stock price and time. to the process.

1) being modified to the process (2.5) will exhibit some boundary behaviour at the location of the singularity in the drift. Only large institutions can trade close to continuously and so. The interested reader is referred to Sch¨nbucher and Wilmott (2000) o who provide an analysis of the behaviour of the modified stochastic process at such singular locations. In the context of markets with finite elasticity. The financial interpretation of this forcing term will be considered in full detail shortly. i. t) can be interpreted as some function dependent on how we choose to model the form of price impact and liquidity. t) as a forcing mechanism on an underlying stochastic process which results in the process (2. However the volatility of the process also becomes singular at the same location and so it may be possible to move beyond the ‘boundary’. t) to be the number of extra shares that should be held due to some deterministic hedging/trading strategy and hence df (S. Also λ(S. the drift of the modified process µ(S. consistent with standard Black-Scholes arguments. which leads to the following pricing PDE for the modified stochastic process incorporating the aforementioned forcing term σ2S 2 1 ∂V + ∂t 2 1 − λ ∂f ∂S ∂2V ∂V + rS − rV = 0. t) will specify the number of shares needed to be bought or sold at time t and price S due to such a strategy. we shall return to this issue in section 2. It is tempting to expect that the stochastic process (2. since at this location the drift will become infinite and consequently the process might be contained within a fixed domain.3.7) Note that. when ∂f ∂S = 1/λ.CHAPTER 2.e.1).5). ˆ Thus far we have been deliberately vague about the financial interpretation of the forcing term in (2. To do this we will use the well-known Generalised Black-Scholes equation (for a more detailed derivation see for example Duffie. Markets are not complete to traders who do not have the opportunity to trade continuously. in a complete . t) does not appear in the option pricing PDE. We now turn our attention to option pricing under the modified stochastic process. we can define f (S. 2 2 ∂S ∂S (2. THE MODELLING FRAMEWORK 50 We can interpret the function f (S. 1996).

we have assumed that European contingent Note that this is for a net long position in the market. which is analysed in detail in chapter 3. 2 2 ∂S ∂S (2. Note too that for simplicity.9) This case we call first-order feedback. if there was a net short position then we would set f = −∆∗ .e. 2 . We shall call this case full feedback. unreasonable to assume that a trading strategy that could impact the price significantly is that of delta hedging. similar to Liu and Yong (2005). This leads to the fully nonlinear PDE.8) This leads to an interesting question about which strategy the hedgers are assumed to follow. In this case the trading strategy f . i. this would then introduce λ into the standard payoff conditions. ∂V 1 σ2S 2 + ∂t 2 1 − λ ∂2V ∂S 2 ∂2V ∂V + rS − rV = 0. THE MODELLING FRAMEWORK 51 market. in equation (2. 2 2 ∂S ∂S (2.10) which is dealt with in chapter 4. ∂S (2. Another (more interesting and challenging) case is when the hedger is assumed to be aware of the feedback effect and so would change the hedging strategy accordingly. This case is considered in the model of stock pinning by Avellaneda and Lipkin (2003) and will be discussed further in chapter 8. resulting in many large institutions selling the options to the small traders and then hedging the risk by replicating the option. and we therefore chose not to do this. the trading strategy adopted has to be found as part of the problem.CHAPTER 2. which corresponds to the case when V ∗ ≡ V . In such a market there is a high demand for these replicating strategies and it is not. This results in a net long position (of the large institution) for stocks in the market. t) = λ w(S. Note that although λ can be scaled out of (2. based on some form of option V ∗ . A naive strategy would be if V ∗ were the Black-Scholes value V BS and thus distinct from the solution V of equation (2. i. therefore. options open up new trading possibilities. This leads to the linear PDE 1 ∂V + ∂t 2 σ2S 2 1− 2 V BS λ ∂ ∂S 2 ∂2V ∂V + rS − rV = 0. t).7).e.2 f = ∆∗ = ∂V ∗ .10) 1 using the simple substitution V (S. For small traders however. options provide no extra trading opportunities to them.7) should be set to an option delta.

as noted by Frey (1998).5. since it depends on the liquidation strategy chosen by the investor. Another form ˆ where λ is a constant price impact coefficient. and this highlights that this factor fundamentally changes the option-price dynamics. in relatively illiquid markets. t) constant and a dimensionless o ˆ measure of the liquidity of the market. for example.9) and (2. T − t is time to expiry and β a decay ˆ for λ(S. can try to profit from this information by front running the anticipated trades. t) = λS ˆ where λ ∈ R is again some measure of the liquidity of the market.10) has appeared in the literature several times with differing forms of the function λ(S. t) can be found in Liu and Yong (2005) in which λ(S. This is primarily due to the fact that the exact liquidation value is difficult to determine. As far as we can ascertain there is little financial justification for this. Frey (1998) has the similar form λ(S. In this context the answer to this question reduces to showing whether or not an option can be perfectly hedged in such a market. In this case we do not need to introduce liquidation costs at maturity into the replicating portfolio.10) with the appropriate . such market traders who know that some other market participant has to dissolve a large hedged portfolio in the near future. The simplest case occurs in Sch¨nbucher and Wilmott (2000). analogous with the work of Sch¨nbucher and o Wilmott (2000). although a good deal of the analysis close to expiry presented here is quite widely applicable to other models. optimal liquidation strategies are discussed. the precise manner in which this is achieved is discussed in section 7. In what follows it is assumed for the most part that λ(S. and it appears to be introduced for numerical expediency to avoid difficulties associated with the growing option gamma as expiration approaches. t) according to the modelling assumptions. How we choose to close out the contracts is not just an academic exercise since. THE MODELLING FRAMEWORK 52 claims are settled by physical delivery of the underlying asset at maturity. Equation (2.CHAPTER 2. t) is a constant. Indeed. hence that there exists a unique solution to equations (2. Finally. t) = λ(1 − e−β(T −t) ) coefficient. who have λ(S. in Almgren and Chriss (2001). the question as to whether or not the model described above leads to a complete market is of interest.

It is well understood that the solution of a linear parabolic second order PDE can be expressed as an expectation of a Markov process.11) .5). Note that this equation can be obtained from an appropriate transformation of Burgers’ equation. It is possible to do so if the nonlinear PDE can be linearised by an appropriate transformation.1 Markovian processes In the full feedback case we effectively break the link between the solution of the PDE and the solution of the SDE. x u(x. 3 (2. For the full feedback problem it is not immediately clear. In the first-order feedback case the linear nature of the equation makes it easy to show this. Introducing the nonlinearity in the above manner results in a breakdown of the Feynman-Kac representation.1 Technical asides In this section we describe some of the more technical details regarding the application of standard analytic methods to the problem as outline above.3.CHAPTER 2. for more information see section 1. although under some fairly restrictive assumptions.7.t where the expectation is taken under the risk-neutral measure. T ) = h(x). 2. however.1. see for example Rosenerans (1972). This is not to say that one cannot use the Feynman-Kac representation theorem (see section 1. the nonlinear equation3 ut + auxx + bu2 = 0. S. Q. Recall. that Frey (1998) showed such existence and uniqueness results. 2. THE MODELLING FRAMEWORK 53 payoff profile. and so the solution to the PDE no longer corresponds to V (S. of the modified stochastic process (2.3) to formulate the solution to a nonlinear PDE as an expectation. For example. t) = EQ e−r(T −t) (K − ST )+ .

T ) = exp b h(x) . and so a link is re-established between the nonlinear PDE and a Markovian stochastic process. t) = exp resulting linear system wt + awxx = 0.11) is a quasi-linear PDE as opposed to equation (2. The linearising transformation can then be applied to the above expectation to recover the original (nonlinear) value function u(x.1 o differentiable. This full nonlinearity makes it extremely unlikely that such a linearising transform can be found and indeed the author could find no such transform. however.1. Markovian). A functional is any function on the sample path of a process.t where xt follows the dynamics dxt = √ b h(xT ) a . Consider for example a function that is C 2. i. t) = EP exp x. 2adWtP . that equation (2. for example the integral process or the maximum process.2 Applicability of Itˆ’s formula o In the application of Itˆ’s formula it is assumed that the function f (S. t) is C 2. In the above example the functional is given by the Cole-Hopf transform. t). if it is not then we have to include local time contributions. The can be linearised using a Cole-Hopf transformation w(x. w(x. compared to a function which is just dependent on the value of the process at the current time (i.5 of Protter (1990) or Peskir (2003).CHAPTER 2.10) which is fully nonlinear. This is a specific example of the fact that nonlinear equations can be expressed as a functional of a Markov process.1 in space-time in two separate regions . 2. For a detailed definition of local time see section IV.e. Note.e. THE MODELLING FRAMEWORK b u(x. For more on the Cole-Hopf transform solution to the nonlinear Burgers’ equation see Rosenerans (1972). w(x. a can thus be written as an expectation using the standard Feynman-Kac representation theorem for Markovian processes. t) a 54 .

x > 0. 5 The sgn function is defined as   −1. however. Evaluating df of (2. x < 0. 2 σ 2 S 2 dt (2. K − ). Note that here we have a well-defined second derivative in the entire domain.  ||    dS. t) = |S −K| where o K can be thought of as the strike price. 2 (2. S ∈ (K + . (2. THE MODELLING FRAMEWORK 55 separated by a kink along a curve in space-time.12) gives   −dS.14) 4 This would correspond to a trading strategy in which we would always hold stock and the size of our holding would be equal to the distance the current stock price was from the strike price K. We can. df = sgn(S − K)dS + σ 2 K 2 lim ↓0 1 {dt|St ∈ (K − . If we are to apply Itˆ’s formula o across the curve. 2 S ∈ (0. sgn(x) = 0. S ∈ (0.  1. K + )} .    (S−K)2 f (S. where we wish to apply Itˆ’s formula to the function f (S. K + ). S ∈ (K + .12) where > 0 is a small parameter. t) = dS + 2| | (dS)2 . K + ). t) = +  2| |    S − K. . ∞). ∞). Taking the limit ↓ 0 leads to5 df = sgn(S − K)dS + lim ↓0 1 {(dS)2 |S ∈ (K − . then we have to take into account the local time spent on that curve (see Peskir. x = 0.4 The first point to note is that this function does not have a well-defined second derivative at S = K and so df is ill-defined at this point. | | . S ∈ (K − .    (S−K) 1 df (S.13) Next we can calculate (dS)2 = and thus we obtain 1 − λ sgn(S − K) 2. K − ). 2005a). S ∈ (K − . To illustrate this we briefly describe (a slight modification of) the so-called Itˆ-Tanaka o formula. overcome this by approximating the non-smooth function by a smooth function such as   K − S.CHAPTER 2. K + )} .

2.CHAPTER 2.13) will become df = sgn(S − K)dS + σ 2 K 2 dLt . The derivation of the governing PDEs provided in this chapter aims to illustrate the links between these frameworks. t]|Su ∈ (K − . However smoothness of the solution to the full feedback PDE has not been determined a priori and if it transpires that it is not C 2. Note that for the Black-Scholes model the value function of a standard put option can be shown to be C 2. is all that is required.2.1 differentiable everywhere in the interior of the solution domain with non-smoothness only on the domain’s boundary (due to the payoff profile). 2. Hence our application of Itˆ’s o formula is valid for the first-order feedback case. In this framework the transaction price St is given by the formula ˆ St (α) = eρα St . and reduced-form SDE models. K + )} . (2004). Since Itˆ’s formula is not being applied across the kink in the payoff profile then Itˆ’s o o formula. in particular the latter two. without local time. reaction-function or equilibrium models. 2 and hence equation (2. A brief overview of each framework is provided below.2 Alternative models Bordag and Frey (2007) identify three distinct frameworks that attempt to model illiquid markets: transaction-cost models.1 Transaction-cost models The main model is this class is due to Cetin et al. THE MODELLING FRAMEWORK 56 We can define the local time spent on the curve St = K as Lt given by Lt = lim ↓0 1 {u ∈ [0.1 differentiable in the interior of the domain then we will have to apply a local time correction to our application of Itˆ’s formula in a similar manner to the o above.

Sch¨nbucher and Wilmott (2000). The normalised stock demand of the large investor is written in the form λΨt . that Ψt = f (St . Lyukov (2004) and Bank and Baum (2004).2.2 Reaction-function (equilibrium) models The models in this class include Jarrow (1994). ρ > 0 is a liquidity parameter and α is the number of shares being traded.e. then the market clearing condition becomes D(St . Frey and Co-authors (1996-2001). t) + λΨt = 1. where St is the price of the stock. t) + λf (St . (where supply meets demand) D(St . where λ ≥ 0 is a parameter that measures the size of the trader’s position relative to the total supply of the stock. Ut .CHAPTER 2. The overall supply of the stock is normalised to one. when α > 0) and receive less when selling (α < 0). Sircar and Papanicolaou (1998). t) = 1. Different models propose different functional forms for D which lead to slightly different prices. Platen and Schweizer (1998). (2004) show that this transaction cost is proportional to the quadratic variation of the stock trading strategy. namely ordinary investors and a large investor. It can be shown that under suitable assumptions on the function D. THE MODELLING FRAMEWORK 57 ˆ where St is some fundamental stock price (usually given by geometric Brownian ˆ ˆ ˆ motion dSt = µSt dt + σ St dWt ).e. Frey and Stremme (1997). Obviously the trader will pay more than the fundamental price for the stock when buying (i. . t) for a smooth function f . Cetin et al. For a very general analysis of the dynamics of self-financing strategies in reaction-function models. Furthermore assuming that this strategy Ψt is Markovian. i. 2. The equilibrium price St is then determined by the market clearing condition. the above admits a unique solution and hence it can be inverted to solve for St . The normalised stock demand of the ordinary investors at time t is modelled as a function D(St . Ut . We shall return to this framework after we have considered the somewhat more intuitive final framework. In such o models there are two types of traders in the market. see Bank and Baum (2004). t). Ut .

We shall consider. since the final term in the SDE can be considered as incorporating price impact. whose properties we aim to analyse in this thesis. Here investors are assumed to be large c traders in the sense that their actions affect the equilibrium price and the liquidity adjusted price process in the presence of a large trader is given directly by dSt = µ(St . Jandaˇka and c ˇ e Sevˇcoviˇ (2005) and Liu and Yong (2005).3 Reduced-form SDE models The models in this class are due to Frey (2000). t)dΨt . 2.e.3 A unified framework In this section we attempt to unify the equilibrium and reduced-form SDE models. In the next section we aim to illustrate how all three frameworks may be ‘transposed’ into a reduced-form SDE (2. the transaction cost model described in section 2.1 can also be rewritten as a reduced form SDE and we shall discuss this next. each of the equilibrium models and show that they can be rewritten as an SDE of the form (2.2. Frey and Patie (2002). t).CHAPTER 2. t) for a smooth function f .15) and hence all the modelling can be encapsulated into the function λ(S. . Again we can make the assumption that the strategy is Markovian. in turn. t)dt + σ(St .2. (2. Note that the model outlined in the first half of this chapter falls under the reduced-form SDE class. i.15). t)dWt + λ(St . We show that any of the equilibrium models existing in the literature can be recast in terms of a reduced-form SDE and so (at least for the purposes of analysis) the reducedform SDE models can be seen as the more general framework.15) where as before Ψt is a semi-martingale representing the trading strategy. In addition. that Ψt = f (St . THE MODELLING FRAMEWORK 58 2. This framework provides a very intuitive means of obtaining the stock price process in the presence of a large trader.

Hence6 dD(St . note that we are neglecting the quadratic variation terms since these would only influence the drift and clutter the algebra. t) = Ut + γ (log St − log S0 ) + f (St .3. Ut .3. 2. t) + O(dt) = 0. THE MODELLING FRAMEWORK 59 2. t) = constant where the demand is modelled as D(St . . However. where S0 and γ constant. Ut .1 Cetin et al. in the interest of brevity we will not investigate this model any further. t). t) + O(dt) where we have not included any quadratic variation terms in the calculation as this would affect only the drift of the process and for the purposes of option pricing we are only really interested in the volatility and price impact terms. Ut . t) = dUt + γ 6 dSt + df (St .2 Platen and Schweizer (1998) The model of Platen and Schweizer (1998) defines the market clearing condition D(St .CHAPTER 2.t) St we can take differentials to get ˆ ˆ dSt = d eλf St + eλf dSt ˆ ˆ ˆ = λdf eλf St + eλf µSt dt + σ St dWt + O(dt) ˆ = eλf St (λdf + µdt + σdWt ) + O(dt) = St (λdf + µdt + σdWt ) + O(dt) ⇒ dSt = µSt dt + σSt dWt + λSt df (St . St Again. t) to be the trading strategy as before. The function f (S. (2004) as ˆ St = eλf (S. t) in the above model is identified as the number of shares traded rather than held and so it is not obvious that we should thus identify f (S. (2004) Rewriting the model of Cetin et al.

t) = −γ −1 .3. 2. λ(St . Ut . t) = −νγ −1 .CHAPTER 2. but in this formulation it is clear that it must be negative in order to produce a price process that has a positive drift and volatility. t) = −νγ −1 . where the demand is modelled as D(St . t) + O(dt). t) = −γ −1 dH . t) + O(dt). Also the authors assume that dUt = mdt + νdWt for m. St hence we can identify σ(St . t) = Ut + γ (log St − log S0 ) + H f (St . t) . THE MODELLING FRAMEWORK 60 where St denotes the equilibrium price. ν ∈ R and so we have that dSt = −γ −1 mdt + νdWt + df (St . St df hence we can identify σ(St . There is discussion about the sign of the parameter γ in the paper of Platen and Schweizer (1998). df . Ut .3 Mancino and Ogawa (2003) The model of Mancino and Ogawa (2003) extends the work of Platen and Schweizer (1998) and so they also define the market clearing condition as D(St . Again dUt = mdt + νdWt so we have that dSt dH = −γ −1 mdt + νdWt + df (St . for any function H. λ(St . t) = constant.

ν ∈ R. t) = (LN )−1 . λ(St . t) = 1. where the right hand side is the supply from the market maker.3.2) D(St .3. t) = mL−1 . σ(St . St L L LN hence we can identify µ(St . t). Ut ). THE MODELLING FRAMEWORK 61 2. Ut . section 2. t) = dMt . t) = D(St . Ut . t) + ρf (St . t) is the normalised aggregate demand per security traded and ρ is the ratio of options being hedging to total supply.2.4 Lyukov (2004) The model of Lyukov (2004) defines the market clearing condition to be dUt + df (St .5 Sircar and Papanicolaou (1998) The model of Sircar and Papanicolaou (1998) define the (normalised) market clearing condition to be (cf. dMt /N dSt /St 2.CHAPTER 2. t) = νL−1 . He also defines liquidity L to be L= and dUt = N mdt + N νdWt . .16) where f (St . (2. where N is the total number of shares and m. Putting these together we have dSt m ν 1 = dt + dWt + df (St . The authors also note that if we restrict the demand function to the form D(St .

there is no explicit time dependence. Ut . St Ut βUtγ Now it is clear from (2. linear. Further the authors assume that φ(z) = βz. Ut .18) that βUtγ = D(St . ⇒ dSt dUt ρSt =γ + df + O(dt). hence βUtγ . t) = 1 − ρf. t) + ρdf = 0.CHAPTER 2. Ut and γ is the ratio γ= σ0 . ⇒d ⇒ βUtγ St γ dUt dSt − Ut St βUtγ + ρdf = 0. THE MODELLING FRAMEWORK 62 i.e. St and so we have dUt ρdf dSt =γ + + O(dt). i. D(St .17) where σ0 is the volatility of the Black-Scholes process given by dStBS = µ0 dt + σ0 dWt . then in order for the model to reduce to the Black-Scholes model in the limit of ρ → 0 the demand must take the form D(St .16) and (2. St (2. Ut ) = φ(Utγ /St ). St Ut 1 − ρf 7 Ignored the quadratic variation terms.18) + ρdf + O(dt) = 0. t) = St Therefore the market clearing condition becomes7 dD(St .e. . Ut . where dUt = µ1 dt + σ1 dWt . σ1 (2. StBS hence γ is the ratio of the volatility of the reference process Ut to the volatility of the Black-Scholes process StBS .

has a significant effect on the option replication price. λ(St .CHAPTER 2.17) gives σ0 µ 1 ρ dSt = dt + σ0 dWt + df + O(dt). St σ1 1 − ρf hence we can identify σ(St . even in this case. . t) = ρ . THE MODELLING FRAMEWORK 63 Finally substitution for Ut from (2. t) = σ0 . 1 − ρf With this survey complete we now proceed in the next chapter to investigate the case of first-order feedback (with λ constant for simplicity) and show how the illiquidity. especially as we approach expiry.

without affecting the price. + rS 2 2 ∂S ∂S (2. This leads to the linear PDE (assuming λ constant) ∂V 1 + ∂t 2 σ2S 2 V 1 − λ ∂ ∂S 2 2 BS ∂2V ∂V − rV = 0. This idea of first-order feedback leading to a modified. highlighting the differences with the classical BlackScholes model. but still linear PDE also appears in Sch¨nbucher and Wilmott (2000). In an illiquid market influenced by a large trader (or by an equivalent large group of small traders) following the Black-Scholes hedging strategy. a small trader can trade any number of shares. we assume that a hedger holds the number of stocks dictated by the analytical BlackScholes delta.9) models the replicating 64 .9). They call o the solution to the PDE (2. This chapter investigates the analytical properties of equation (2.Chapter 3 First-order Feedback Model As a starting point to investigating how liquidity can affect the option value. We also consider American options in this framework which has not previously been attempted. Hence equation (2. but under a different guise.9) the price taker’s price. but still has important and interesting differences from the classical Black-Scholes PDE. rather than the delta from the modified option price.9) which is somewhat easier to solve than the full-feedback problem PDE (2. in particularly in the region close to expiry.10). on a small scale.

FIRST-ORDER FEEDBACK MODEL 65 cost of an option for such small traders. Here.2.1 shows numerical results from the solution of equation (2. and exercise price. zero (some of the analysis below will confirm this). volatility. of course. Note that finite difference methods will be the preferred method of solution throughout this thesis. for these traders only.9) (obtained using a Crank-Nicolson procedure1 ) for European call options (all with time to maturity. and this highlights some subtle. K = 1) for λ = 0. For more on finite difference methods see Smith (1978). often with errors within the line width of the graphs presented. As λ is increased. It should be noted at this stage that the size of errors and related implementation details will be omitted from the presentation of numerical results. but important differences. Figure 3.2) are presented in figure 3.1). Although the illiquid results appear to be rather qualitatively similar to the liquid (λ = 0) results. Corresponding results for put options (using the same parameters as for figure 3. Finite difference methods have the advantage over the alternative finite element methods because we almost exclusively work in rectangular domains (asset price and time). in such situations finite difference methods are much easier to implement. 5. the market appears liquid. the option value is apparently eroded monotonically towards the amount by which the contract is currently in the money or.04. a more detailed analysis (applicable for times close to expiry) follows.CHAPTER 3. r = 0.2. with the standard put payoff condition (1.e. if out of the money. In all calculations the error levels were more than acceptable. 10. 1. the standard call expiry payoff at t = T has been implemented. The result with λ = 0 is. T = 1 year. i. σ = 0. who are aware of the large traders influence on the market. condition (1. the classic Black-Scholes result. The techniques used are more often than not standard and have well understood error estimates.1) on page 21. risk-free rate. 2. and these too strongly point to a monotonic asymptote on to the payoff function (for fixed T ) as the liquidity parameter λ increases. 1 .

K = 1) for λ = 0. 1.4 0.04. 1. σ = 0. 1 0.CHAPTER 3.7 0. r = 0.9 0.8 1 1.2. FIRST-ORDER FEEDBACK MODEL 66 0.5 Call value 0. 10.1: Value of European call options with first-order feedback (T = 1.4 0. the variation with λ appears to be monotonic. . r = 0. 2. 2.4 0.6 S 0.2: Value of European put options with first-order feedback (T = 1. K = 1) for λ = 0. σ = 0.1 0 0 0. 5. the variation with λ appears to be monotonic.2 1.04.2 0.2 0.8 1 1.1 0 0 0.2.2 0.3 0.6 0.4 Figure 3.3 0.8 Put value 0.5 0.6 0.2 1.6 λ=0 λ = 10 PSfrag replacements S 0. 10.4 Figure 3. 5.2 λ=0 λ = 10 PSfrag replacements 0.4 0.

1) (i.9) into Vτ − σ 2 S 2 VSS BS 2 (1 − λVSS ) 2 − rSVS + rV = 0. setting τ = T − t (representing time to expiry). (3. the inner solution. This zoomed domain we refer to as the inner region and the solution in this domain. 1995) that the solution f when η = O(1).2) We next investigate the small τ behaviour of (3. we wish to zoom in on the solution domain close to strike and expiry. 2 (3. FIRST-ORDER FEEDBACK MODEL 67 3..3) . Naturally the domain and solution outside of this region are given the prefix outer. for times close to expiry). The standard substitution.4) which is often called the inner variable and whose form can be verified a posteriori. (3.1 Analysis close to expiry: European options In this section we consider the behaviour of the option value close to expiry. for which we also need to know the behaviour of the Black-Scholes equation (3. is given by the solution to the ordinary differential equation (ODE) σ 2 K 2 fηη + ηfη − f = 0.CHAPTER 3. . shedding more light on the value of options as the parameter λ is increased.2) in this limit.5) For a survey of these methods applied to the equations arising in continuum mechanics see Barenblatt (1996).1) where subscripts now denote derivatives and V BS is the solution to the corresponding Black-Scholes equation 1 BS BS VτBS − σ 2 S 2 VSS − rSVS + rV BS = 0.e. This is generally the most critical and intricate period for option pricing models and offers us some insight into the valuation dynamics. 2 (3. transforms (2. To obtain this. such a solution is sometimes called a self-similar solution. hence as τ → 0 the solution takes the form V BS = τ 2 f (η) + O(τ ). Mathematically this zooming is done via the following well known transformation.2 It can be shown (see for example Wilmott et al. where η= S−K τ2 1 1 (3.

10) (3. we can perform a local similarity analysis similar to that just performed for the liquid Black-Scholes equation. To investigate the small τ behaviour of this equation. Λ 2π 1 η 2 Λ η − 1 + √ e− 2 ( Λ ) Λ 2π (3. (S−K)2 (3. and for a call f → η as η → ∞. f → −η as η → −∞ Using these boundary conditions it is straightforward and well known to show (cf. To illustrate this powerful technique the analysis will be explained in detail.8) We can now proceed to incorporate this into the first-order feedback illiquid problem (3. where ξ= S−K . First we seek a solution of the form V = τ α g(ξ).9) . Wilmott et al.CHAPTER 3.1).7) and. the local Black-Scholes gamma is given by BS VSS = σK 2πτ 1 √ e− 2τ σ2 K 2 . consequently. 1995) that equation (3.5) leads to the solution for a put f P (η) = η Φ and likewise for a call f C (η) = ηΦ 1 η 2 Λ η + √ e− 2 ( Λ ) . 1 2 (3. rewriting in terms of the original variables. Λ 2π x −∞ e− 2 y dy.6) where Λ = σK and Φ(·) is the standard normal cumulative distribution function defined as 1 Φ(x) = √ 2π Considering the second derivative gives P C fηη = fηη = 1 η 2 1 √ e− 2 ( Λ ) . τβ (3. FIRST-ORDER FEEDBACK MODEL 68 For a put the appropriate boundary conditions become f → 0 as η → ∞. f → 0 as η → −∞..

To obtain an appropriate scaling we balance this with the time derivative term which is O(τ α−1 ). which can verified a posteriori ). (3. Substituting (3. leading to the conclusion that α − 1 = α − 2β + 1 ⇒ β = 1.12) This can be solved using the method of characteristics. α and β are constants to be determined. .1) and BS re-writing the approximation of VSS close to expiry (3. to obtain V P (S. τ ) = Ke−rτ − S V C (S. . τ ) = S − Ke−rτ + + . The first point to note is that if the Black-Scholes local solution described above is used.11) It is clear that the denominator of the second term is O(τ −1 ) in the limit τ → 0 (provided that 2β − 1 > 0. 1 α = β = 2 . (3.9) without the diffusion term. Vτ − rSVS + rV = 0.9) and (3.8) in terms of the new inner variable ξ gives τ α−1 (αg − βξgξ ) − σ 2 K 2 τ α−2β gξξ 2 1− λ √ e σK 2πτ 2 2β−1 − ξ τ2 2 2σ K 2 + rKτ α−β gξ + rτ α g = 0. i. in conjunction with the appropriate initial condition. Hence the outer solution is given by the solution to equation (2.10) into (3. Therefore it would appear that close to expiry the dynamics of the first-order feedback model are significantly different from the standard Black-Scholes model. To fix α we exploit the fact that the inner solution τ α g(ξ) must match with the outer solution. We shall discuss this matching procedure in more detail shortly. In this (outer) region the second derivative of the solution is effectively zero since the payoff profile has no curvature here. (3.13a) (3. the solution that is valid outside of our inner region close to strike and expiry.e. i. FIRST-ORDER FEEDBACK MODEL 69 and is assumed to be O(1). Consequently the second derivative term is O(τ α−2β+1 ) as τ → 0.CHAPTER 3.1) becomes much smaller than the other terms in the equation in the limit τ → 0. then the second derivative term in (3.13b) for puts and calls respectively.e. Thus we require τ α g(ξ) = S − Ke−rτ for a call option in the limit ξ → ∞.

τ ) = Ke−rτ − S V C (S.15) Note that this satisfies our a priori assumption that 2β − 1 > 0. (3. which is O(τ 2 ) as τ → 0 (see (3.10) suggests we must also have S − K = O(τ β ). (3.11) gives g − ξgξ − σ 2 K 2 τ −1 gξξ 2 1− λ √ e− 2σ2 K 2 σK 2πτ ξ2 τ 1 2 − rKgξ + rτ g = 0. τ ) = 0 ξ → −∞ τ Figure 3.14) Note that on the relatively short ξ = O(1) scale. close to the strike price. Substituting for α and β into (3.CHAPTER 3. that is somewhat smaller than the classical Black-Scholes model. FIRST-ORDER FEEDBACK MODEL 70 however the preceding arguments suggest that for the matching to work we require S − K = O(τ α ).3: Asymptotic Matching. We conclude that3 α = β = 1. . τ ) = τ g P (ξ) V C (S. S PSfrag replacements V P (S. τ ) = τ g C (ξ) V P (S. this is clearly an important difference from the standard Black-Scholes model behaviour close to expiry. Note that the scaling here implies a region O(τ ) in asset space S. λ2 (3. and taking the O(1) terms leads to πσ 4 K 4 gξξ + (ξ + rK) gξ − g = 0. we are effectively replacing (3. In addition. τ ) = 0 V C (S.4)). hence (3.3). by construction ξ = O(1) in the inner region. τ ) = S − Ke−rτ ξ→∞ K O(τ ) V P (S.8) with BS VSS = 3 σK 2πτ 1 √ .

2π g C (ξ) = (ξ + rK)Φ (3. |ξ|→∞ S→K. Furthermore differentiating (3.17) and (3.16) Practically we re-write the outer solution in terms of the inner variable ξ and then equate the result to the inner solution τ g(ξ) to give the appropriate boundary conditions. τ g(ξ) in the limit |ξ| → ∞ to match with the outer solution (3. on the inner scale at least. and formally the matching condition is defined as lim V OUTER (S. 1964). consistent with our observations above regarding figures 3. for a put. g → 0 as ξ → −∞.13).7). and for a call: g → ξ + rK as ξ → ∞. This procedure leads to the boundary conditions for a put: g → 0 as ξ → ∞. λ ξ + rK κ 1 ξ+rK 2 κ − 1 + √ e− 2 ( κ ) .τ →0 (3. S = K(1 − rτ ).3.14) can be solved analytically.18) where Φ(·) is the cumulative normal distribution function defined by (3. 2π (3.18) with respect to λ directly gives ∂g C σ 2 K 2 − 1 ( ξ+rK )2 ∂g P = = −√ e 2 κ < 0.e. the option value is monotonic decreasing in the liquidity parameter λ.1 and 3. taking on the payoff form away from this point. the solution is g P (ξ) = (ξ + rK) Φ where κ = √ 2 2 πσ K . van Dyke. g → −(ξ + rK) as ξ → −∞. Note that increasing illiquidity (λ → ∞) implies κ → 0 and this in turn indicates that (3.CHAPTER 3. A schematic of this is given in figure 3. .2.18) become increasingly focused about ξ = −rK.17) and (3.14) for standard puts and calls are obtained from an asymptotic matching procedure (cf. Equation (3. FIRST-ORDER FEEDBACK MODEL 71 The appropriate boundary conditions to equation (3. For asymptotic matching we require the inner solution. τ ) = lim τ g(ξ). i. ∂λ ∂λ 2λ2 confirming that.17) and for a call ξ + rK κ 1 ξ+rK 2 κ + √ e− 2 ( κ ) .

Figure 3. BS need not necessarily be the same as the free boundary of the liquid option VAM . and so a consideration of this possibility is considered next.05 0 -0.1 0.05 1 1. it is possible for g P − [−ξ]+ < 0 (i. 0. g C −[ξ]+ > 0 for all ξ). 0. 0.3 0.05 g C (ξ) − [ξ]+ 0.04.5 shows results for the American put with the same financial parameters as for the earlier European options. In the case of the puts.2 0.1.3 g C (ξ) − [ξ]+ g P (ξ) − [−ξ]+ 0.4: Inner solution minus the payoff for put and call options.2 0. the most consistent model has the delta in (2.05 -2 -1.5 ξ (b) Call -0. σ = 0. r = 0. 0.5 ξ (a) Put 0 λ↓0 0 λ↓0 -2 -1. In the context of first-order feedback.15. In addition to confirming the monotonic behaviour in λ.15 0.5 0 0. V .2. which does permit early exercise.e.e.2. .25 0.5 2 0.4 shows the difference between the inner solution and the payoff function for both put and call options for various values of the liquidity parameter λ.2 Analysis close to expiry: American put options The remarks above naturally beg the question as to the value of a put option on a finitely liquid underlying if early exercise is permitted. FIRST-ORDER FEEDBACK MODEL 72 Figure 3..1 0. . .25 0.CHAPTER 3. As with the classical Black-Scholes result for European calls. V − payoff < 0) for g P (ξ) − [−ξ]+ PSfrag replacements PSfrag replacements certain ranges of ξ. obtained via a standard Projected Successive .5 -1 -0.5 -1 -0. which opens up the potential for the optimal early exercise (on the ξ scale).5 2 Figure 3. it can be seen that call values always lie above the payoff curve (i.8) on page 51 computed BS using the liquid (λ = 0) American put value VAM . 3. note that the free boundary (optimal exercise price) of the illiquid put option.4.15 0. K = 1 and for λ = 0. in the present case it is never optimal to early exercise calls.5 1 1.

CHAPTER 3. FIRST-ORDER FEEDBACK MODEL

73

Over Relaxation (PSOR) iterative procedure. The convergence criteria chosen for the algorithm was that maximum error between subsequent iterations was less than 1 × 10−6 . At each node the Black-Scholes American value was computed using a PSOR algorithm and then this value was used in the PSOR algorithm for the first-order feedback PDE (2.9) subject to (1.2). Again we see the ‘collapse’ of the option value on to the payoff as the liquidity parameter λ is increased (which implies the location of the free boundary always moves towards the exercise price as λ increases). However, although the results appear to be qualitatively similar to the λ = 0 case, there are subtle differences, as we shall now show.
0.25

0.2

Put value

0.15

λ=0
0.1

PSfrag replacements
0.05

λ = 10
0 0.8 0.9 1 1.1

S

1.2

1.3

1.4

1.5

Figure 3.5: Value of American put options, T = 1, r = 0.04, σ = 0.2, K = 1 and for λ = 0, 1, 2, 5, 10; the variation with λ appears to be monotonic. Analysis of the liquid (λ = 0) American put option close to expiry leads to a somewhat complicated structure, as detailed by Kuske and Keller (1998). Here, the η scale defined in (3.4) can be shown to fail to capture the free (exercise) boundary. Instead, √ the free boundary is located at a somewhat larger distance (O( −τ log τ )) from the exercise price (with a significant price variation in a region O( −τ / log τ ) of this exercise boundary). It was shown by Widdicks (2002) that as τ → 0, on the η = O(1) scale, the solution of the liquid (λ = 0) American option takes the same form as that

CHAPTER 3. FIRST-ORDER FEEDBACK MODEL

74

of its European counterpart, i.e. (3.6). Therefore, it is entirely self consistent to use this form and, indeed, the European gamma (3.8), for the American case when η = O(1) or smaller, which is relatively distant from the free boundary. However, recall that for the case when λ = 0, with ξ = O(1) we have clear indications of the possibility of early exercise (on the ξ scale) for the illiquid put. In other words the ξ scaling for the first-order feedback equation encompasses the free boundary (unlike the η scaling for the liquid (λ = 0) case). Therefore, the American problem in this case reduces to the solution of (3.14), subject to the conditions4 g → 0 as ξ → ∞, g = −ξ and gξ = −1 on ξ = ξf , (3.19a) (3.19b)

where we have used the usual smooth pasting conditions (continuity of the option value and its derivative) and ξf denotes the location of the free boundary (on the ξ scale). It is straightforward to solve the system (3.14), (3.19) fully numerically, however it is also possible to reduce the above problem to a transcendental equation for ξf , a procedure which has not previously been done in the literature and shall be outlined below. It is convenient to make the shift z = ξ + rK which transforms the system (3.14), (3.19) to κ2 gzz + zgz − g = 0, g → 0 as z → ∞, g = −z + rK, gz = −1 on z = zf , (3.20a) (3.20b) (3.20c)

where κ is as before and zf the free boundary on the z-scale. To proceed we seek a solution of the form, g(z) = zˆ(z) g
Note that here the outer solution is given by V P (S, τ ) = (K − S)+ rather than V P (S, τ ) = (Ke − S)+ since we are dealing with the American option and so the outer solution will be trivially the payoff profile.
−rτ 4

CHAPTER 3. FIRST-ORDER FEEDBACK MODEL

75

which upon substitution leads to 2 z gzz ˆ = − − 2. gz ˆ z κ Integrating once gives gz = ˆ A − 1 ( z )2 e 2 κ , z2

where A is a constant of integration. Integrating once more gives A − 1 ( y )2 e 2 κ dy, y2 z ∞ A ∞ − 1 ( y )2 A 1 y 2 − 2 e 2 κ dy, ⇒ g (∞) − g (z) = − e− 2 ( κ ) ˆ ˆ y κ z z 1 y A 1 z 2 A ∞ − 2 ( κ )2 e ⇒ g (z) = − e− 2 ( κ ) + 2 ˆ dy, z κ z [ˆ]∞ = gz where we have applied the boundary condition (3.20b). Returning to the original function g(z) gives g(z) = zˆ(z) = −Ae− 2 ( κ ) + g
1 z 2

Az κ2

∞ z

e− 2 ( κ ) dy.
1 y

2

(3.21)

It is now required to determine the value of A using the remaining boundary conditions on the free boundary. To do this we differentiate equation (3.21) to obtain A gz (z) = 2 κ
∞ z

e− 2 ( κ ) dy.
1 y

2

We can now apply the two boundary conditions at zf , i.e. g(zf ) = −zf + rK = −Ae− 2 ( κ ) +
1 zf 2

Azf κ2
2

∞ zf

e− 2 ( κ ) dy,
1 y

2

(3.22) (3.23)

gz (zf ) = −1 = From (3.23) we have

A κ2

∞ zf

e− 2 ( κ ) dy.
1 y

A= hence substituting into (3.22) gives

zf

−κ2 , 2 ∞ −1(y ) 2 κ e dy

−zf + rK = ⇒ rK
∞ zf
y 2 κ

zf

κ2 e − 2 ( κ ) − zf , 2 ∞ −1(y) e 2 κ dy
1 z 2

zf

2

f 1 1 e− 2 ( ) dy = κ2 e− 2 ( κ ) ,

CHAPTER 3. FIRST-ORDER FEEDBACK MODEL

76

which can be written in the form of the standard cumulative normal distribution function as rK 2π Transforming back to the original ξ variable yields Φ or further Φ
8

Φ

zf κ

= 1−

κ √

e− 2 ( κ ) .
1

zf

2

ξf + rK κ λ(ξf + rK) √ 2 2 πσ K

=1−

κ −1 √ e 2 rK 2π

ξf +rK κ

2

,

σ 2 K − λ2 =1− √ e 2π 2rλ

ξf +rK σ2 K 2

2

.

(3.24)

6

4

log(−ξf ) PSfrag replacements

2

0

-2

-4

-6 0 1 2

λ

3

4

5

Figure 3.6: First-order feedback put (with early exercise), location of free boundary (as τ → 0) with λ, K = 1, r = 0.04, σ = 0.2. Figure 3.6 shows the variation of the local free boundary ξf (more particularly log(−ξf )) with λ for the financial parameters considered earlier, i.e. r = 0.04, σ = 0.2, K = 1. The key point to note is that solutions of the system do exist, i.e. the short S − K = O(τ ), ξ = O(1) scale captures the location of the free boundary with firstorder feedback, whilst as noted above, the liquid (λ = 0) case evolves on a relatively √ longer scale of S − K = O( −τ log τ ); consistent with this as λ → 0, ξf → −∞. Further asymptotic analysis can describe this behaviour, but is omitted in the interests of brevity. Note that transforming back to the original (S, τ ) variables using equation (3.10) we can see that Sf (τ ) = K + ξf τ + . . .

It can be seen that equation (3. determined by the solution of the transcendental equation (r + σ 2 )τ0 = log 5 λ √ σK 2πτ0 . Figure 3.τ ) √ = 0.25) This equation can be solved explicitly by setting x = ln(S/K) and doing so we arrive σK 2πτ λ √ 1 2 .24). .τ ) √ = σS 2πτ 1 2 for both puts and calls where d1 (S. τ ) = log S K + r + 1 σ2 τ 2 √ .9) one might naively think that a singularity occurs when 1 − λVSS = 0. Using the analytic solution for the Black-Scholes equation we find that BS VSS e− 2 d1 (S.7 shows the results for the same set of financial parameters as used throughout this chapter. Hence the free boundary approaches the strike price at expiry linearly for small times to expiry.CHAPTER 3. hence a possible breakdown in the diffusion term of the first-order feedback PDE. 1− σS ∗ 2πτ at √ 3 S (τ ) = K exp − r + σ 2 τ ± 2σ 2 τ (r + σ 2 )τ − log 2 ∗ 1 ∗ 2 (3.9) vanishes is given by the solution to the equation λe− 2 d1 (S . 3. σ τ Hence the location where the denominator of equation (2.5 Considering equaBS tion (2.3 The vanishing of the denominator One further interesting property of the first-order feedback model is that we have the possibility of the denominator of the volatility term vanishing. τ0 ) for some finite time-to-expiry τ0 . FIRST-ORDER FEEDBACK MODEL 77 where ξf is determined by equation (3.25) has two distinct solutions for τ ∈ (0. This shall be even more important in our consideration of the full feedback problem discussed in chapter 4.

04 and σ = 0.025 0. for a second order ODE in the form VSS = F (VS . K = 1. r = 0. i. . . V.015 0.01 0. See. S) .CHAPTER 3. Also note that the location of the singularity at τ = 0 is K as one might expect. Even though equation (2. Note that when considering the Frey (2000) model an explicit expression for τ0 can be obtained (see section 7. and thus the above result cannot be applied directly. V.02 1.2.9) vanishes it is now interest to investigate the behaviour of the solution at these points.e. it is informative to re-write (2.e. Having determined the location in which the denominator of equation (2. FIRST-ORDER FEEDBACK MODEL rag replacements 78 1.9) is a PDE. Hence possible singularities of the solution occur at singularities of the function F (·).97 0 0. V (n−2) .9) with λ = 0.03 0. i. It is a well known property of ODEs6 that singularities of the solution occur only at singularities of the equation when it is written in the standard form V (n) = F V (n−1) .9) in standard form to give VSS = 6 2 BS (Vτ − rSVS + rV ) 1 − λVSS σ2S 2 2 .01 S∗ 1 0.04 0. for example.1).1. (1997) .005 0.98 0. S .045 Figure 3.035 0.7: Location of the vanishing of the denominator of (2. Kruskal et al. For τ > τ0 the equation has no solutions.99 τ0 0.02 τ 0. the denominator does not vanish in this region. . .

9: The second derivative (Γ) of the Black-Scholes equation (3. FIRST-ORDER FEEDBACK MODEL PSfrag replacements 79 BS from which we can see that the right hand side has no singularities except at |VSS | → ∞...85 0. . τ ) = (K.15 Figure 3.05 -0.9) (solid line) for τ = 0.95 S 1 1.015.8 and 3.85 0. 0.8: The first derivative (∆) of the Black-Scholes equation (3.05 5 0 0.05.01. 0).1 1. Compare the location of the vanishing denominator 3.7. 45 40 35 ∂2V ∂S 2 30 τ = 0. instead it is clear that at the locations of the vanishing of the denominator the second derivative will be forced to zero. Compare the location of the vanishing denominator 3. .95 S 1 1.9) (solid line) for τ = 0.2) (dotted line) and the first order feedback PDE (2.015. which only occurs at (S.15 Figure 3.05 1.CHAPTER 3.1 1. . 0.01 25 20 Γ= S∗ 15 10 τ = 0.8 τ = 0.4 ∆= -0.01. Hence it is expected that no singularities will appear in the solution for τ > 0. 0 -0.01 PSfrag replacements -1 0.05.7. Figures 3. . 0.9 show the first and (more importantly) the second derivative .2) (dotted line) and the first order feedback PDE (2.6 τ = 0.05 1.2 ∂V ∂S -0. 0. .9 0. .9 0.

(1998). The numerical investigations of the first-order feedback equation described above indicate that the solution profile does indeed remain convex.1 differentiable and further that VSS remains positive. (1996) or El Karoui et al.9) in the vicinity of S ∗ respectively. τ ). We have shown that for small times to expiry the solution is indeed monotonically decreasing in the parameter λ. More importantly they show that (in one dimension) a local volatility model. Indeed convexity preservation is a well-known property of option prices under the assumption of geometric Brownian motion. despite the vanishing of the denominator. just ‘skimming’ zero as S ∗ is approached. τ ) = ˆ σ2S 2 BS (1 − λVSS ) 2.e. This is true only in certain models and is not necessarily true for certain models when in higher dimensions. in agreement with the stated results. however this in not the whole story for τ = O(1). see for example Bergman et al. Ekstr¨m et al. It can be seen that the solution at S ∗ appears to be at least C 2. σ 2 (S. i. It can be seen that for the closest time to maturity a monotonic decreasing relationship is shown. this relationship appears to be increasing for sufficiently large times away from maturity. We can begin to see what may be happening if we take a closer look at the modified volatility term of the first-order feedback case. i. (3. i.10 shows the solution to equation (3.26) . FIRST-ORDER FEEDBACK MODEL 80 of the solution of (2. will be convexity preserving.e. One final subtlety of the behaviour of the first-order feedback equation comes when we take a closer look at the hypothesised monotonic decreasing behaviour of the option value with the liquidity parameter λ. Convexity preservation means that given convexity at t the option price remains convex for all times prior to t. o (2005) show that geometric Brownian motion is the only convexity preserving model in higher dimensions.CHAPTER 3. τ ) as we have here.e VSS ≥ 0 for all (S. however as we increase the time to expiry. a model for the underlying with an arbitrary volatility function σ(S. Figure 3.1) for two slightly different values of λ (the dotted line representing the higher value) and also at three different times to maturity. thus indicating that the solution remains convex as τ increases.

(3.14 0.0125 0.04 and so we are in the region in which VSS < 1/λ and we should thus expect monotonic increasing behaviour in λ. Recall that the results of Ekstr¨m et al. 7 See for example Bergman et al.7 hence to determine the option price dependence on λ we need only determine the dependence of the modified volatility on λ.0375.27) indicates that the solution dependency on the liquidity parameter λ is BS monotonic increasing in regions in which VSS < 1/λ and monotonic decreasing for BS BS VSS > 1/λ.075 0. which it appears we have. As such we have the relationship that an increase in volatility will result in an increase in option price.06 τ = 0. However in the limit as λ → ∞ the region VSS > 1/λ expands to fill the whole domain and so this will become the dominant behaviour for a fixed time to expiry.09 (solid line) and λ = 0. FIRST-ORDER FEEDBACK MODEL rag replacements 81 0.1 1.15 Figure 3.0375 V 0.04 τ = 0. figure 3. (2005) suggest that the solution to the PDE o (3.CHAPTER 3.10.12 0.075. El Karoui et al. τ = 0.2. since for the parameters used. K = 1 and λ = 0.0125.08 0. dependent on the size of VSS .05 1.02 0 0.1 (dotted line). 0.1) (for convex payoff profiles) remains convex for all (S.04. (1996).10: First-order feedback put option value for two different values of λ at various times to expiry. σ = 0. For r = 0.85 0. Differentiating (3.7 indicates that the denominator of equation (3.26) with respect to λ yields BS σ 2 S 2 VSS ∂σ2 ˆ = BS 3 ∂λ 2 (1 − λVSS ) (3.1) does not vanish for τ BS 0. 0. The above agrees well with the results shown in figure 3.1 τ = 0. τ ). Compare with figure 3. In fact.95 S 1 1. (1998) or Janson and Tysk (2003) .27) BS and it is clear that the sign of the above may change.16 0.7.9 0.

.CHAPTER 3. FIRST-ORDER FEEDBACK MODEL 82 With this necessary background complete. in the next chapter we may proceed to investigate the more challenging full-feedback model.

These results. but rather is based on the actual delta of the modified price. The aim being to illustrate exactly how things go wrong. Existence and uniqueness was given by Frey (1998) which shows that options in such a market can be perfectly replicated. are not applicable to standard put or call options (nor any non-smooth payoff profile) and so here we investigate the solutions to the PDE in such regimes. τ )VSS )2 (4. with the view to informing modellers on how to incorporate non-smooth payoffs into the intuitive framework outlined in chapter 2. resulting in nonlinearity. The full feedback equation has been studied extensively in the literature with various functional forms of the liquidity parameter λ(S. and as a consequence the price impact is fully considered in the trading strategy. however. In this case the trading strategy has to be determined as part of the problem.Chapter 4 Full-feedback Model We now turn our attention to the full feedback case. hence the market is complete. 2 (1 − λ(S. This corresponds to a situation where all market participants performing such hedging strategies are aware of the effect that their strategies have on the price. 83 . namely the equation Vτ − σ 2 S 2 VSS − rSVS + rV = 0.1) where the trading strategy assumed to affect the price is not simply the Black-Scholes delta hedging strategy as discussed in the previous chapter. t).

The nonlinearity of equation (4. using various analytical and numerical techniques. hence we must take care to specify the option . Liquidating the portfolio would change the price. Equations of this form were first studied by Barenblatt and co-workers in the context of hydrodynamics and more recently have arisen in models occurring in quantitative finance. numerous difficulties arise when liquidation strategies are incorporated into such dynamic hedging strategies.2) and (1. Note that equation (4. τ. and due to the negative slope of the demand curve the realised value would be less than the paper value.CHAPTER 4. with the standard put and call payoff profiles (1.1).1) has the form 1 Vτ − F (S. so-called because the value satisfying the PDE is just the paper value of the option. VSS )S 2 VSS − rSVS + rV = 0. As such the aim of this chapter is investigate thoroughly the properties of the nonlinear PDE (4.1). However. Nonlinear diffusion equations are a frequent occurrence in the physical sciences and the work done in these disciplines can provide much insight into the nonlinear behaviour of the models arising in mathematical finance.1). As such there is a significant difference in the value of the option to someone holding a long position as opposed to a short position. We also give a brief overview of some of the techniques used to solve general nonlinear PDEs and appraise their appropriateness for equation (4. If we have a nonlinear PDE then one of the most striking differences with linear equations is that the sum of two or more solutions is no longer necessarily a solution itself. 2 and as such is fully nonlinear. for example in many transaction cost models such as Barles and Soner (1998).1) has many important consequences. FULL-FEEDBACK MODEL 84 The full-feedback model described here is what Sch¨nbucher and Wilmott (2000) call o the paper value replication for the large trader. It is for this reason that the majority of models in the literature (and the present study) consider only the paper value or make the assumption that the option is closed out using physical delivery to bypass any difficulties with the liquidation value.

and in fact the Black-Scholes equation can be shown to be a sufficiently well-posed problem. A portfolio consisting of the same option held both long and short would be priced at zero since this portfolio has a zero payoff and is thus worthless. When faced with a partial differential equation. to the concept of the bid-ask spread. let us consider any nonlinear transaction cost model. The problem has a solution. 3. 2. The most fundamental being does there exist a solution. quite naturally. well known to exhibit possible multiple solutions. However when pricing each option separately. The solution depends continuously on the data given in the problem. The effect of transaction costs and liquidity costs are always a sink of money for hedgers. see section 4. and if so is this solution unique? The latter question becomes even more important when dealing with nonlinear equations. In addition if we require the solution of a PDE of order k to be at least k times continuously differentiable. FULL-FEEDBACK MODEL 85 position. Stating some results from general PDE theory. existence and uniqueness results are well known. a problem is well-posed if:1 1. the difference being that of the total transaction costs incurred. there are many questions that one must ask. This solution is unique. As an example of this.1) with non-smooth payoff profiles. transaction costs will be incurred on both options and such costs will aggregate causing a disparity between the value of the portfolio and the sum of its constituent parts. For linear (diffusion) equations. It is quite remarkable therefore that the inherent nonlinearity of the pricing equations leads. As it turns out this idea of a weak solution is exactly what is needed when tackling the solution to equation (4. Many PDEs do not have classical solutions but are nonetheless well-posed if we allow for properly defined generalised or weak solutions. 1 See for example Evans (1998) .CHAPTER 4.6. then we call a solution with this much smoothness a classical solution of the PDE.

e. An alternative and novel approach to providing existence and uniqueness results.2 In the sequel we will be considering the more general scenario of non-smooth payoff profiles. τ ) = λS and for sufficiently smooth payoff profiles. (1968). can be found in section A.1) was well-posed for ˆ λ(S. σ = σ(S.CHAPTER 4. i. This can be shown by simply substituting the put call parity relationship V P = V C − S + Ke−rτ into the nonlinear equation for the put value V P (S. even in this highly nonlinear situation. VτP − and the payoff profile P σ 2 S 2 VSS 2 (1 − P 2 λVSS ) P − rSVS + rV P = 0. since the second derivative of the put and call option coincide. τ. V P (S. This was done by differentiating the fully nonlinear PDE in V to obtain a quasi-linear PDE in the hedging strategy ∆(S. Frey (1998) showed that equation (4. 0) = (S − K)+ . exploiting the maximum principle for parabolic equations. τ ) for which existence and uniqueness was shown using arguments similar to Ladyzenskaja et al.1 Put-call parity Firstly we note that put-call parity can be shown to still hold.e. hence it is clear that the parity relationship will still hold. hence we can recover the call option value from the put option value.1) differs from the Black-Scholes equation by a function of the second derivative of the option value only. Note that the nonlinear equation (4.2. 0) = (K − S)+ . Doing so we obtain VτC with − C σ 2 S 2 VSS 2 (1 − C 2 λVSS ) C − rSVS + rV C = 0. 4. FULL-FEEDBACK MODEL 86 As previously mentioned. VSS ). V C (S. i.2. τ ). where existence an uniqueness results have not been established. 2 .

Such solutions can be obtained by exploiting symmetries of the governing equation (and boundary conditions). λ = λ(τ ). and furthermore is only valid for payoff profiles depending quadratically on S. the solutions obtained in this way are generally only valid for very restrictive boundary conditions.1) is a function of τ only. 2λ 4. t) in order to obtain this solution (without any real financial justification). Note too that regularity issues arise if h = which are not unrelated to the analysis of chapter 5. As an example of this. 1 . FULL-FEEDBACK MODEL 87 4. τ ) = S 2 h(τ ).1) we can employ the powerful technique of similarity solutions.1) gives hτ − σ2h − rh = 0. τ ) in equation (4. based on the theory of Lie groups. Substitution into (4. In addition. It should be emphasised here that we have been restricted to a constant λ(S. where A is a constant determined by the payoff profile.CHAPTER 4. Making the further assumption that λ is constant we can arrive at the implicit solution for h: σ2 σ2 ln(h) + ln (1 − 2λh)2 + 2r r σ + √ arctan r √ r (1 − 2λh) σ = (r + σ 2 )τ + A.1). then we can seek a solution of the following form V (S. These similarity solutions. however the application of such methods tends to be limited by the fact that many nonlinear PDEs do not have such symmetries.2 A solution by inspection It should be noted that it is possible to find exact analytic solutions to the PDE (4. It should be . i. can be useful in investigating nonlinear problems. if we assume that λ(S. (1 − 2λh)2 which is now an ODE and so open to standard solution techniques.3 Similarity solutions In order to gain more analytical insight into the behaviour of the highly nonlinear PDE (4.e.

The idea behind similarity solutions is to exploit the fact that the equations and the initial (final) and boundary conditions are invariant under a certain scaling. for example the initial behaviour of the American option free-boundary problem and the value of an at-the-money option shortly before exercise.2) ˆ of invariant solutions is also found.3) becomes the much simpler σ 2 uzz − uz (a − r)uz + ru − ˆ 2 1 − λ(uzz − uz ) = 0.1) gives the following (highly nonlinear) ODE (a − r)uz + rku − σ 2 uzz + (1 − 2k)uz − k(1 − k)u ˆ 2 1 − λ uzz + (1 − 2k)uz − k(1 − k)u = 0.3) 2 If k = 1 then equation (4.1) can be found in Bordag (2007). On the other hand. Hence for equation (4.1) where λ(S. The global similarities (of Lie type) to equation (4. that the similarity solution technique is rarely successful in solving a complete boundary value or Cauchy problems. (4. which are difficult to resolve numerically.2) into equation (4. (4. i.e. it can be extremely useful when considering a local analysis in space or in time. a = 0. o with constant liquidity parameter λ. for example S → νS. because it requires special symmetries in the equation and the initial/boundary conditions.CHAPTER 4. it is proved that λ ∼ S k+1 where k ∈ R is the only case with a non-trivial symmetry group and a complete set there exists a global similarity transform of the form V (S. FULL-FEEDBACK MODEL 88 noted.4) 2 .1). In addition the case k = 0 corresponds to the model developed by Frey and his co-workers (see section 7. Substitution of (4. τ ) = S 1−k u(z) where z = log S + aτ. τ → ν 2 τ for any real number ν. under the assumption that λ = λ(S). In that paper. however. Note that k = −1 corresponds to the model of Sch¨nbucher and Wilmott (2000). Such a scaling is called a one-parameter group of transformations. Under this transformations an equation is invariant and so S √ τ is the only combination of S and τ that is independent of ν and S √ τ hence the solution must be a function of only. τ ) = λS k+1 . (4.

This leads to the ODE uzz + uz = 0 which has the most general solution u(z) = A − Be−z where A and B are constants to be determined by the boundary and payoff conditions. which appears to have no analytic solution and so we are forced to turn to numerical techniques. for the k = 1 case see Bordag (2007) and for k = 0 see Bordag and Chmakova (2007) and Bordag and Frey (2007). all the solutions found in this way correspond to differentiable payoff profiles.CHAPTER 4. However.5) by setting a = r. (4. For the present model being studied. equation (4. k = −1. In addition Bordag and her co-workers showed families of explicit solutions to equations (4. τ ) = AS − Be−rτ which is indeed a valid solution of equation (4.e.5) under the assumption of zero interest rates (r = 0). We can start to see already that singular behaviour is inherent in this .5) Under the assumption of non-zero interest rates we can quite easily obtain a solution to (4. After transforming back to the financial variables this gives V (S.3) reduces to (a − r)uz − ru − σ 2 uzz + 3uz + 2u ˆ 2 1 − λ uzz + 3uz + 2u 2 = 0. however it does not satisfy any practical boundary and payoff conditions. these global solutions may be useful to test the accuracy of numerical techniques applied to such highly nonlinear systems.4) and (4. FULL-FEEDBACK MODEL 89 and when k = 0 (corresponding to the Frey model) we have the (even simpler) equation (a − r)uz − σ 2 uzz + uz ˆ 2 1 − λ(uzz + uz ) 2 = 0. which differ from the majority of the payoff profiles considered in the present thesis (which are more financially relevant). i. However.1).

Substituting this expansion into (4.6) and collecting together terms of the same order in λ gives3 O(λ0 ) : O(λ1 ) : O(λ2 ) : 1 V0τ − σ 2 S 2 V0SS − rSV0S + rV0 = 0. (4. . τ ) as follows V (S.e. If we solve this using the quadratic formula we obtain uzz = σ  1 −φ− 1± ˆ ˆ λ 4 λ2 ψ 2  ˆ 8λψ 1− 2 σ 1 2  from which it is clear that difficulties will occur if the square root were to become negative. 2 1 2 2 V1τ − σ S V1SS − rSV1S + rV1 = 2V0SS (V0τ − rSV0S + rV0 ) . τ ) = V0 (S. First we re-write equation (4. 2 1 2 2 V2τ − σ S V2SS − rSV2S + rV2 = 2V0SS (V1τ − rSV1S + rV1 ) 2 2 + 2V1SS − V0SS (V0τ − rSV0S + rV0 ) . This can be done by exploiting the techniques of asymptotic expansions. we are forced to turn to numerical solutions. τ ) + .CHAPTER 4. However it is possible to find an approximate solution for small values of the parameter λ. ˆ λ 2 ψ u2 + zz σ2 ˆ ˆ − 2λψ + 2λ2 φψ uzz + 2 σ2φ ˆ ˆ + ψ − 2λφψ + λ2 φ2 2 =0 where φ = 3uz + 2u and ψ = (r − a)uz − ru. 4.4 Perturbation expansions Since it appears that no analytical solution can be found with the required boundary conditions. where Vn (S. . τ ) + λ2 V2 (S. We shall return to this in section 4. i. τ ) are functions to be found. .6) Note that a similar perturbation analysis is outlined in the appendix of Sch¨nbucher and o Wilmott (2000). FULL-FEEDBACK MODEL 90 highly nonlinear system by rearranging the above equation into a quadratic equation in uzz .1) in the more convenient form 1 (1 − λVSS )2 (Vτ − rSVS + rV ) − σ 2 S 2 VSS = 0. τ ) + λV1 (S. 2 Now we expand V (S. 3 .6.

This recursive process is continued until the desired level of accuracy is required (although in practise solving past the second correction term V2 becomes too analytically cumbersome or numerically expensive). LBS V0 = 0. it can be shown (see appendix A) that if we restrict ourselves to the regime in which |VSS | < 1/λ in the entire solution domain (corresponding to sufficiently smooth payoff profiles) then the solution to equation (4. this is in agreement with the result shown in figure 4. These results indicate that (similar to first-order feedback in the regime |VSS | < 1/λ) the inclusion of market illiquidity increases the put option price. τ ). . However. i.CHAPTER 4. . .4 This cannot be guaranteed a priori and the unbounded second derivative of the payoff profile suggests that we may not be able to apply such a regular expansion in the region around any singular points.1 shows the first-order correction term V1 (S.1. V1 . . Vn−1 ). 4 See for example Johnson (2004). For more on singular perturbations see Johnson (2004). . . Moreover. . specifically we need the derivatives of V (S. . the left-hand-side is merely the Black-Scholes operator LBS acting on the nth approximation and the right hand side is a function of the previous approximations (which have been found).e. LBS V2 = f2 (V0 . τ ) to be bounded.1) is monotonic increasing in the liquidity parameter λ. LBS Vn = fn (V0 . it should be noted that in order to permit a regular asymptotic expansion of the kind outlined above we must assume sufficient regularity in the function V (S. τ ) to the price of a European put option. Figure 4. LBS V1 = f1 (V0 ). V1 ). FULL-FEEDBACK MODEL 91 This reveals some structure in the successive approximations.

subject to the put payoff condition (1.1) with λ constant for simplicity.2 1. FULL-FEEDBACK MODEL rag replacements 92 0. 2004). this is considered below.04. even though they were obtained with a relatively fine grid (time-step δτ of 10−3 . The results (for the delta) are clearly erroneous. λ = 0) European put option for various time to expiry.e. The .5 Numerical solutions Consider next a numerical treatment of (4. σ = 0. . This sort of difficulty is understandably sidestepped in published works (for specific details see chapter 7) but a study of its causes will surely be helpful for the next phase of modelling in the field. but of course.2. 0.3 0.1: The leading order correction term V1 (S. in addition. 4.8 S 1 1. Figure 4.05 0 0. grid-size δS of 5 × 10−4 ). which are not unconnected. which even a cursory inspection of (4. The first is linked to the inevitable infinite behaviour of the gamma with standard payoff conditions.2). r = 0.1.2.1 τ increasing 0.6 0.15 0. τ ) 0. Note that this erroneous behaviour is not simply due to the well documented ‘ringing’ behaviour associated with the Crank-Nicolson finite-difference scheme (see Duffy.2 shows results obtained using a similar Crank-Nicolson scheme to that successfully employed on the first-order feedback model. τ ) to the Black-Scholes (i. In fact there are two problematic issues with regard to these difficulties. .1) suggests will be problematic.4 Figure 4.2 0. incorporating iteration in order to treat properly the inherent nonlinearity in the problem. K = 1. T = 1 and τ = 0. 1. . . the output was found to be highly dependent on the choice of grid.25 V1 (S.CHAPTER 4.

λ = 0. H(·) denotes the Heaviside function.CHAPTER 4. .1 τ =1 -0.1)) is the likelihood of difficulties if there is a zero in the denominator of the volatility term. which is associated with smoothed payoff functions.1 and T = 1.04 Figure 4. a thorough asymptotic analysis of the option valuation close to maturity (τ → 0) can yield significant insight into the dynamics of the problem. 4.5 1 ∆= ∂V ∂S 0. will be deferred until chapter 5. Thus.6 Analysis close to expiry As noted earlier.4).5 0 τ = .5 0. we have a different form for the valuation equation in two regions.7) where η is defined in (3.02 1. σ = 0.2: Deltas for full-feedback (European) put. which is necessary to ‘mimic’ the behaviour of the payoff. A discussion of this issue. close to expiry. one in S > K (above the strike) and the other in S < K (below the strike). clearly we are allowing for a discontinuous delta close to expiry at the .98 S 1 1. although the option value is assumed to be continuous. K = 1. τ ) = −τ 2 ηH(−η) + τ φ(η) + .2. 1. 1 (4. Consequently. . FULL-FEEDBACK MODEL 93 second difficulty (again revealed by a cursory inspection of (4. and consequently this limit is studied next.96 0.5 PSfrag replacements -1 -1.04. r = 0. For this we seek a local solution for the put value of the form (which can be justified a posteriori ) V (S.

In addition. 2 (4.e. Indeed.8) and (4. In the region S < K (i. 2 2 (1 − λφηη )2 σ 2 K 2 φηη η + rK = 0.9) in these limits. φ − φη − 2 2 (1 − λφηη )2 (4. we sought solutions with continuous deltas. These results indicate that the option values all lie below the payoff5 (the repercussions of this will be discussed below). it enables us (with a little work) to deduce Since from (4. and it is our assertion that such solutions do not exist for this problem. .8) 1 with φ → 0 as η → ∞. Sample results for a put option are shown in figure 4.CHAPTER 4.9) with φ → −rK as η → −∞. τ ) − (K − S)+ ≡ τ φ(η). It is helpful to shift φ as follows: φ = φ∗ − which leads to the equation σ 2 K 2 φ∗ η ηη φ∗ − φ∗ − 2 η 2 1 − λφ∗ ηη φ∗ → 5 rK . φη continuous) is appropriate.4) it is evident that V (S.e. η > 0) the following equation describes φ: η σ 2 K 2 φηη φ − φη − = 0. which is rather broader than the scale appropriate for the first-order feedback options (where S − K = O(τ )). η < 0) the appropriate equation is (4.3 (obtained via a straightforward Runge-Kutta fourth-order shooting method). without success. Note also the slower decay to the |η| → ∞ asymptotes as the volatility increases due to the O(σ 2 K 2 ) scaling that emerges from (4. FULL-FEEDBACK MODEL 94 exercise price.7) and (3. It should be noted that the above indicates that the crucial regime is within a distance O(τ 2 ) of the exercise price as τ → 0 (a result determined through asymptotic analysis). 2 2 + rK [2H(−η) − 1] = 0. smooth pasting (φ. similar to the λ = 0 liquid options (as discussed in the previous section). At η = 0. In the region S > K (i.10) which has the useful property of antisymmetry of φ∗ with respect to η = 0 (and so sgn(η) rK 2 as |η| → ∞).

11) i. The standard Black-Scholes putcall parity is given by V P = V C − S + Ke−r(T −t) . Substitution thus gives.7). Note that the scaling for a call was obtained by replacing η by −η in the put scaling.1).11). V C = ητ 2 H(η) + τ φC (−η) + o(τ ). after a little rearranging ητ 2 [1 − H(−η) − H(η)] + τ φP (η) − φC (−η) = −rτ K.2. (4. . and it is the neglect of this that is undoubtedly responsible for the apparent spurious results observed in figure 4. which reduces to φC (−η) = φP (η) + rK.e. namely (4. Note that this symmetry of the local solutions is simply a manifestation of the put-call parity relationship which still holds for all time. FULL-FEEDBACK MODEL 95 the results for calls from the results for puts. namely φC (η) = φP (−η) + rK.. confirming put-call parity for the nonlinear case. we can recover the local solution for calls from that of puts. The key observation in the above is the discontinuity in the delta (∆ = ∂V ) ∂S 1 1 1 1 at η = 0 as indicated in (4.CHAPTER 4. which corresponds to the symmetry obtained for the inner equations. V P = −ητ 2 H(−η) + τ φP (η) + o(τ ). e−rτ = 1 − rτ + o(τ ). Another point to be noted is that figure 4. provided that early exercise is not permitted. a somewhat undesirable property (although (4.11) indicates this is not the case with calls). For the nonlinear problem.3 indicates the possibility of negative put options values. even in this highly nonlinear case (see section 4. the chosen scaling for the inner region is given by S = K + ητ 2 .

at times away from expiry).CHAPTER 4.005 -0.8) and (4.035 -0. 0. 2λ2 ψφ2 − 4λψ + σ 2 K 2 φηη + 2ψ = 0.015 φ -0.8) and (4. For values of σ just below 0. this is the form that was taken as the basis of the numerical treatment used to treat the results shown in figure 4. where we have taken the negative root in order to satisfy the condition that φηη → 0 as |η| → ∞. it turns out that yet another anomaly occurs. with the onset of negative roots in the computation.15. σ2K 2 .02 σ decreasing -0.6 -0. ηη where ψ = φ − η φη + rKH(−η).3: Local (τ → 0) solution of a full-feedback put.03 PSfrag replacements -0.95. . 0 -0.2 η 0 0.e. To understand this.15 (taking the other parameters used in figure 4. 0.4 0.1. Indeed.04 -0.04 and σ = 1.9) failed.2). λ = 0. we rewrite (4.025 -0. this time in the limit as σ decreases (with other parameters held fixed). . K = 1. Using the quadratic formula we can write the 2 ‘solution’ for φηη as φηη 8λψ 1 σ2K 2 1− 1+ 2 2 = + 2 λ 4λ ψ σ K 1 2 . the numerical treatment applied to (4.4 -0.2 0. r = 0. FULL-FEEDBACK MODEL 96 Before a consideration of the problem for calculations for non-small values of τ (i.6 Figure 4.3..9) in the form of a quadratic in φηη .01 -0. . and inspection of the results indicated that difficulties arose if 1+ 8λψ < 0.

3.CHAPTER 4. an alternative strategy was adopted. the difference between the option value and payoff. a standard Crank-Nicolson-type scheme was adopted. such that V − = V + and V1+ = V1− − 1. These results also help to justify of the original form of the solution. for sufficiently large λ. as evidenced by 4. and as such can be compared directly with the small-time-to-maturity solutions displayed in figure 4.10). which concerns itself with the full problem. figure 4. The grid was then chosen in such a manner that the strike price K coincided with the S grid. In the time-wise direction. which adds significant credence to the integrity of the results.7.2. Calculations performed in this manner provided accurate and highly reliable results. showing distributions of V (S. τ ) − max(K − S. This latter condition effectively builds the proposed jump in the delta at the strike price into the numerical scheme. 6 Since no inner solution with a continuous delta could be found. 0). i. This modified procedure involved writing (4. τ ) = ∂V /∂S. ∂S The computations shown are highly robust (i. which led to the aforementioned difficulties. At S = K two values of the option price and its delta were computed. clearly indicating the jump in its value at S = K.7 Numerical results . .e. In order to incorporate this into our numerics.1) as a system of two first-order equations namely in V (S.1. i.7). The analysis in the previous section points to6 a discontinuity in the delta (∆) at the strike price (S = K) of +1 in the case of a put option. based on the Keller (1978) scheme.e. (4. FULL-FEEDBACK MODEL 97 Hence. in particular to the correctness of the jump condition. 4.4.e. as evidenced in figure 4. τ ) and V1 (S. or sufficiently small σ (since ψ must be an odd function about η = 0.full problem We now revisit the choice of parameters employed in figure 4. namely V − and V1− (for S − = K) and V + and V1+ (for S + = K). Furthermore.5 shows the corresponding distributions of the delta ( ∂V ). we may expect this regime to arise for large values of the ratio λ/σ 2 K 2 . We shall return to a consideration of this regime later in section 4. grid independent).

CHAPTER 4.e.6 shows results (option value . we have freedom in our hedging strategy. i. provided it perfectly replicates the option payoff. however. but are also always above the payoff and. It makes little financial sense to allow negative option values in any model incorporating market frictions. . FULL-FEEDBACK MODEL 98 There is. hence. the solution to the American put will trivially correspond to the payoff for all time.payoff) for the corresponding call. τ ) ∂S = 0 should be applied. τ ) = 0 and ∂V (Sb (τ ). in transaction cost models the writer would not re-hedge the portfolio (and hence incur extra transaction costs) at times when he does not need to. In doing this. this could also be regarded as a somewhat undesirable and unrealistic feature of the model. Whilst in certain extreme option valuations. by a simple backward induction argument. A corollary to the above remarks is that it can also be seen (from figure 4. because if the European option value is always below the payoff immediately prior to expiry then. The same is true for liquidity. Essentially the hedging strategy should never force the hedger into an irrational position. This could be avoided in practise by imposing the condition V ≥ 0 which effectively creates another free boundary on the PDE at Sb where the conditions V (Sb (τ ). this may be acceptable.4) that the model permits negative values for put options. indicates that there is no value in early exercise. provided the option is still perfectly hedged. generally this may be regarded as an unwanted facet of the model. such as those involving storage costs. Note that Bakstein and Howison (2003) make a similar observation and call this condition the ‘American’ constraint. the corresponding American option will always be exercised immediately when the contract is initiated at t = 0 (or τ = T ). the price being modelled is the cost of replicating the option by trading in the underlying.4. a further issue relating to the results observed in figure 4. For example. namely that this indicates the put option value (close to expiry) is always less then the option payoff. This clearly reveals that call values not only remain positive. Figure 4. This has implications for the pricing of American options in this framework. at least under the dynamic hedging (replication) pricing paradigm.

4.6 -0.02 1. K = 1.96 0.005 -0.2 and λ = 0.01 V -payoff PSfrag replacements -0. It was therefore decided to mount an homotopy type of approach in this regime. since here even the τ < 0.4: Full feedback put. 1 regime is unclear.1.02 -0. modified numerical scheme.025 -0.04 0 0. r = 0. modified numerical scheme. 0.CHAPTER 4. K = 1.6.04.5: Full feedback put.04.5 S 1 1.015 -0.03 -0.5 2 Figure 4. r = 0.7.1 A second solution regime 8λψ σ2 K 2 Returning now to the other regime outlined in section 4. specifically by considering a payoff function of the form V (S.035 τ =1 -0.98 S 1 1.04 Figure 4.4 -0. 0) = 1 K−S+ 2 (K − S)2 + ρ2 (4. when 1 + which turns out to be even more problematic. i.12) . σ = 0.2 ∆ PSfrag replacements -0.1 0 -0.2 and λ = 0.1. FULL-FEEDBACK MODEL 99 0 τ = .e.8 -1 0.1 -0.2 τ =1 τ = . σ = 0.

04. These results were based on the method employed for figure 4. (4.2 and λ = 0. r = 0. In Frey and Stremme (1997) and Frey (1998) this smoothed payoff profile was used to represent an ‘idealised’ option payoff. but instead with σ = 0. .005 τ = . it is possible to mimic a standard put payoff as the smoothing parameter ρ → 0. Here its use is slightly different.01 0.2.1 0 0.1 and at a time shortly before expiry (τ = 0.1).1) and for three choices of ρ are shown in figure 4. Results corresponding to the parameter choice of figure 4. K = 1.5 0 S 1 1. In this way. τ ) =   0 for S > K.035 0.6: Full feedback call.04 τ =1 0.1. it is merely a mathematical tool to investigate the limit of smoothness. FULL-FEEDBACK MODEL 100 0. These calculations strongly indicate that in the limit as ρ → 0. the solution for the put takes the trivial form: V (S. which represented a well-diversified portfolio containing a multitude of different payoffs with different strikes which combine to produce a sufficiently smooth payoff to satisfy the smoothness assumptions imposed for existence and uniqueness.CHAPTER 4.4. in conjunction with the full problem (4. modified numerical scheme.015 0.03 V -payoff PSfrag replacements 0.13)  Ke−rτ − S for S < K.7. but were tested extensively for numerical grid convergence and found to be numerically consistent on the scale shown.5 2 Figure 4.025 0. σ = 0.02 0.

σ = 0. λ = 0. (4.0001 -0. thereby failing to smooth out any discontinuities in the derivative of the payoff profile. K = 1.0003 ρ = .98 ρ = .0002 -0.04 Figure 4.1 and τ = 0. is to suppress the diffusion term of the equation in regions of non-smoothness. . Such a breakdown can be seen to be a direct result of the singular nature of the diffusion coefficient in the the governing equation. Duck et al. FULL-FEEDBACK MODEL 101 0. for the same reasons expounded earlier for the other regime.0004 0.CHAPTER 4. r = 0. smoothed payoff. One interpretation of the above results is that the effect of the nonlinearity.0005 0. for all time. Note that this form of solution indicates discontinuous option values (compare the small volatility analysis of Widdicks et al.1).1). 2008). Note also that (4.0003 -0..1.00025 S 1 1.0002 V -payoff 1e-04 ρ = .7: Full feedback put. for standard (non-smooth) payoff profiles.0004 0.01.96 0. which occurs for smoothed payoff profiles.001 0 PSfrag replacements -0.02 1. Here the diffusion term effectively eliminates itself completely and the discontinuity at S = K and τ = 0 cannot propagate away from this point for τ > 0 since there is no diffusion. as would normally be the case with the Black-Scholes equation. The following chapter investigates another breakdown of the nonlinear PDE.04.13) indicates that American options in this regime will always be exercised immediately (at t = 0). 2005. solutions which do (trivially) satisfy (4..

it can be seen that there is the potential for further difficulties to arise due to the vanishing of the denominator in (4.1) Firstly. 102 . infinite gamma) of the payoff profile.1).Another Breakdown The difficulties encountered in the previous chapter have been. note that for sufficiently smooth payoff profiles. i.e. note that for standard put and call payoff profiles. 0) to VSS → 0 as τ → ∞. This function is smooth.1) may never be satisfied in the solution domain. since the solution must pass from VSS = ∞ at (K. To illustrate the circumstances under which we should expect such singular behaviour.Chapter 5 Smoothed Payoffs . 0) = 1 K−S+ 2 (K − S)2 + ρ2 (5. condition (5. T ]. condition (5. If we instead assume smoothness in the payoff (i. One can consider this as parameterising 1 Note that for simplicity here λ is a constant but can be generalised in what follows.1) must always be satisfied somewhere in the domain D ⊆ R+ × [0. when1 VSS = 1 .e.e. we will once again consider the smoothed payoff profile V (S.2) where ρ ≥ 0. Secondly. so far. but in the limit as ρ → 0 recovers the discontinuous payoff profile of a put option. attributed to the discontinuous delta (i. finite gamma). λ (5.

τ )∈D For the analysis in the remainder of this chapter λ(S. i. 0) = 7 2 2 + ρ2 2 (K − S) 2 (K − + 2 3ρ (K − S) (5. (S. If we wish to prevent the denominator from vanishing then this can be seen as placing a restriction on the size of the liquidity function λ(S. τ ) ≤ sup 1 VSS . 0) = − VSS (S.τ )∈D (S.3a) (5. .3b) (5.3c) (K − S)2 + ρ2 ρ2 3 2 5 . that the maximum of the second S-derivative of the solution in the entire domain will coincide with the maximum at τ = 0. with the limit ρ → 0 representing highly non-smooth functions (in the sense of very large second derivatives in the region of the strike) and conversely the limit ρ → ∞ representing increasingly smooth functions (small second derivatives). via a judicious application of the maximum principle. (S. in other words. In fact it is intuitively clear from the diffusive nature of equation (4. λ(S. τ ) (S. we must have λ(S.e.2) direct computation gives VS (S. Returning to the smoothed payoff profile (5. sup {VSS } ≤ 1 .1) for increasing τ that this should be so. τ ) will be considered constant for simplicity.e. sup {VSS } = sup {VSS } . With this in mind the crucial property in determining the existence of singular behaviour will be the maximum of the second derivative of the solution at τ = 0.τ )∈D or alternatively as placing a restriction on the payoff profile. i. 0) = VSSS (S.e. Furthermore it can be shown. SMOOTHED PAYOFFS .CHAPTER 5. 2 (K − S)2 + ρ2 2   2 2 2 3ρ  4(K − S) − ρ  . 0) = 1 2 1+ ρ2 S)2 (K − S) . i.τ )∈D0 where D0 = R+ × {0}.ANOTHER BREAKDOWN 103 the smoothness of the payoff profile by ρ. (5.3d) . VSSSS (S. outlined in appendix A. the payoff profile. τ ).

It should also be mentioned that problems associated with the vanishing of the denominator have been highlighted previously in the literature. 0) we can see that VSSSS (K.see section 7.CHAPTER 5. It should be noted at this stage that the results for existence and uniqueness of a replicating portfolio provided by Frey (1998) only apply when the denominator is not allowed to vanish (here we impose no such restriction). SMOOTHED PAYOFFS . then to restrict the denominator from vanishing it is required to set λ = 0 and so this model cannot treat non-smooth payoff profiles. Also a corollary to this result is that if we have a payoff profile with a discontinuous first derivative (delta).3. when we are in the regime that λ > 2ρ.ANOTHER BREAKDOWN 104 The maximum of VSS (S. 0) = D0 1 . . i. 0) = 0. To check that this is indeed a maximum of VSS (S. Condition (5. where is determined to be sufficiently large such that the denominator in the diffusion term is always positive . In what follows we shall assume smooth payoff profiles and investigate the nature of the singularities that arise if this restriction is not imposed. Therefore the maximum of the second derivative of the payoff profile is given by sup {VSS } = VSS (K.e.4) from which it can be seen that the smoother the payoff profile the more liquidity the model can handle. (5. which includes the majority of the payoff profiles used in practise. 0) is determined by setting VSSS (S. 2ρ and we can exclude the denominator from vanishing if we place the restriction that λ ≤ 2ρ. which yields (obviously) that the maximum occurs at S = K. but that this regime has deliberately been avoided. 0) = −3 ≤0 2ρ3 since ρ ≥ 0 by definition.4) may seem rather restrictive and indeed it is when considering standard put and call payoff profiles. For example Sircar and Papanicolaou (1998) set the option value to be the Black-Scholes price a small time prior to expiry.

To solve the full equation (4. Along the same lines Frey and Patie (2002) modify the diffusion term of the equation in an ad hoc manner. Doing so yields S0 = K ± λρ2 2 2 3 − ρ2 . see section 7.1) to a simpler ODE valid locally in the region close to the singularity.ANOTHER BREAKDOWN 105 In addition Lipton (2001) states that to avoid any undesirable behaviour of the the option prices we have to limit the magnitude of the local volatility from above and from below. For the smooth payoff profile (5. Note that the solutions at τ = 0 are not themselves singular. λVSS } for sufficiently large δ0 and sufficiently small δ1 . This is done in order to bypass any problems associated with the limits σ → 0 or σ → ∞.1) when the singularity condition (5. ˆ σS 1 − min {δ1 . more specifically they set σ (S.CHAPTER 5. Hence for the payoff (5.2) we can calculate the explicit locations of any singularities (denoted S0 ) at τ = 0 by equating the second derivative (5.3b) to 1/λ. τ ) = max δ0 . hence ensuring the denominator is nonzero and that the denominator does not become too large to ‘annihilate’ the diffusion term.5. this has the effect of fundamentally changing the option price dynamics close to expiry. although he gives no suggestions about how to do this. Finally Liu and Yong (2005) suggest a form of the liquidity function λ(S. τ ) that is hoped to suppress such singular behaviour. Instead a local similarity solution is to be attempted which reduces the PDE (4.2) there are two singularities. This analysis is outlined in the next section.1) is satisfied. due to the inherent singular behaviour.1) near these singular points will be particularly difficult. SMOOTHED PAYOFFS . We can expect singular behaviour of (4. each equally spaced either side of the strike K. but what remains is to determine if and how singularities propagate through the solution for τ > 0. . both analytically and numerically. Here we make no such modifications and attempt to fully investigate the nature of these singularities.

e. .CHAPTER 5.e. i. the solution in the vicinity of the singular point S0 must be analytic (at least for τ = 0) and so can be expressed in the form of a Taylor series about S = S0 . at the strike price.7) into (4. ρ = 0) then the two singularities will coincide. τ ) = V0 + τ α ηV1 + τ 2α η2 ˆ + τ β V (η) + . and so can not be thought of as isolated anymore and the following analysis will not be appropriate. 0)+ VSSS (S0 . Direct substitution of (5. V (S.1). 0).1 Local analysis about the singularities We consider a general form of payoff profile. SMOOTHED PAYOFFS . 2λ (5. where VSS = 1/λ. 0) = V (S0 . 0) + τ β V (η). which we have determined to have an isolated singularity in the payoff profile at S = S0 . to remain close to the singular point at τ = 0 we also require that VSS (S0 . 0)+ (S − S0 )3 (S − S0 )2 VSS (S0 . τα (5.e. τ ) = V (S.2 A local expansion for small τ is sought about the point where the equation becomes singular. 2 6 (5. section 3.7) where V0 = V (S0 . Since we are assuming a smooth payoff profile.8) +r V0 + τ α ηV1 + 2 τ η ˆ + τ βV 2λ 2α 2 Note that for the case of the put or call payoff profile (i. 0) and V1 = VS (S0 . .5) In addition.1) gives τ β−1 ˆ ˆ β V − αη Vη − 2 ˆ σ 2 S0 λ−1 + τ β−2α Vηη ˆ2 2λ2 τ 2β−4α Vηη − rS0 V1 + τ αη ˆ + τ β−α Vηη λ = 0. 0) = 1 . Combining the Taylor series about S0 (5. both of which are assumed to be known. . .6) where α and β are to be determined from the appropriate balancing of terms and asymptotic matching (cf. with η= S − S0 .5) and the small τ expansion (5.ANOTHER BREAKDOWN 106 5. i. . . isolated in the sense that there are no other singularities in the vicinity of S0 . 0)+. . (5. given the form of the payoff profile. 0)+(S−S0 )VS (S0 .6) we therefore seek a similarity solution in the vicinity of the singularity of the form V (S. λ Next we seek a similarity solution for small τ of the form ˆ V (S.

5 3 β= . 3 V − η Vη − ˆ2 2λ3 Vηη (5. .1) and evaluating in the limit τ → 0 yields 2 5σ 2 S0 ˆ ˆ = 0. . (5. . . 0). . .10) Note that the above matching procedure has also provided us with the appropriate boundary conditions (for large η) of the inner solution.5). 2λ which after substitution into (4. SMOOTHED PAYOFFS .8) it is clear that we require β − 1 = 4α − 2β ⇒ 3β − 4α = 1. (5. (5. To be consistent. as τ → 0) must match with the Taylor series expansion of the solution at τ = 0. the matching of the inner and outer solution is used.e. . Hence lim V0 + τ α ηV1 + τ 2α η2 ˆ + τ β V (η) + . 5 as |η| → ∞.e. the form of the solution in the vicinity of the singularity (5. i. .10) into (5. 2λ ∂iV (S0 . . .11) hence the appropriate form of the solution to try around the singularity is given by V (S. τ V (η) = 6 |η|→∞ ⇒ lim |η|→∞ ˆ ˆ For a non-trivial inner solution V (η) we require that V = O(1) as τ → 0. that η 3 V3 ˆ V (η) → 6 Substituting (5.12) . . 2λ 6 where we have defined Vi = Since the first three terms on both sides are identical (by construction) this reduces to lim ˆ τ β V (η) + .7) in the limit as |η| → ∞ (i. .9) we find that 1 α= . i.9) To fix the values of α and β. this forces us to set β = 3α. . = (S − S0 )3 V3 + .CHAPTER 5. . ∂S i |η|→∞ = V0 +(S−S0 )V1 + (S − S0 )2 (S − S0 )3 + V3 +.ANOTHER BREAKDOWN 107 To balance the diffusion term and the time derivative term in (5. (5. 6 τ 3α η 3 βˆ V3 + . . τ ) = V0 + τ 5 ηV1 + τ 5 1 2 η2 3 ˆ + τ 5 V (η) + .e.

rather it is only the leading order term in the asymptotic matching procedure. Substitution into (5..CHAPTER 5. 5.12). We can see that (5.11). We can determine the next order correction by seeking a solution to the inner equation (5.ANOTHER BREAKDOWN 108 Before attempting to solve (5. SMOOTHED PAYOFFS .11) that were derived from an asymptotic matching procedure. which leads to the equation 5A − 2 5σ 2 S0 2λ3 V32 1 = 0(η −5 ).12) gives (3 − γ)Aη γ − 2 5σ 2 S0 2λ3 ηV3 + γ(γ − 1)Aη γ−2 2 = 0. 2 η therefore we have that the constant A must be given by A= 2 σ 2 S0 .11) is not a solution of the inner equation (5.12) of the algebraic form 3 ˆ (η) = η V3 + Aη γ . we first look a little closer at the matching procedure performed above and the relevant boundary conditions that arise. V3 = 0. Note that the second term is a higher order correction as |η| → ∞ iff γ < 3. Since we are interested in the solution as |η| → ∞ we can approximate the denominator as follows (3 − γ)Aη γ − ⇒ (3 − γ)Aη γ − 2 5σ 2 S0 2λ3 η 2 V32 2 5σ 2 S0 2 2λ3 η 2 V32 1− 1+ γ(γ−1)A γ−3 η V3 = 0. which must contain higher order matching terms. V 6 (5. 2λ3 V32 It is clear that we have an infinite asymptotic series solution as |η| → ∞ with each subsequent term corresponding to a higher-order term in the Taylor series expansion . Hence in the limit |η| → ∞ we must have γ = −2.12) given the appropriate boundary conditions (5..1 Asymptotic matching Let us look again more closely at the boundary conditions (5. 2γ(γ − 1)A γ−3 η +.1.13) where A and γ are constants to be found.

12) we can attempt to solve this nonlinear system.14) back to the outer variables. which is the focus of the next section. Now that we have the corrected boundary conditions (5. which shows that V3 can be either positive or negative depending on which of the two singularities we are seeking a local expansion near.14) The significance of the extra term can be seen if we transform the large η behaviour (5.7) in terms of the outer variable is given by V (S.CHAPTER 5.ANOTHER BREAKDOWN 109 of the outer solution. Doing so we have that 7 σ2S 2τ 5 V3 (S − S0 )3 ˆ + O τ 5 (S − S0 )−7 . τ ) =V0 + (S − S0 )V1 + + V3 1 (S − S0 )2 + (S − S0 )3 2λ 6 2 τ σ 2 S0 + O τ 2 (S − S0 )−7 .14) to the inner equation (5. . 2λ3 V32 (S − S0 )2 (5. One final point to note is that the sign of V3 may affect the qualitative behaviour of the solution. V3 is identified as the third derivative of the payoff profile evaluated at the location of the singularity. suggesting strongly that the scaling used is the correct scaling for this problem.11) is modified to 3 2 2 ˆ (η) = η V3 + σ S0 + O(η −7 ) as |η| → ∞. these further terms can be determined by performing the same procedure adopted above. SMOOTHED PAYOFFS . It appears that the inner solution is a power series in η starting from η 3 and decreasing by powers of five. + 3 2 0 V (η) = 3 2 2λ V3 (S − S0 ) 6τ 5 2 and the form of the similarity solution (5. V 6 2λ3 V32 η 2 (5. the matching condition (5. To summarise.15) This shows that the matching procedure results in integer powers of τ . Returning to the smoothed payoff for a moment we can see with a little work that V3 = 3ρ2 2 2 λρ2 5 3 λρ2 2 2 3 − ρ2 .

i. leads to χ = 4/3 and to the exact solution ˆ V (η) = 243κ 80 1 3 1 η = 4 3 3 2 5 3 (σS0 ) 3 4 η3.17) However this clearly does not satisfy the matching condition (5. 2λ3 (5. which would remove the constant from the equation and also from the leading term of the boundary condition. Unfortunately. such as shooting or finite difference methods.12) as ˆ2 ˆ ˆ Vηη 3V − η Vη = κ where κ = 2 5σ 2 S0 . The remainder of this chapter .CHAPTER 5. λ 2 (5.1.16) with the boundary conditions above proved fruitless.16) The first point to note is that κ can be scaled out of the problem 1 ˆ ˆ by setting V = κ 3 V .2 Properties of the inner solution For simplicity we shall rewrite the inner equation (5.16) exists.14). numerical solutions of (5.16) subject to the boundary conditions (5.14) may not exist. Therefore in order to obtain a solution with the required boundary conditions we must turn to numerical techniques. however this scaling would then place the constant κ into the boundary conditions (5. shooting methods floundered and finite-difference schemes failed to converge. SMOOTHED PAYOFFS .14). however it would not be removed completely from the boundary condition and consequently we shall not make any such scalings. η = κ 5 η.ANOTHER BREAKDOWN 110 5. η 3 leadingorder behaviour as |η| → ∞. The previous statement suggests that a solution to equation (5. Trying a solution of the form ˆ V (η) = Bη χ where B and χ are constants. It is also noted that an exact solution of the ODE (5.e. If we are a little more sophisticated we could perform the transformation 3 ˆ ˆ V = κ5 V .

in fact. du f (u.18) gives the following dv g(u. Any general second order (autonomous) ODE of the form uxx = g(u.18a) (5. hence More generally we can have   ux = v.3 Introduction to phase-plane analysis A useful tool for the study of differential equations.ANOTHER BREAKDOWN 111 attempts to prove that this is. v) = . 5. vx = g(u. Eliminating the x variable in (5. For a more detailed introduction see for example Jordan and Smith (1999) or Hirsch and Smale (1974) and the references therein.  v = g(u. v). SMOOTHED PAYOFFS . Below we shall attempt to provide a brief overview of the main properties of such phase portraits.16). x ux = f (u. An investigation of the phase portrait of equation (5. v).16) using phase-plane analysis can provide us with such a proof and also give us invaluable insight into the qualitative behaviour of the solutions to (5. especially if they are in two dimensions. the case. is the so-called phase portrait. (5. ux) can be expressed as two coupled first order ODEs by defining the new variable v := ux .18b) The emphasis of phase portraits is on the general qualitative properties of differential equations and their solutions rather than finding a closed form solution. v) .CHAPTER 5. This indeed becomes extremely useful when such systems have no such closed form solutions. This analysis will be outlined in the following subsection.1. v).

e. v) = 0 alone would cause problems. v) = . The only problem that can arise is if we ever have f (u.ANOTHER BREAKDOWN 112 where the variables u and v provide the axes for the phase portrait. then it remains at that point for all x since here ux = uxx = 0. v) = g(u. v) which would give zero gradient in the (v. the determinant of the coefficient matrix . v) = g(u. if they do then this would contradict uniqueness. v) = 0. u) plane. v c d v x or more concisely ux = A. since at these points the equation becomes singular and nothing can be said about the direction of the field at these points. SMOOTHED PAYOFFS . In addition. dv g(u. (5. so called because if a solution starts at (or reaches) a fixed point. If we assume a linear system of the form ux = au + bv. One might assume that a zero in the denominator.u. which includes the fixed points. v) or g(u. v) are singular. i.19) and. It can be shown that the nature (and stability) of the fixed point is determined by the solution of the linear system (5. f (u. phase paths cannot normally intersect. vx = cu + dv. The points where f (u. as it transpires.CHAPTER 5. In fact the only place where phase paths can intersect is when either f (u. v) = 0 are identified as fixed points (also called equilibrium or stationary points) of the system. v) plane. which corresponds to a vertical slope in the (u. which can be better represented in matrix form as      u a b u   =  . however in this case we could simply shift the axis and consider du f (u. This derivative represents the field direction in the phase portrait.19) then the only possible fixed point of such systems are at u = v = 0.

2 + iβ1. Furthermore if α < 0 then we have a stable spiral (sink) and if α > 0 at unstable spiral (source).CHAPTER 5.2 = 0 then the solutions become periodic but the trajectories are closed. SMOOTHED PAYOFFS . For a nonlinear system. which are entirely determined by the values of α1. In this case we have a spiral fixed point. so-called because.2 = 0. However it can be shown3 that provided the system is structurally stable. spirals and saddle points. Furthermore if α1.2 . i. since there can be multiple fixed points which may interact.19) with the eigenvalues of A given by ω1. α1 = α2 = α and β1 = −β2 = β.ANOTHER BREAKDOWN 113 A. the structure of the phase portrait is not obvious. in this case the fixed point is called a centre. Nodes If β1. the eigenvalues are real and if both α1. As an example. In addition if β1. namely nodes. i.2 .2 = 0 we have a complex conjugate pair of eigenvalues.2 > 0 then we have a unstable node (source) since the solution will move away from the fixed point as x → ∞.2 have the same sign then we have a nodal fixed point.2 < 0 we have an stable node (sink) since in the limit x → ∞ the solution will tend to the fixed point and if α1. then matters are nearly as simple as in the linear case outlined above. A saddle point is stable along one direction (corresponding to the eigenvector of the negative eigenvalue) and unstable along another (corresponding to the positive eigenvalue) Spirals If β1.2 = 0 but α1. Three qualitatively different classes of fixed points can be identified. real eigenvalues and α1 and α2 have opposite sign then such a situation corresponds to a saddle point. due to the periodic functions (sin and cos) in the solution.e.2 and β1.e. .e. if we have a linear homogeneous system of the form (5. the solutions will spiral into or out of these fixed points. then the general solution is given by   u(x) = u0 eα1 x (cos β1 x + i sin β1 x). 0 2 2 See for example Peixoto (1997).2 = α1. Saddle Points If again β1.2 = 0. 3  v(x) = v eα2 x (cos β x + i sin β x). i. however. When considering a nonlinear system.

. a centre). the combination of which entirely determines the qualitative behaviour of the ODE and its solutions. which will be outlined in the following subsection. 5.20) Immediately we can see that the choice of the positive sign corresponds to a mapping from x ∈ (−∞. spirals and saddles) and in this case linear stability implies non-linear stability (provided none of the eigenvalues have zero real parts.1. ∞) to η ∈ (0.g. Fortunately.CHAPTER 5. Moreover each singularity (fixed point) is of the same elementary type as for linear systems (e. ∞) and the negative sign corresponds to the negative semi-infinite plane in η.16). Substituting (5.20) into (5. however. Hence we are effectively making two separate transformations on two different Riemann surfaces. however.16) does not exhibit such nonlinear behaviour and so this will not be discussed further. For nonlinear systems.16) can be made autonomous. Consider the nonlinear system (5.e. Furthermore. the solution could undergo bifurcations at critical values of the parameter. where the nonlinear system is dependent on some parameter. the nonlinear system (5. SMOOTHED PAYOFFS . Firstly we make the variable transformation η = ±ex . i. (5.16) yields (for both transformations) (Vxx − Vx )2 (3V − Vx ) = κe4x . However it turns out that we can produce an autonomous system by making an appropriate transformation. where the number of solutions increases or decrease. These are fixed orbits that attract (or repel) nearby paths and correspond to fixed oscillatory solutions of the ODE.4 Deriving an autonomous system Equation (5.ANOTHER BREAKDOWN 114 multiple singularities can exist (but only a finite number). the observant reader may have noticed that this equation is not of the autonomous type (since the independent variable η appear explicitly in the equation) and so will not have a two dimensional phase portrait. nodes. there is the additional possibility of so-called limit cycles in the phase portrait.

e. This can be rearranged to make uxx the argument. this second order ODE can be expressed as a system of coupled first order equations. These points correspond to the singular points of (5. from which it is clear that the equation will become autonomous if we set µ = 4 .e. i. the behaviour of this nonlinear system is entirely determined by the location and behaviour of its fixed points. (5. where the field direction cannot be determined.22)  . Setting v = ux we arrive at the coupled system    v u   =  4 −9u − 5v ± v 3 x κ 5 u−v 3  from which we can eliminate the independent variable x to produce the equation for the field lines of the phase portrait. where x = ln η and u = e− 3 V . 3 resulting in 4 5 u + ux + uxx 9 3 4x 2 5 u − ux 3 = κ. gives (after substitution) µ(µ − 1)u + (2µ − 1)ux + uxx 2 (3 − µ)u − ux e3µx = κe4x . dv 4u 5 1 =− − ± du 9v 3 v κ . −v (5.CHAPTER 5. The nature and stability of the fixed point can be determined by investigating the linearised system in the vicinity of the fixed point.21) 5 u 3 Consistent with standard phase-plane theory.ANOTHER BREAKDOWN 115 and further making the transformation V = eµx u(x). i. 5 4 uxx = − u − ux ± 9 3 5 u 3 κ . the points where ux = uxx = 0. The next section outlines the linearisation procedure and the classification of the fixed points in more detail. SMOOTHED PAYOFFS .e. However before proceeding we note that a further simplification can be made .22). i. − ux As outlined in the previous section. for further details see for example Peixoto (1997).

−v (5. both of which are complex. ˆ (5. . v) = − u − v + 9 3 1 5 u 3 .5 Behaviour of the fixed points We wish to find and classify the fixed points of the system ux = f (u. v0 ) = 0 and so it can be seen from (5.21). 3 Hence for all intents and purposes we can set κ = 1 in the original system (5. v0 ) = g(u0 .23). u= 243 80 1 3 e± 2iπ 3 . hence the aim of the next section is to find and classify the fixed points of the nonlinear system (5. SMOOTHED PAYOFFS . v )-space will be independent of the u ˆ parameter κ. If we seek a solution of the form u = κα1 u. − 9 5u which only has two solutions. the parameter κ can be scaled out of the equation entirely by another appropriate transformation.24) that the fixed points correspond to v0 = 0 with u0 the solution of the following equation4 u3 = 0 4 243 . ˆ v = κ α2 v . Now that we have our autonomous system in the simplest possible form we can begin to investigate the structure of the phase plane.21). v) = v. 5. Hence the positive root seems the correct choice. 80 Note that if we were to take the negative squareroot of the equation then the fixed point equation becomes 4u 3 − = 0.ANOTHER BREAKDOWN 116 to the system (5. i. if we choose 1 α1 = α 2 = .21) and we recover the correctly scaled solution via the transformation (5. 5 4 vx = g(u.23a) (5.e.1.CHAPTER 5.23b) then it can be shown that the equation in (ˆ. The fixed points are defined by f (u0 . Recall that the phase plane’s structure is entirely determined by the location and nature of its fixed points.24) where we have dropped the hats for simplicity of notation.

v) and g(u. v0 ) + v (u0 . v) = f (u0 + u.ANOTHER BREAKDOWN 117 Obviously this has three roots. v0 + v ) = f (u0 . v0 ) ∂v (u0 . 1 3 (5. and this can be performed by linearising the nonlinear equation around these points. η)-space. v0 ) + u ∂u (u0 . v0 + v ) = g(u0 . v0 ) + v ∂v (u0 . v0 ) + o( ) ¯ . v) = g(u0 + u. v0 ) + o( ). we need to undertake analysis in the local neighbourhood of the fixed point.  +  ∂u ∂g ∂g (u0 . v)-space corresponds to the exact solution of (5.26a) (5. v0 ) ∂f (u0 . ¯ ¯ ¯ ¯ ∂u ∂v Hence the system becomes     ∂f ∂f ¯ u + u ¯ f (u0 . by setting u = u0 + u.14). In addition the other O(1) term also disappears as it is the functions . namely (5. v0 ) + v ∂v (u0 . v0 ) + v (u0 .25b) (5. v) about the fixed points (u0 . In order to determine the nature of these fixed points. v0 ) which gives f (u.12) in (V. v0 ) ∂u x x The first term in the above equation disappears as it is a derivative of a constant (fixed point). (5. v0 ) + o( ) ¯ v0 + v ¯ x          ∂f (u0 .  0  = ∂g ∂g ¯ g(u0 . v0 ) u0 u ¯ u ¯ f (u0 . SMOOTHED PAYOFFS . however recall that this solution does not satisfy the required boundary conditions (5. ¯ v = v0 + v . the real part of the fixed points above in (u.25a) 2iπ 3 e 1 3 . one real and a complex conjugate pair.CHAPTER 5.25c) e− 2iπ 3 Interestingly.17). v0 ) v0 v ¯ v ¯ g(u0 . ¯ ∂u ∂v ∂g ∂g g(u. . v0 ) + o( ). v0 ) + u ¯ ¯ ¯ ∂f ∂f (u0 . They are u01 = u02 = u03 = 243 80 243 80 243 80 1 3 . v0 ) ∂v   +   =    + o( ).26b) where is a small parameter (corresponding to a small perturbation) and performing a Taylor series expansion on the functions f (u. ¯ (5. v0 ) + u (u0 . v0 ) + u ∂u (u0 .

. This leads to the following linear system for (¯. the system becomes      u ¯ u ¯ 0 1  . v0 ) u ¯ ∂v   ∂g (u0 . v0 ) v ¯ ∂u x ∂f (u0 . det  23 2 − 3 − 15 − ω which has two (complex) solutions ω1. 30 (5. the long term behaviour of the linearised system near a fixed point can differ qualitatively from the long term behaviour near a fixed point of the fully nonlinear system. For the nonlinear system (5. which are determined by the solution to the following characteristic equation   0−ω 1  = 0. SMOOTHED PAYOFFS .   = v ¯ v ¯ − 2 − 23 3 15 x The behaviour of this linear system is determined by its eigenvalues. ∂v ∂g 4 5 =− − ∂u 9 6 ∂g 5 1 =− + ∂v 3 2 5 u−v 3 5 u−v 3 3 −2 . v0 ) ∂v   v ¯ . ∂u ∂f = 1. Fortunately however there are only two situations where this can occur. The linearisation performed here does not always work however. Considering first u01 .CHAPTER 5. at this point. In all other cases the local picture of the nonlinear system near a fixed point looks like its linearisation. v ) u ¯   =  ∂u 0 0 ∂g (u0 . v ).2 = √ 1 −23 ± i 71 .24) we have ∂f = 0. 3 −2 We now evaluate these derivatives at each fixed point in turn.28) .ANOTHER BREAKDOWN 118 f and g evaluated at the fixed points which by definition is equal to zero. One is when the fixed point of the linearised system is a centre and the other when the linearised system has zero as an eigenvalue. u ¯    ∂f (u .

SMOOTHED PAYOFFS . .24) the two complex fixed points can be omitted from our analysis. usually called a spiral sink.rice. Dormand and Prince. in the complex domain) to fully determine their behaviour. (cf. 3 ω1 = − (5.e.1 shows the phase portrait of the the autonomous system (5. For more information see http://math.3) we have a stable fixed point. at this point the local linear system corresponds to      0 1 u ¯ u ¯   =   9 −2 −5 v ¯ v ¯ 9 x 2 .29a) (5. Polking. assume that we 5 Copyright John C.14) is that it too must pass through this fixed point. To conclude we have determined that the (real) fixed point is a (stable) spiral sink.edu/∼dfield/. Figure 5.ANOTHER BREAKDOWN 119 Systems with complex eigenvalues correspond to spiral node fixed points and since the real part of the eigenvalue is negative (see section 5. every path (each corresponding to a different boundary condition) passes through this fixed point. negative eigenvalues Next consider the fixed point u02 . The results were obtained using MATLAB and the pplane ODE software package5 which employed the Dormand-Prince modification to the standard Runge-Kutta shooting technique. What this implies for the solution of (5. 15 5 ω2 = − .1.29b) It also turns out that the final fixed point u03 has the same linearised system as above and so the same eigenvalues.24) (with κ scaled out of the problem completely).12) subject to the boundary condition (5. which has two real. Further. However since these fixed points are in the complex domain we are strictly required to perform a full (four-dimensional) complex stability analysis about these fixed points (i. Recall that two negative real eigenvalues correspond to a stable node. and so will be unable to satisfy the boundary conditions as η → ∞ and η → −∞. The important point to note is that in the absence of any other fixed points. However since we are only really interested in real solutions to the nonlinear system (5. 1980).CHAPTER 5.

CHAPTER 5.17)). equation (5. Note the fixed point at u = 243 3 . since the solution at the fixed point is fixed as η → ∞. (5.24). 4 1 5. cf. The following subsection investigates the structure of the phase plane in yet more detail. and in fact takes the form V ∼ η 3 (i.ANOTHER BREAKDOWN rag replacements 120 8 Complex Region 6 4 2 v 0 -2 -4 -6 -8 0 2 4 u 6 8 10 Figure 5. This path (like all paths) must pass through the fixed point and by definition it must remain there for all x as x → ∞. we have no hope of satisfying the boundary condition (5. However.12) exists (and hence no smooth inner solution about the point S0 ) satisfying the boundary condition (5.1: Phase portrait of the autonomous system (5. Solving from η = 0 corresponds to shooting in the current phase plane (Riemann surface) from x = −∞.6 Structure of the phase portrait Firstly it is clear that the equation (5. we must first check that all fixed points of the system have been found and indeed that every path must pass through the fixed point we have previously found.e. 3 .1. corresponding to η → ∞.31).14). The dotted line represents an analytic 80 envelope for the phase portrait close to the singular line v = 5u . Before we can conclude that no smooth solution to the ODE (5. v = 0 and the field direction lines. 0) and ‘jumped’ to the current phase plane. SMOOTHED PAYOFFS .24) only has real solutions for 5u − v > 0. 3 have obtained the solution for η ∈ (−∞.14) as η → ∞.

We first transform variables to give u = A 0 e 3 + A 1 e− and so v = ux = 5A0 5x 10A1 − 10x e3 + e 3 . 3 3u2 yields 5u 1 − . However the extra term in the matching condition (5. which after substituting into (5. SMOOTHED PAYOFFS . correspond to the line v = − 4u on 3 the phase plane. Similarly solutions of the form V ∼ η 3 correspond to the line v = 0 on the phase plane and solutions of the form V ∼ const.ANOTHER BREAKDOWN 5u 3 121 hence the line v = is a limiting point for imaginary solutions and is in fact a singular line. and so there is a chance that shooting methods will work here.. but we can make an approximation for large x that x= 3 ln 5 u A0 . We wish to determine whereabouts on the phase plane this condition corresponds to. The singular line thus corresponds to where we must apply the boundary conditions of the ODE (5.CHAPTER 5.12) and so it should be clear that we have no chance of applying the boundary condition on this singular line.31) and A1 = 1 2 5V3 v= Hence this is just below the singular line.14) means that the boundary condition is to be applied slightly below this singular line. which corresponds to solutions of the form V ∼ η 3 in the original variables. 3 3 (5. η2 4 where A0 and A1 are known constants. Clearly this cannot be expressed explicitly in terms of just u and v. To see this recall that the boundary behaviour (5. ..30) gives v= Recalling that A0 = V3 6 5u 10A1 A2 0 − .14) for large η has the form V = A0 η 3 + A1 +.30) 5x 10x 3 . 3 54u2 (5.

here we have that u1 α2 > 0.7 Other fixed points Recall that in phase plane analysis. 2 which also gives the value of C2 to be 8 C 2 = ± − u1 + 9 12 5u1 1 2 (u − u1 )α2 provided 3 . the location of the fixed point. We are interested in the limit u → u1 . for example v ∼ (u − u1 ) 2 .1 that the field lines appear to be approaching v = 0 in a square root fashion.32) only has real solutions provided u1 < 243 80 1 3 = u0 .ANOTHER BREAKDOWN 122 It can also be seen from figure 5. (5. 5. where u1 is the v = 0 intercept. If we are interested in calculating the behaviour to the right of the fixed point then a solution of the form v = C2 (u1 − u)α2 should be used.32) The constant C2 found in equation (5. However.1. It can be shown that this is indeed the correct behaviour by seeking a solution of the form v = C2 (u − u1 )α2 to give 4 5 2 α2 C2 (u − u1 )2α2 −1 = − u − C2 (u − u1 )α2 + 9 3 1 5 u 3 1 − C2 (u − u1 )α2 . SMOOTHED PAYOFFS .CHAPTER 5. 5u1 . once we have determined the location and behaviour of all the fixed points of the system we have entirely determined the qualitative behaviour of the solution. This gives 4 2 α2 C2 (u − u1 )2α2 −1 ≈ − u1 + 9 and so we must have 1 2α2 − 1 = 0 ⇒ α2 = . there may still be fixed points which we have .

(5.33b) 5 3 1 2 Next in order to investigate the behaviour at infinity we make the transformation6 1 ρ= .ANOTHER BREAKDOWN 123 still not considered. φ) = ρ cos φ sin φ + ρ sin2 φ + 9 3 4 5 φx = g(ρ. This leads to the following system in (ρ. namely those at |u| = |v| = ∞. φ) = cos2 φ − cos φ sin φ − 9 3 6 ρ 2 sin φ 5 3 5 cos φ + sin φ ρ 2 cos φ 3 1 2 1 2 .24) into the above yields 5 5 rx = r cos θ sin θ − r sin2 θ + 1 9 3 r2 5 4 θx = − cos2 θ − cos θ sin θ + 3 9 3 r2 sin θ 5 3 cos θ − sin θ cos θ cos θ − sin θ 1 2 . cos φ + sin φ Note that this corresponds to the transformation z = z −1 in complex space z = reiθ . and differentiation gives uux + vvx . φx = −θx . SMOOTHED PAYOFFS . ˆ . r φ = −θ.34a) (5.34b) 5 3 + sin2 φ.CHAPTER 5. r2 rx = Substitution of equation (5. r uvx − vux θx = . To investigate any fixed points at infinity it is convenient to transform the problem into plane polar coordinates. (5. − sin2 θ. This is done via the transformation u = r cos θ.33a) (5. v = r sin θ. φ)-space 5 5 ρx = f (ρ. and differentiating gives ρx = −ρ2 rx .

Evaluating the partial derivatives of our system yields ∂f 5 5 = cos φ sin φ + sin2 φ + ∂ρ 9 3 2 5ρ 2 sin φ 5 3 3 cos φ + sin φ 5 1 2 . Transforming these fixed points back to the original (u. ρ 2 1 + sin2 φ + 5 cos φ sin φ ∂f 10ρ 5ρ 3 = cos φ sin φ + cos2 φ − sin2 φ − . φ0 ) φ ∂ρ 0 x ∂f (ρ . 1 3 Hence this has solutions when either tan φ = or tan φ = which have infinitely many solutions. φ) ρ ¯    ∂f (ρ . Again to investigate the nature of the fixed point it is required to perform a linearisation about the fixed points. φ0 ) ∂φ 0   ¯ φ . 9 3 (5.35) Equation (5. φ). Doing so leads to the following linear system in (¯. All that remains is to determine the nature of these fixed points. 3 5 ρ 2 1 + sin2 φ + 3 cos φ sin φ 10 5 ∂g 2 2 = cos φ sin φ − cos φ − sin φ + . 3 5 ∂φ 3 9 2 3 cos φ + sin φ 2 ∂g =− ∂ρ 2 3ρ 2 cos φ 5 3 1 cos φ + sin φ 1 2 . and so we have only two solutions. SMOOTHED PAYOFFS . φ ) ρ ¯   =  ∂ρ 0 0 ∂g ¯ (ρ . 3 ∂φ 9 3 2 5 cos φ + sin φ 2 3 .35) can be factorised as follows 4 cos φ − sin φ 3 1 cos φ − sin φ 3 4 3 = 0. The nature of the fixed points in this space will remain unchanged under the transformation back to the original coordinate system. φ0 ) ρ ¯ ∂φ 0   ∂g (ρ . however we are only interested in the principle branch when 0 ≤ φ ≤ 2π.ANOTHER BREAKDOWN 124 Clearly the only fixed point of this system is when ρ = 0 and when φ satisfies the following equation φx = 5 4 cos2 φ − cos φ sin φ + sin2 φ = 0. For simplicity we shall remain in the transformed space (ρ. v) coordinates it can be shown that these two fixed points corresponds to 4 1 the point at infinity along the lines u = − 3 v and u = − 3 v.CHAPTER 5.

φ) = (0. Finally considering the fixed point at (ρ. 0. but of opposite sign.9273). 0.37a) (5. φ) = (0. One final point of interest is that the analysis of the fixed points at infinity has revealed a path which does not terminate at the fixed point near the origin. arctan 1 ) ≈ (0. arctan 4 ) ≈ (0.CHAPTER 5.36a) (5. 3 ω2 = 1. 3 ω2 = −1. This path however is not realistic in the context of numerical solutions of the original ODE. as . since the matrix is diagonal clearly has eigenvalues 4 ω1 = .36b) with eigenvectors along the ρ-direction and the φ-direction. These eigenvalues are both real and positive which corresponds to a nodal source fixed point.ANOTHER BREAKDOWN 125 First we will consider the fixed point at (ρ. In other words any perturbation in the ρ-direction will result in the solutions being pushed away from this fixed point.37b) Here we have real eigenvalues. We can move from the nodal source at infinity along the φ direction and arrive at the saddle node (also at infinity) provided there is no movement in the radial direction. (5. corresponding to a saddle node. which has a stable direction (here corresponding to the φ-direction) and an unstable direction (the ρ-direction). Here the 3 linearised system becomes      4 ρ ¯ 0 ρ ¯   = 3    ¯ ¯ 0 1 φ φ x which. which is unstable.3218) leads to the 3 following linearised system      1 ρ ¯ 0 ρ ¯   = 3   ¯ ¯ φ 0 −1 φ x which has eigenvalues 1 ω1 = . SMOOTHED PAYOFFS . (5.

However.CHAPTER 5.1). for standard option payoff profiles. Note too that as ρ → 0. to prevent such behaviour. η3 4 in the original variables. insofar as in this limit yet further asymptotic analysis is applicable. there is a further subtlety as ρ → 0 (which we do not explore). in guiding the asymptotics described earlier. therefore.ANOTHER BREAKDOWN 126 any solution method would introduce small numerical perturbations and the solution would always terminate at the spiral sink near the origin. that every numerically simulated path in the phase space of the nonlinear system under consideration. the two values of S0 will coincide and in this limit the problems associated with the vanishing of the denominator are in some ways mediated by the problems of the infinite gamma. Finally. Hence we have shown. corresponding to solutions of the second order ODE with any given boundary condition (at a point) will always terminate at the fixed node near the origin.7 are in the range ρ < λ . it should be pointed out that strictly the parameter values taken in figure 4. The corollary to this is. indicating (another) failure in the underlying modelling. involving another small parameter. Figure 4. In this section we have used phase-plane analysis to show that it does not appear possible to resolve the singular behaviour of equation (5. suggesting that. 2 as discussed in the present chapter. despite applying a smoothed payoff profile. non-smoothness has been ‘induced’ into the solution for τ > 0. Hence the fixed point in u corresponds to the exact solution of the original equation. Hence any solution of a numerical shooting method given any condition at any boundary will asymptote to the fixed point solution u = which corresponds to the solution V = 243κ 80 1 3 1 3 243 80 . .7 is still useful. even using small-scale analysis. SMOOTHED PAYOFFS . that there is insufficient financial modelling in (4. namely ρ itself.12). via phase plane analysis. however.

in this parameter regime the denominator does not vanish since λ < 2ρ (cf. The next set of results (obtained using a straightforward PSOR scheme). correspond to a calculation obtained taking the smoothed payoff condition (5. VP DE . (5. For these options the dependence on time. so the partial differential equation is reduced to an ordinary differential equation. r = 0. To be consistent with the final payoff conditions.1. σ = 0. however.2. or rather on time left to maturity.7 has demonstrated that the full-feedback model with early exercise leads to what amounts to a trivial problem for puts. The situation is quite different. λ = 0. shown in figure 6. in particular those which do not have discontinuous deltas (and assuming the difficulties raised in chapter 5 can be bypassed).2).4)).25). This set of results (for an American-style put option) corresponds to the payoff condition with ρ = 0. 127 .Chapter 6 Perpetual Options Explicit solutions to parabolic free-boundary problems are rare. the question that naturally arises (given the results of the previous chapter) is what of other payoff conditions. is removed. This chapter investigates such perpetual options in the context of the nonlinear models described in chapter 2.04.15 (together with K = 1. if we consider perpetual American options. Although section 4. the early-exercise condition was imposed by taking V = max 1 K −S+ 2 (K − S)2 + ρ2 .

K = 1. PERPETUAL OPTIONS 128 at all S and τ at each iteration of the PSOR algorithm. τ = 0. 1. The computation was permitted to continue until a near steady state had been attained (i. ρ = 0.2. Figure 6. . . unabated.1). λ = 0.2 τ =0 0 0. There is a subtlety with the application of the smoothed payoff profile (5.8 V PSfrag replacements 0. for long maturities. If we apply the smoothed payoff profile to the standard Black-Scholes equation. more specifically if Vτ ever changes sign.1). of course.5 3 0 Figure 6.1: Full feedback American put. indicating that there is an early-exercise region. which will certainly be the case for standard payoff functions on account of the discontinuous deltas. For a smoothed put numerical investigation shows that Vτ at expiry can be both positive and negative. σ = 0. . 10.4 0.e. Note that we are in the regime λ < 2ρ and so we should expect no singular behaviour. . r = 0.CHAPTER 6.2).5 2 2.5 1 τ = 10 S 1. where VP DE is the solution to (4.6 0. and evaluate Vτ at final maturity (directly from the PDE) then this will provide us with an indication of whether there will exist any early-exercise regions or not. This does emphasise. 1. However for ρ large enough then this is not the case and Vτ always remains negative and thus the option will always be exercised immediately . that much of the difficulty reported above with standard payoff conditions is associated with the vanishing of the denominator in (4.1 clearly indicates that the computation could be extended.15 (smoothed payoff).25.04. (3.2 1 0. the asymptote to a perpetual valuation).2) to perpetual options that should be noted and that we shall attempt to outline below.

which performed an iteration procedure to . However. that American options are always early exercised.1) subject to (the standard early-exercise put conditions) V → 0 as S → ∞. Regime IV is of little interest (since we would never optimally exercise the option) and also figure 6. using a local expansion about τ = 0. ρ > ρmax . we have demonstrated in chapter 4. 2 IV.e. For regime I. This system was solved using a straightforward Runge-Kutta algorithm. Given that long-term solutions to (4. We shall not investigate this regime further but recall however. that in chapter 5 it was shown that we should expect non-smooth behaviour for the European option in this regime and hence it is likely that the American counterpart will exhibit similar solution difficulties. 2 (1 − λVSS )2 V = K − S. 1 2 2 VSS σ S + rSVS − rV = 0. and = −1 on the free boundary S = Sf . II. ρ = 0.e.1 indicates that in regime III there exists a well-posed American option problem.1) (with early exercise) can exist under certain parameter regimes.CHAPTER 6. λ . 2 λ < ρ < ρmax . 0 < ρ ≤ III. i. it is of some interest to investigate the behaviour of this system with the time variation omitted. since the (Crank-Nicolson) finite difference scheme successfully employed to the system in regime III proved unsuccessful in regime II.1) where we can now identify four regimes I. dV dS (6. the behaviour of the solution to the American option problem in regime II still remains unclear. Numerical investigations reveal that the same behaviour is also seen for the nonlinear equation (4. kinked payoff profiles. i. Hence for the Black-Scholes equation the early-exercise boundary exists only for 0 ≤ ρ < ρmax . PERPETUAL OPTIONS 129 (at t = 0).

9 0.2.1) are shown in figure 6.04.2 0. 0.1). r = 0.1 λ=0 S 2. σ = 0. However these solution branches appear to be merely a numerical artifact of the equation (and the solution technique) as increasing the resolution of the grid saw these solution branches collapse down onto the ‘stable’ branch. PERPETUAL OPTIONS 130 evaluate Sf .1. Results. 0.5 5 Figure 6.5 2 λ = 1.1).5 3 3. λ = 0.1).2. .3). and thus reveals yet another interesting feature.5 4 4. namely the approach of the free boundary towards S = 0.6 V PSfrag replacements 0.2. .2.CHAPTER 6. for the choice of parameters taken above. corresponding to the smooth solutions shown in figure 6. 1 0. it was observed that multiple solution branches could be found using certain numerical techniques. free-boundary location as indicated.1 0 0 0. such as finite difference methods and the so-called body-fitted coordinate system (described further in section 9.1. The location of the free boundary is also clearly marked. K = 1.2: Perpetual full-feedback American put. with K = 1. σ = 0. r = 0.04. . based on (6. .5 1 1. .4 0. As a final cautionary note on the numerical solution of the nonlinear ODE (6.7 0.3 0.8 0.2 for a range of values of the parameter λ. For λ 1. These solutions exhibited non-smooth behaviour and were thought to be a possible steady-state solution of the time dependent PDE (4. 1. it would appear that it is never optimal to early exercise the perpetual option (the free boundary reaches S = 0 at λ ≈ 1.1.5 0.

as stated in section 1.3.2) > 0 and Sf is the (fixed) location of the free boundary determined by Sf = αK . we have β → 1 and so the free boundary for the American call tends to infinity and the solution reduces to the trivial solution V C (S) ≡ S.5 the American call option value is coincident with the European call option value and so there exists no (optimal) early-exercise region for the American call. As an alternative to resorting to fully numerical solutions we can utilise perturbation methods to obtain . If. however. Unfortunately the nonlinear ODE (6.1) has no analytical solution.4) 1 r − D − σ2 2 2 and the free boundary Sf given by + 2rσ 2  . In fact the value of the perpetual American call option on an underlying paying a constant dividend yield D is given by V (S) = (Sf − K) where β > 0 is given by  1 1 β = 2 − r − D − σ 2 + σ 2 C S Sf β . PERPETUAL OPTIONS 131 6. we include the payment of a constant dividend yield in the underlying then the optimal exercise boundary becomes non-trivial and thus its perpetual counterpart will have a nonzero value. (6.1 Analytic solutions and perturbation methods It is well known that the Black-Scholes perpetual American put option admits an exact analytical solution V (S) = (K − Sf ) where α = 2r σ2 P S Sf −α (6.3) Furthermore.CHAPTER 6. Hence the value of a perpetual American call option will be trivially equal to the current value of the stock. α+1 (6.  Sf = βK . β−1 Interestingly we can see that as D → 0.

1) as 1 2 2 σ S VSS + (rSVS − rV ) (1 − λVSS )2 = 0 2 and we proceed by trying a regular expansion of V in powers of λ. (6. now a non-homogeneous Black-Scholes equation. . Substituting the above into equation (6. sections 1.2).e. (6. V = V0 + λV1 + λ2 V2 + . where again the constants C and D are to be determined from the boundary conditions. or more generally V0 (S) = AS + BS −α .6c) The solution to the leading order equation (6. with α as previously defined and constants A and B are to be determined from the appropriate boundary conditions.4) O(λ0 ) : O(λ1 ) : O(λ2 ) : 1 2 2 σ S V0SS + rSV0S − rV0 = 0. 2 ⇒ S 2 V1SS + αSV1S − αV1 = −2α2 (α + 1)2 B 2 S −2α−2 . To deal with the non-homogeneity we seek a particular solution of the form V1 (S) = kS −2α−2 . It is useful to rewrite (6. .6b).7) . i. . which can also be solved analytically. Substitution into (6. where k is to be determined. The general solution to this equation is thus V1 (S) = CS + DS −α . Note that we are required to use this solution in order to solve the next order equation (6. 2 1 2 2 σ S V2SS + rSV2S − rV2 = 2V0SS (rSV1S − rV1 ) 2 2 − V0SS − 2V1SS (rSV0S − rV0 ) . 2 1 2 2 σ S V1SS + rSV1S − rV1 = 2V0SS (rSV0S − rV0 ) .6b) becomes 1 2 2 σ S V1SS + rSV1S − rV1 = −2rα (α + 1)2 B 2 S −2α−2 .5) (6.6a) (6. (6.7) gives (2α + 2) (2α + 3) k − α (2α + 2) k − αk = −2α2 (α + 1)2 B 2 .6a) is simply the solution to the BlackScholes perpetual option.5) and collecting together the powers of λ gives the following asymptotic set of equations (cf. PERPETUAL OPTIONS 132 an approximation of the solution for small values of the parameter λ. Hence equation (6.8 and 4.CHAPTER 6.6b) (6.

(6. namely Sf = Sf0 + λSf1 + .9b) . . . . PERPETUAL OPTIONS 133 which can be solved for k to yield k=− 2α2 (α + 1)2 B 2 .) + λV1 (Sf0 + λSf1 + .) = V0 (Sf0 ) + λSf1 V0S (Sf0 ) + O(λ2 ). In this case the boundary conditions are given by V (S) → 0 as S → ∞. − (2α + 3) (α + 2) The constant B is found from the boundary conditions on the leading order equation V0 and C and D are found from the boundary conditions on the first order correction V1 . these shall now be determined for the case of a (non-dividend paying) perpetual American put option. . = K − Sf0 − λSf1 − . .9a) (6. Along with the perturbation in V (S) the boundary condition (6. . .) = V1 (Sf0 ) + λSf1 V1S (Sf0 ) + O(λ2 ). Exploiting the smallness of λ and recalling Taylor’s theorem we have V0 (Sf0 + λSf1 + . . V1 (Sf0 ) = −Sf1 1 + V0S (Sf0 ) .8c) First we must also apply an asymptotic expansion to the location of the free boundary Sf . . . . VS (Sf ) = −1. . .8b) thus becomes V0 (Sf0 + λSf1 + . . (2α + 3) (α + 2) Hence the solution of the first order correction is V1 (S) = CS + DS −α 2α2 (α + 1)2 B 2 −2α−2 S .8b) (6. . .8a) (6.CHAPTER 6. (6.) + . hence equating powers of λ we can see that this boundary condition becomes O(λ0 ) : O(λ1 ) : V0 (Sf0 ) = K − Sf0 . V1 (Sf0 + λSf1 + . V (Sf ) = K − Sf .

 0       V0 (Sf ) = K − Sf .8c) yields O(λ0 ) : O(λ1 ) : V0S (Sf0 ) = −1.10b) Interestingly we can see that the smooth pasting condition (6. However we still have the smooth pasting condition on this correction which can be exploited to give us an estimate of the correction to the free boundary.CHAPTER 6. V1S (Sf0 ) = −Sf1 V0SS (Sf0 ). V0SS (Sf0 ) leading order system is given by General solution. α B = (K − Sf0 ) Sf0 . Perturbed free boundary. This coincides exactly with the Black-Scholes Perpetual Put whose solution was given by (6.       V0S (Sf ) = −1. Boundary condition 2. 0 0   V0 (S → ∞) = 0. α+1 The system for the first order correction V1 is   V (S) = CS + DS −α − 2α2 (α+1)2 B 2 S −2α−2 . Boundary condition 2. Boundary condition 1. Bringing things together we have that the   V (S) = AS + BS −α . PERPETUAL OPTIONS 134 A similar application of Taylor’s theorem to the smooth pasting condition (6. therefore rearranging (6. 1 V0SS (Sf ) 0 General solution. hence A = 0.  1  (2α+3)(α+2)      V1 (Sf ) = 0.       Sf = − V1S (Sf0 ) .10a) when substituted into (6. (6. Boundary condition 1. This implies that the solution of V1 (S) can be determined without knowledge of the correction to the free boundary. Smooth pasting. 0   V1 (S → ∞) = 0. .10a) (6. Sf1 .9b) results in the condition at the free boundary for the first-order correction reducing to zero.2).10b) gives Sf 1 = − V1S (Sf0 ) . 0 Sf 0 = αK .

Figure 6. PERPETUAL OPTIONS 135 Clearly from the boundary condition at infinity we have C = 0 and the condition at the free boundary leads to D= α 2(α + 1)2 Sf0 .CHAPTER 6. i. it can be seen that there is a good agreement in the solutions.e.4 shows the same comparison as in figure 6.3 shows the first order correction term.11) is valid in the region S < Sf0 . results in Sf 1 = − 2(α + 1) . V − V BS . expectedly the agreement with the ‘exact’ solution worsens for larger values of λ. .1) and the Black-Scholes value. after some laborious algebra.e.11) with the free boundary now located at Sf = S f 0 − 2λ(α + 1) + O λ2 . λV1 and compares it to the difference of the (numerical) solution to the full problem (6. Note that V1 has only been calculated in the region S ∈ (Sf0 . (2α + 3)(α + 2) To determine the position of the perturbed free boundary involves evaluating the derivatives of V0 and V1 which. 2α + 3 Figure 6. i. ∞) since it is not entirely clear whether the approximate solution (6. (6. 2α + 3 Hence our approximate solution can be written as Sf V (S) = 0 α S Sf 0 −α 2λ(α + 1)2 + (2α + 3)(α + 2) S Sf 0 −α − S Sf 0 −2α−2 + O λ2 .3 but for increasing values of the parameter λ.

5 λ = 0.5 S 2 2.05 λ = 0.01 0.5.5 3 3.2 λ = 1. σ = 0.04.015 λV1 0.5 S 2 2.5 Figure 6.CHAPTER 6.5 1 1.1 0 0 0. . K = 1. PSfrag replacements 0.04. 1.1.1 Sf 0 0.025 0.0 0. PERPETUAL OPTIONS PSfrag replacements 136 0.5 3 3.3: The first order correction to the Black-Scholes perpetual American put option (solid line) compared to the difference of the fully numerical option value with the Black-Scholes (dotted line).15 λV1 0.2 and λ = 0. K = 1.2 and λ = 0.02 0.5 1 1. 0.4: The first order correction to the Black-Scholes perpetual American put option (solid line) compared to the difference of the fully numerical option value with the Black-Scholes (dotted line) for various values of λ. σ = 0. r = 0. r = 0.1.005 Sf Sf 0 0 0 0.5 4 Figure 6.25 0.

namely (4. and leads ˆ ˆ to the same PDE as (2. and for a put is given 137 . t) in (4. the model as introduced by Sch¨nbucher and Wilmott o (2000). which is more consistent when using geometric Brownian motion as the reference process. from which we will be able to ascertain whether or not the difficulties outlined in the preceding chapters (for constant λ) are also present. including those which involve non-constant λ(S. We now discuss some of these. τ ) effectively models the price impact on the percentage price change rather than the absolute price change. The same scaling as was employed for the full-feedback model as τ → 0.Chapter 7 Other Models We have shown that significant difficulties arise when the form of the function λ(S.7) can be used here. The solution turns out to be very similar. in particular by investigating their small τ behaviour. 7. τ ) = λS where λ ∈ R. We will not present derivations of the models below.1) is taken to be constant.10) but with λ(S.1 Frey (1998. 2000) The model of Frey (1998. t) as was briefly discussed in chapter 2. In fact it can be seen that the Frey model is in some sense a more consistent model of price impact as this form of λ(S. There have been alternative models proposed. the interested reader is referred to the appropriate references. 2000) is the most similar to that discussed earlier.

2000) is when we consider first-order feedback.τ ) √ =0 1− σ 2πτ where d1 (S.it merely leads to a rescaling of λ. (7. − rKH(η) = 0. Again it can be seen that there exists no solution past a critical value of τ .3 and chapter 5) regarding the zero in the denominator of (2. 2000) model vanishes when λe− 2 d1 (S .2) since there exists no real solution when λ2 < 1. The same argument holds in the case of call options. 2πσ 2 τ hence when τ > τcrit where τcrit = λ2 . Equally.1) can be solved explicitly to obtain 1 2 S ∗ (τ ) = Ke−(r+ 2 σ )τ exp ±σ τ log λ2 2πσ 2 τ .3 the denominator of the first-order Frey (1998.2) Figure 7.7. 2πσ 2 . However. since the addition of S is not sufficient to alter the qualitative behaviour of the solution . one interesting difference in the model of Frey (1998.CHAPTER 7. τ ) = log S K 1 ∗ 2 (7. the arguments expounded earlier (in section 3. Similar to the Sch¨nbucher o and Wilmott (2000) model equation (7.10) remain applicable.1) + r + 1 σ2 τ 2 √ .1 shows these locations for the same parameters as figure 3. OTHER MODELS 138 by the equation η φ − φη − 2 and for a call η φ − φη − 2 σ 2 K 2 φηη ˆ 2 1 − λKφηη 2 σ 2 K 2 φηη ˆ 2 1 − λKφηη 2 + rKH(−η) = 0. σ τ and S ∗ (τ ) is the location of the singular denominator. It is clear that this model will exhibit the same behaviour as the model discussed previously. When considering the location of the vanishing of the denominator similar to the analysis in section 3. This can be seen directly from equation (7.

However this additional structure is not seen on the small scale close to expiry where the scaling (4.2 Frey and Patie (2002) Here an asset dependent liquidity is introduced in order to reproduce the volatility smile with ˆ λ(S. r = 0.99 0.3) ˆ where I denotes the indicator function and λ.02 1. 2000) (solid line) and Sch¨nbucher and Wilmott (2000) (dotted line) model with λ = 0. λ = 0. i.CHAPTER 7.2. a1 and a2 are found by minimising the squared distance of the observed price from the model.e.7) reduces (7.7.e. This form of the liquidity structure incorporates so called liquidity drops. 7.025 0. τ ) = λ 1 + τ (η − η0 )2 a1 I{η≤η0 } + a2 I{η≥η0 } .039789.045 Figure 7.015 0.2.005 0. i.04 and σ = 0.1: Location of the vanishing of the denominator of the Frey (1998.04 0. o K = 1. (7.03 0.01 S 1 0. PSfrag replacements 0 139 1.1 and σ = 0. .01 0.1. t) = λ 1 + (S − S0 )2 a1 I{S≤S0 } + a2 I{S≥S0 } .035 0.97 0. i.98 0. o where the previous analysis is thus applicable.e. ˆ which as τ → 0 reduces to λ. then we have τcrit ≈ 0. the model of Sch¨nbucher and Wilmott (2000). that λ(S. t) increases if the stock price drops. OTHER MODELS For the parameters used in figure 3.3) to ˆ λ(S.02 τ 0.

(7.6 but with a discontinuous jump in the value of the elasticity/liquidity parameter . It turns out that the small τ analysis considered earlier is quite similar to (7. in particular using the scaling (4.6) The two equations above are subject to the same boundary conditions as employed in section 4.10) with λ(S.4) remains positive.CHAPTER 7.4). is switching off the effect of the price impact close to expiry.7) leads to the following small-τ equation for a put: η φ − φη − 2 and. ˆ 1 − λVS The authors state that there will be difficulties with the PDE when the denominator passes through zero (as has been outlined in chapter 5 of the present study).4) ˆ where again λ ∈ R. offer the financial argument that transaction costs act as a natural smoothing close to strike and close to expiry and so the cost of replication (hence the price) would naturally be smoothed. note that these are the same form considered in section 4. for a call η φ − φη − 2 σ 2 K 2 φηη 2 1− ˆ λK ˆ 1−λH(η) 2 σ 2 K 2 φηη 2 1− ˆ λK ˆ 1+λH(−η) φηη 2 + rKH(−η) = 0. This is effectively introducing a smoothing in the payoff function and. To circumvent this difficulty. With a little rearranging we can see that this equates to (2. similarly. τ . where is chosen such that for τ > the denominator of (7. They do.3 Sircar and Papanicolaou (1998) Another interesting model is that of Sircar and Papanicolaou (1998). VS ) = ˆ λS . Indeed. (7.5) φηη − rKH(η) = 0. who arrived at the following PDE 1 Vτ − σ 2 S 2 2 ˆ 1 − λVS ˆ ˆ 1 − λVS − λSVSS 2 VSS − rSVS + rV = 0. Sircar and Papanicolaou set the value of the option close to expiry to be equal to the Black-Scholes analytical value. More specifically this is done in the region 0 < τ < . indeed. OTHER MODELS 140 7. however.6. (7.

.3 respectively.10). with K = 1. this is as a consequence of the inclusion of VS into the function λ(S. r = 0. This matter was not pursued further but it would appear that a treatment along the lines of section 4. OTHER MODELS 141 (equivalent to λ) at S = K (η = 0).2. it was found for values in excess of those shown (up to 0.04 0. and results for a call and a put are presented for a range of values ˆ of λ in figures 7. 0. 0.6.02 0. Equations (7. φcall (η) = φput (−η) + rK. Another interesting point to note is that the symmetry seen in the full-feedback model of section 4.04.2 0. suggesting yet again another solution regime. . τ ).015 0.025 ˆ λ = 0. and λ = 0. Although in ˆ both cases there appears to be very little variation with λ. 7. r = 0.4 -0. .CHAPTER 7.4 Bakstein and Howison (2003) Bakstein and Howison (2003) developed a model for liquidity effects which results in . σ = 0.4 Figure 7.035 0.2: Local (τ → 0) call solution of the Sircar and Papanicolaou (1998) model ˆ K = 1.2 and 7.2 ˆ λ=0 φ PSfrag replacements 0. in a manner described in section 4. as is our discussion regarding the vanishing of the denominator in (2.2 η 0 0. with the occurrence of negative square roots in the calculation. 0.2 in the case of calls) that the calculation failed.8) and (4. σ = 0.04.2. 0.03 0.9).3 in the cases of puts.6) were then solved in a manner similar to that employed on (4.01 0.005 0 -0.05.6 is again relevant.2.6 has now been broken. .5) and (7.

4 Figure 7. 0.035 -0.005 -0. 1 2 ˆ Vτ − σ 2 S 2 VSS − λσ 2 S 3 VSS − 2 1 ˆ2 3 λ (1 − α)2 σ 2 S 4 VSS − rSVS + rV = 0.3 ˆ λ=0 φ PSfrag replacements -0.7) can be applied to the Bakstein and Howison (2003) model to obtain a valid local solution. the following PDE. this is what Bakstein and Howison (2003) term price slippage. r = 0. the large trader will inevitably obtain a worse price for the order than the quoted prices. and that he has also provided the other side of the large trade. then it is not unreasonable to expect that in the next period the market maker will quote different prices in order to neutralise his position.2 0.2.CHAPTER 7.01 -0. σ = 0..02 -0. hence a permanent impact will be felt by the market. and indeed this shall be done . α = 1 corresponding to no ˆ slippage. . but we shall return to this later.3. The first point to note is that this equation looks uncannily like a small λ expansion of the previously discussed models. .3: Local (τ → 0) put solution of the Sircar and Papanicolaou (1998) model ˆ K = 1.7) ˆ where λ ∈ R is a measure of the market’s liquidity and α is a measure of the price slippage impact of a trade felt by all market participants. When a large order has been placed. First we shed a little light onto the term price slippage.05. OTHER MODELS 142 0 -0.03 -0.04. 2 (7. .015 ˆ λ = 0. a question that may be asked is whether this large order should have a permanent affect on the price process or not.025 -0. Assuming that a market maker provides the quotes. It can be shown that the non-smooth scaling (4.2 η 0 0. and λ = 0 0.4 -0.04 -0. However.

1ˆ 3 Vτ ∼ λ2 (1 − α)2 σ 2 S 4 VSS .7) it can be shown that in the limit τ → 0 the equation for the inner solution becomes the cubically nonlinear ODE1 3 fηη + ν1 (ηfη − f ) = 0 (7.9) ˆ totic match which is the same as for the corresponding Black-Scholes (λ = 0) case. 2 We seek a solution of the form V (S. i. Substituting this into equation (7. 2000) and Sircar and Papanicolaou (1998) cases. the cubic VSS term in equation (7. Note that ν1 can be scaled out by setting f (η) = place the constant ν1 into the boundary conditions. Frey (1998. 4 Hence applying this scaling to the full equation (7. However it transpires that.7) will dominate over the other lower order terms in VSS . τ ) = τ γ1 f (η) where η = S−K τ γ2 (7. 1 ˆ where ν1 = 2λ2 (1 − α)2 σ 2 K 4 −1 . Hence to find an appropriate scaling we require a balancing between this cubic term and the time derivative. due to the increasing gamma in the region close to strike and expiry.1).CHAPTER 7.e. a suitable scaling (applicable to standard put and call payoff profiles) can be found in the class of smooth functions. unlike in the Sch¨nbucher o and Wilmott (2000). section 3.8) we have 1ˆ 3 γτ γ−1 (f − ηfη ) ∼ λ2 (1 − α)2 σ 2 K 4 fηη τ −3γ 2 we can see that in order to obtain an appropriate balance of terms (for all τ ) we are forced to set γ − 1 = −3γ ⇒ 1 γ= .8) where we require γ1 = γ2 = γ in order to obtain an O(1) inner solution and correctly match with the standard payoff profiles (cf. For the standard payoff profile (puts and calls) we have that. The boundary conditions arise from an asymp√ ˆ ν1 f(η) but we will not do so as this would . OTHER MODELS 143 in the following subsection. The following outlines the procedure adopted to find such a scaling.

in this case the quadratic VSS term in the equation can no longer be neglected and will be of comparable size to the cubic term for certain ranges of τ . in the absence of price slippage impact.5 λ ↓.e. the parameter ν1 increased) the solution appears to collapse down onto the standard put option payoff profile..4: Solution to equation (7.9) becomes degenerate and looking again at the full PDE (7.1 -1 -0.2.10) can be solved using standard finite-difference techniques. (7. α = 1.5.01. f → 0 as η → ∞. When α = 1 however. In this limit.1 0 -0.5 1 Figure 7. Figure 7. this can be seen by balancing the quadratic and cubic VSS terms in equation (7.e.5 0.4 shows sample results for the inner put solution with σ = 0.8 0.6 f (η) 0.2 0.7) it is clear that the scaling used above is no longer appropriate when α → 1. 5.7).04. 1. f → 0 as η → −∞ for puts.10a) (7. .04.5 and with λ = 0.3 0. PSfrag replacements f → −η as η → −∞ for calls. Note that as λ is decreased (i. 1 0.9) and (7. 0. . the smallness of 1 − α 2 must be considered. Here the inner equation (7. K = 1.9) for a put option with λ = 0. . ν1 ↑ η 0 0.10b) The system (7.2.9 0. However there is another subtlety that arises with the above scaling in the limit α → 1. and α = 1. 1. σ = 0. OTHER MODELS 144 i.e.CHAPTER 7. the cubic term in equation . with the solution becoming increasingly focused around η = 0. r = 0. 5.5. r = 0. K = 1. f → η as η → ∞. i.5. Therefore the limit α → 1 is not a trivial one.7 0. suggesting that an asymptotic breakdown occurs when τ = O (1 − α)8 .4 0.01. 0.

2 145 (7. This shall not be investigated further. This suggests that either the chosen form of the solution is inappropriate or that a smooth solution to the equation may not exist. τ ) = τ 3 g(ξ) where ξ = leading to the equation (in the limit τ → 0)3 2 gξξ + ν2 (ξgξ − g) = 0 1 S−K τ3 1 .10).12) ˆ where ν2 = 3λσ 2 K 3 −1 and it is once again coupled with the boundary conditions (7. (7. 48 2 ν2 g(ξ) = D1 ξ. Furthermore the numerics indicate that the solution most likely takes on the form of the (non-smooth) payoff profile. Performing the same power balancing analysis as above leads to the conclusion that the appropriate scaling for the problem when α = 1 is given by V (S. however neither of these satisfy the required boundary conditions (7. attempts to solve the system numerically using the same techniques employed on equation (7. In addition. OTHER MODELS (7.10). The results were not consistent with grid refinement and kinked solutions started to appear. It is (very) interesting to note that this PDE also arises in the quadratic transaction cost model of Cetin et al.7) disappears and the equation is reduced to2 1 2 ˆ Vτ − σ 2 S 2 VSS − λσ 2 S 3 VSS − rSVS + rV = 0.CHAPTER 7. rather we leave this as a subject of future research. ˆ 2 . 3 Note again that ν2 can be scaled out by setting g(ξ) = ν2 g (ξ) but we will not do this.9) proved ineffective.12) then we obtain gξξ (2gξξξ + ν2 ξ) = 0 which suggests two solutions to equation (7. Note that if we differentiate equation (7.12) g(ξ) = − C2 ν2 ξ 4 C1 ξ 2 + + C2 ξ + 1 .11) In this case the appropriate balancing of terms is now between the quadratic term in VSS and the time derivative. (2004).

CHAPTER 7. Vτ − σ 2 S 2 VSS ˆ 2 1 − λSVSS 2 − rSVS + rV = 0.11). 2 for a call. The cubic nonlinearity in the second-order derivative φηη demands a somewhat different numerical approach from that adopted for the Sircar and Papanicolaou (1998) (7. OTHER MODELS 146 Finally.e. Clearly the assumption that λSVSS 1 prohibits the denominator of the equation (7. but also leads to a regime in which standard put and call payoff profiles are not permitted due to their infinite second derivatives.6.1 Non-smooth solutions to the Bakstein and Howison (2003) model As mentioned in the previous section.7) to equation (7. i. . (7. equation ˆ (7. and hence equation (7.13) ˆ ˆ Making the assumption that λ is small and further that λSVSS make the approximation ˆ ˆ (1 − λSVSS )−2 ≈ 1 + 2λSVSS + .4.15) . 2 1 then we can which coincides with the Bakstein and Howison (2003) model for α = 1.13) can be approximated by 1 2 ˆ Vτ − σ 2 S 2 VSS − λσ 2 S 3 VSS − rSVS + rV = 0. if we apply the scaling (4. with the boundary conditions described in section 4.7).e. 7. 2 and 1 η ˆ φ − φη − σ 2 K 2 φηη − λσ 2 K 3 (φηη )2 2 2 ˆ λ2 − (1 − α)2 σ 2 K 4 (φηη )3 − rKH(η) = 0. we can obtain a valid local solution and furthermore doing so for a put we obtain 1 η ˆ φ − φη − σ 2 K 2 φηη − λσ 2 K 3 (φηη )2 2 2 ˆ λ2 − (1 − α)2 σ 2 K 4 (φηη )3 + rKH(−η) = 0.13) vanishing.14) (7. let us recall the equation arising from the Frey (2000) model. . i.

6 Figure 7. the Bakstein and Howison model degenerates to the standard Black-Scholes equation and. and λ = −5.2 ˆ λ=0 η 0 0. α = 1. Other computations performed suggested that although the variation ˆ of option values with α is generally quite small (with fixed λ).02 -0. figures 7. and with λ = −5.4 -0. . 0 ˆ discuss possible values for these latter two parameters (it appears that |λ| is likely -0. ˆ K = 1. 7.CHAPTER 7. Bakstein and Howison (2003) do very small).2 0.6 for puts and calls respectively. -4. . .14) and (7.025 -0. in some regimes the numerical scheme failed to converge.6 indicate that a non-trivial solution to the classical Black-Scholes problem does . r = 0.04. .15) do not exist (which in turn suggests the possibility of a regime akin to that described in section (4. 5. . Consequently.04. -4.5.6)).005 -0.01 ˆ λ = −5 -0. we followed a treatment which considered the problem as a system in φ and φ1 = φη . α = 1. with σ = 0.75.04 -0. 5. thereby resulting in two first-order equations.2 New non-smooth solutions to the Black-Scholes equation ˆ It should be noted that when λ = 0. OTHER MODELS 147 model.4 0. Second-order finite differencing.2.6 -0.4.03 ˆ λ=5 -0. σ = 0.2.5 and 7.015 φ PSfrag replacements -0. .75.5: Local (τ → 0) put solution of the Bakstein and Howison (2003) model ˆ K = 1.035 -0.. . r = 0.5. Sample results are shown in figures 7. suggesting the possibility of regimes for which solutions of (7. somewhat intriguingly. coupled with Newton iteration was then employed.5 and 7.

. and λ = −5.75.4 0. equation (7. Note that this does not contradict the standard and well known uniqueness results of the (linear) Black-Scholes equation as these results are only valid in a restricted class of smooth (classical) solutions to the PDE. To illustrate the non-smooth behaviour of these solutions figure 7. exist with a discontinuous delta.005 0 -0. σ = 0.035 0. Although this new solution is found as the limiting case of the nonlinear Bakstein and Howison model it can be illustrated by directly applying the scaling (4.01 ˆ λ=5 0.5. OTHER MODELS 148 0.04 0. η ηη 2 2 ˆ i.025 φ PSfrag replacements 0. 5. (3.03 ˆ λ = −5 0. .2 0.6: Local (τ → 0) call solution of the Bakstein and Howison (2003) model ˆ K = 1. . using the Keller (1978) scheme (described in section 4.6 -0. Doing so we arrive at the equation for the inner solution of a put η 1 φBS − φBS − σ 2 K 2 φBS + rKH(−η) = 0.6 Figure 7.02 0.2.2 ˆ λ=0 η 0 0. r = 0.4 -0.CHAPTER 7. seeking a solution of the Black-Scholes equation (3. -4.2).e.04. α = 1. i. In fact it should also be noted that there also exists infinitely many smooth solutions to the Black-Scholes equation but ones which do not satisfy the required growth conditions on the coefficients of 1 ..15) with λ = 0. quite distinct from the classical solution.7 gives sample numerical solutions of the Black-Scholes equation.2) of the form V BS = −τ 2 ηH(−η) + τ φBS (η).e.015 0.7) to the Black-Scholes equation.7) to build in the jump in the first derivative.

2 0 0. The authors’ rationale behind this choice of the liquidity function is stated that as time passes.CHAPTER 7. τ ) = λ(1 − e−βτ ) (7. This is achieved by adding a time dependency to the function λ(S.5 2 Figure 7.8 0. β ∈ R. Uniqueness of the Black-Scholes PDE relies on its ability to be reduced to the heat equation where uniqueness results are well known. furthermore uniqueness of the heat equation is only ensured if we prescribe the behaviour of the solution for large |x|.04.5 Liu and Yong (2005) The model of Liu and Yong (2005). namely the volatility term. K = 1.5 S 1 1. OTHER MODELS 149 1 0. the private information about the asset value is gradually revealed so that the price impact gradually decreases to zero at maturity.2.16) ˆ where λ. which will .4 τ =1 V 0.25 0.6 τ = . σ = 0. Also Widder (1975) shows that there is at most one solution that is nonnegative for t ≥ 0 and all x. 7. r = 0. t) models absolute temperature or option prices. τ ) of the form ˆ λ(S.7: Non-smooth solution of the Black-Scholes equation. a reasonable assumption when u(x. previously discussed in chapter 2. the PDE. attempts to overcome the undesirable asymptotic behaviour at expiry by effectively ‘switching off’ the effect of liquidity as we approach it.2 PSfrag replacements 0 -0.

but it may for the full feedback case which we now consider.τ )2 √ = 0. equation (3. However. the denominator will never vanish since here the denominator becomes uniformly unity.7) is no longer appropriate for this PDE and in fact it transpires that the standard Black-Scholes scaling (3. e 2 σS ∗ 2πτ where d1 (S. leading to σ 2 K 2 fηη + ηfη − f = 0. Figure 7. In addition. The best we can do .1 Vanishing of the denominator First we consider the first-order feedback case.CHAPTER 7.3) is the relevant one to use as τ → 0. In the full feedback case of the Liu and Yong (2005) model at τ = 0 the denominator never vanishes because the denominator reduces to 1 at τ = 0. Conversely when considering the limit β → 0.5.8 shows the location of the singular denominator for various values of β. To determine if the denominator vanishes in this simple case reduces to determining whether there exists a real solution S ∗ (τ ) to the equation 1− ˆ λ(1 − e−βτ ) − 1 d1 (S ∗ . τ ) has been defined previously. as we shall outline next. τ ) defined by (7. τ ) may not completely circumvent the issues associated with the vanishing of the denominator. The first point to note is that the Liu and Yong (2005) model reduces to the Sch¨nbucher and Wilmott (2000) model in o the limit β → ∞. hence we can see that the denominator does still vanish for sufficiently large values of β. as such the location of the vanishing denominator in this limit was shown in figure 3. This will not cause any problems in the first-order feedback model (as was outlined in chapter 3). The non-smooth scaling (4.e. Note that this has the same structure as the standard Black-Scholes model as τ → 0. equation (3. it is of interest to check to see if the denominator vanishes for τ > 0. OTHER MODELS 150 also prevents any stock price manipulation at maturity. i. it appears that this form of the liquidity function λ(S.7.5) and hence the asymptotic behaviour of the Liu and Yong (2005) model close to expiry will be close to the Black-Scholes model.16). 7. i.e.1) with λ(S.

τ 1 and S ≈ K.e. . i. 1 × 106 .. 2 × 105 . In this region the Liu and Yong (2005) model is identical to the Black-Scholes local solution and hence we can approximate VSS in this region by the Black-Scholes local solution.99 0. if this is also in the region τ 1.035 0. 2π The exponential is bounded above by one and so the denominator will not vanish provided β< σK λ 2π . hence if β is sufficiently large.e.02 τ 0. r = 0.98 0.005 0. σK 2πτ (S−K)2 valid for both puts and calls. is investigate the region close to strike and expiry. Liu and Yong (2005) use the value β = 100 in the numerics giving τ = O(10−5 ) which is within the region where τ 1.97 0 0. Using this. K = 1.04. .CHAPTER 7. and β = 1 × 105 . τ in other words there is a potential for model failure (breakdown) in the region τ = O(β −2 ).8: Location of the vanishing of the denominator for the Liu and Yong (2005) model for various value of β.2. OTHER MODELS rag replacements 151 1. .04 0. i.015 0.03 0. VSS e− 2τ σ2 K 2 √ = .01 S 1 β increasing 0.045 Figure 7.025 0.01 0. and the knowledge that in this region e−βτ ≈ 1 − βτ the denominator will thus vanish if and when 1− βλ σK 2 τ − (S−K)2 e 2τ σ2 K = 0.02 1.1. . λ = 0. σ = 0.

is dependent on an exogenous Brownian motion (ds = µsdt + σsdWt ) via an exponential price impact function. K = 1.18) where a ∈ R.2. . with σ = 0. However the . However it is clear that this model will encounter difficulties if we have discontinuous payoff profiles. S s (7. for a call and fη → −1 as η → −∞. i. S. t) again denotes the number of stocks held by the hedger and g a so called effect parameter. Note that. subject to fη → 1 as η → ∞. . is the Jonsson and Keppo (2002) model. 1. -0. Note that in this case there is no discontinuity in the derivatives and we appear to have a classical solution. This leads to a very different nonlinear pricing PDE. ds dS = egf (S. OTHER MODELS 152 7. The above system was solved using a straightforward fourth-order shooting scheme. It transpires that the relevant scaling in this case is also that of Black-Scholes (3.CHAPTER 7. 2 (7..3). namely 1 Vτ − σ 2 S 2 e2aVS VSS − rSVS + rV = 0.19) for a put.9.e. (7. results for calls and puts are shown in figures 7.17) where f (S. such as binary options. the call option value is monotonically increasing in the parameter a. We therefore conclude that equation (7.6 Jonsson and Keppo (2002) Another model (in addition to Bakstein and Howison. 2003) that can be found to be free of the problems with non-smooth solutions for standard put and call payoff profiles. f → 0 as η → −∞. Here the price observed in the market.2 of Jonsson and Keppo (2002). and for a = −1.18) admits well-behaved solutions at times close to expiry. f → 0 as η → ∞.9 and 7. . in agreement with proposition 3.t) . which leads to the equation σ 2 K 2 e2afη fηη + ηfη − f = 0.10 respectively. and conversely the put monotonically decreasing.

σ = 0.9.4 Figure 7. a link which is outlined below.4 f 0. exist a link to the other models discussed in this chapter. 0. there does. -0.6 0.5 0.4 -0.. σ = 0. . 0.4 -0. .3 a=1 0. . ..4 f 0. and a = −1. -0.2 PSfrag replacements 0. however.6 0.1 0 -0. 1. .1 a = −1 0 -0.10: Local (τ → 0) put solution of the Jonsson and Keppo (2002) model K = 1.2. .4 Figure 7.3 0.2 η 0 0.9.2 0. .2 η 0 0.2 0.5 0. 1. OTHER MODELS 153 modelling assumptions used to arrive at this equation may be questioned.2 a = −1 a=1 PSfrag replacements 0.CHAPTER 7.9: Local (τ → 0) call solution of the Jonsson and Keppo (2002) model K = 1.2. and a = −1.

t) 1. 2000) etc. OTHER MODELS 154 7. t) = s s = µdt + σdWt + gf (S. s It is now possible to equate this model to the reduced form SDE model.2). s S in other words the liquidity function λ(S. In this case equation (7. L → ∞ the relationship (7. t) if we allow the parameter λ to be λ(S. become equivalent for small gf (S. and in order for the two processes to agree we require that gf (S.20) This is intuitive since.17) can be approximated to dS ds ≈ 1 + gf (S. t) ds = λ(S. i. therefore. section 1. L (7. The models. (2. t) . if the elasticity of the market increases. t) f ds =g . or more specifically if gf (S.CHAPTER 7.4).1 Connections with the other modelling frameworks A connection of the Jonsson and Keppo (2002) model with the models of Frey (1998. in line with our understanding of price elasticity. t) = g S. t) can be chosen such that λ(S. can be seen if we consider small values of the effect parameter g.e. . S s df If we identify f as the number of shares traded and s as their price.20) gives that λ → 0 and hence the liquidity of the market also increases. t) S s ds ds + gf (S.6. t) df (S. t) ds . then it is possible to define the quantity s df f ds = L as the price elasticity of the market to trades (cf.

clustering appeared when non-optionable stocks became optionable and disappeared when optionable stocks became non-optionable. It transpires that the models outlined in this thesis can be used to partly explain and quantify such interesting market behaviour. The most comprehensive empirical investigation of stock price pinning was undertaken by Ni et al. and on non-expiration 155 . Krishnan and Nelken (2001) observed Microsoft stocks (during the period 1990-2001) and concluded that the probability of the stock price pinning at strike (i. however. Ni et al. who provided striking evidence that the presence of options perturbs the prices of underlying stocks. First. despite understandable interest from market professionals. we start by discussing some of the empirical evidence for stock pinning.29%. (2005).Chapter 8 Explaining the Stock Pinning Phenomenon This chapter aims to illustrate one of the most documented forms of price impact. being within a small of strike) on expiration days was 23. Stock pinning is defined as the tendency of stock prices to move to the strike price of heavily traded option contracts as the options approach expiry. more specifically that on expiration dates. that of the stock pinning phenomenon. (2005) suggested that this pinning effect is most likely due to delta hedgers moving the price and possibly due to intentional market manipulation.e. Prior to this there had been little indication of any significant impact.

This can be calculated via the Kolmogorov backward equation which is given by1 ∂P 1 2 ∂2P ∂P + µ(S.CHAPTER 8. i. With this in mind Avellaneda and Lipkin (2003) therefore make the assumption that the underlying stochastic process is modified to dS = S µ − nE ∂∆ ∂t dt + σdWt . (8.6). note the negative sign.1) where n is the open interest and E a constant price elasticity term. Avellaneda and Lipkin (2003) described anecdotal evidence of the pinning of J. The rational behind this is as follows: If large institutions such as hedge funds sell options to market makers (defined in section 1. ∂∆ dS ∼ dt. t) 2 = 0. If the large institution is not also hedging the sale of the options. they must become short the underlying in order to hedge their position. The model assumes that the price impact is proportional to the ‘rate of change’ of the Black-Scholes delta. undertaken to maintain delta hedges on existing net-purchased-option positions is allowed to impact the price and as a consequence pushes the stock price toward the strike price as expiration approaches. t) + σ (S. Edwards stocks in 2003. t).52%.2) See for example proposition 5. ∂t ∂S 2 ∂S 1 (8. counter to the assumptions made in chapter 2. In addition. defined as the probability.e. then the net position (of the buyer and seller of the option) in the market for the underlying will be short. EXPLAINING THE STOCK PINNING PHENOMENON 156 days was only 13. denoted P(S. Since the market makers will be long options.11 of Bj¨rk (2004) o .1 Linear price impact Avellaneda and Lipkin (2003) developed a model in which stock trading. i. but rather on calculating the so-called pinning probability. that the stock price will end up at S = K at t = T . then the market makers will inevitably hedge their position. S ∂t Furthermore they argue.e. The focus of the work by Avellaneda and Lipkin (2003) is not on option pricing.D. 8. that the net position (in stock) of delta hedgers in the market is short rather than long. pinning.

P(S. for the special case µ = 0 and r + 2 σ 2 = 0.3b) Furthermore. t) the volatility.1) this corresponds to solving the system ∂∆ ∂P + µS − nE ∂t ∂t ∂P 1 2 2 ∂ 2 P + σ S = 0. which can calculate directly as ∂∆ = ∂t 1 log(S/K) − r + 2 σ 2 (T − t) 3√ 2σ(T − t) 2 2π 1 log(S/K) + r + 2 σ 2 (T − t) exp − 2σ 2 (T − t) 2 . (8. correspondingly.CHAPTER 8.4) 1 Avellaneda and Lipkin (2003) showed that. otherwise. In fact. Jeannin et al. this might be expected since. ∂S 2 ∂S 2   1. and more importantly r + 1 σ 2 = 0 the authors showed that there still exists a positive 2 probability of pinning.3) numerically. the system (8. To determine this probability however we are required to solve (8.5) from which it is clear that there is a greater pinning probability when nE is increased.3) admits an exact solution given by P(S.3a) if S = K. we assume for simplicity (and to be consistent with the original paper) that the delta is given by the delta of a call option. t) = 1 − exp − log(S/K) nE exp − 2σ 2 (T − t) 2π(T − t) 2 σ . a decreased probability above. (8. EXPLAINING THE STOCK PINNING PHENOMENON 157 where µ(S. (8. (2006) commented on the similarities of the model with those outlined in this thesis. For the case when µ = 0. Doing so we see that an increase in r results in an increased pinning probability below the strike price and. the process will drift upwards more on average. the above model can be seen as simply an approximation to the form of price impact considered in this thesis with any terms from the quadratic variation of the process and the effects on the volatility ignored.1 shows the solution to equation (8. for an increase in r. T ) =  0.5) Figure 8. t) is the drift of the process and σ(S. This can be seen more clearly by considering . (8. Subsequent to the work of Avellaneda and Lipkin (2003). For the model of (8.

ˆ ˆ S Hence the model of Avellaneda and Lipkin (2003) only includes the time derivative term of the change in delta.3 S Figure 8.. since 1 + nES ∂∆ > 0 in the entire domain. hedging a long call option position) is decreased in the region of the strike. K = 1. this is due to the net long ∂S option position assumption. The Note that for (8. This can be attributed to the fact that not only does the price impact affect the drift of the process it also affects the volatility.9 0.6 P 0.e.7 0.6) dS = µ(S.1 1.6) the problems associated with the vanishing of the denominator highlighted in this thesis are not present.1: The pinning probability (8. . t)dWt . t)dt + σ (S. 5.7 0. and σ = 0. the following dS = µdt + σdWt − nEd∆(S.5) for values of nE = 0. 1.1 0 0.6) and showed that the pinning probability was higher in this case than the corresponding Avellaneda and Lipkin (2003) model.1.5.5 0. t) S ∂∆ ∂∆ 1 ∂2∆ = µdt + σdWt − nE dt + dS + (dS)2 2 ∂t ∂S 2 ∂S = ⇒ 1 µ − nE 1 + nES ∂∆ ∂S ∂∆ σ2S 2 + ∂t 2 1 + nES ∂∆ ∂S ∂2∆ 2 ∂S 2 dt + σdWt .4 0. EXPLAINING THE STOCK PINNING PHENOMENON rag replacements 158 1 0. 1 + nES ∂∆ ∂S (8.9 nE increasing 1 1. 2 . whereas the model outlined above includes the time derivative and the delta convexity term.CHAPTER 8. which for the case investigated above (i.8 0.2 0. . (2006) solve the associated Kolmogorov equation (numerically) to determine the pinning probabilities for the more accurate model (8.2. T −t = 0.3 0. .8 0.2 1.2 Jeannin et al.

7 0.6 0.e. possibly helping to explain the concavity of the price impact function. (2003) concluded that price impact is well described by a power . (2002) showed that this relationship is sublinear (i. Bouchaud et al. empirical work by Kempf and Korn (1999) brought into question the reliability of the assumption of linear price impact using empirical evidence on German index futures.2 shows comparisons of the pinning probabilities for the model (8.9 0. for the same value of nE.1 0 0. σ = 0. and the Avellaneda and Lipkin (2003) model. Lillo et al.2 Figure 8.CHAPTER 8.15 1. Furthermore. 0.8 0.8 PSfrag replacements 0. Figure 8.3 0. concave) and further still. 2 8. finding that the average order book has its maximum away from the best bid (or ask).2.1.6) (solid line) with the model of Avellaneda and Lipkin (2003) (dotted line) for nE = 0.05 1.1 1. EXPLAINING THE STOCK PINNING PHENOMENON 159 combined effect is that the drift pushes the underlying towards the strike and the reduced volatility effectively keeps the underlying in the vicinity of the strike.6). (2002) studied the distribution of the order flow and the resulting average order book. obtained from the associated Kolmogorov backward equation.2 0. Plerou et al.85 0. This motivated several studies to determine quantitatively how a market order of a given size would affect the price of the underlying.2: Comparing the pinning probability associated with (8.5 P 0.4 0. T − t = 0. and r + 1 σ 2 = 0.95 S 1 1. K = 1.1.2 Nonlinear price impact Recently.

6) but with increased volatility around strike rather than decreased. (2003) hypothesised that p = 1/2. EXPLAINING THE STOCK PINNING PHENOMENON 160 law where the change in price (dS) caused by an order of volume w is given by dS(w) ∼ w p where p is found to be between 0. In addition. (2007) attempted to incorporate the empirical evidence of nonlinear price impact into the linear model first introduced in Avellaneda and Lipkin (2003).CHAPTER 8.5. These agent-based models aim to reproduce the main stylized facts observed in real financial markets. In recent years a number of computer-simulated. Jeannin et al. which is at odds with their numerical solutions of the model (8. again a concave function. such as fat-tailed distributions of returns and volatility clustering. . (2006) proposed such an agent-based model (based on a double auction) in an attempt to model stock pinning whilst also incorporating the aforementioned nonlinear price impact. artificial financial markets have been constructed.1 and 0. (2005) proposed a 3/5 power dependence whereas Gabaix et al. Simulations of the model give the same qualitative effect on the drift as the model described by (8. More recently. Avellaneda et al. However the value of p is greatly contested in the literature and there has been many attempts to determine its value.6). Almgren et al. This still remains an open question in the empirical literature. They do so by assuming a price impact of the form dS ∼ sgn S ∂∆ ∂t ∂∆ ∂t p dt hence they assume the stochastic process for the underlying in the presence of delta hedgers hedging a long call position to take the form dS = S µ − nE sgn ∂∆ ∂t ∂∆ ∂t p dt + σdWt . recent work by Potters and Bouchaud (2003) suggested that this relationship may be better described by a logarithmic price impact function. see LeBaron (2000) for a review of work in the field.

0.15 1.7b) and conversely a non-zero probability if p > 1 .1. 1. σ = 0.7) for five values 2 of the exponent p.2 and r + 1 σ 2 = 0.9 0.7 0.8 0.2 0.3 A new nonlinear price impact model The aim of this section is to suggest a possible extension to the model which would incorporate the empirically observed power-law price impact into the more accurate (linear) price impact model (8.8. (2007) showed that there is a zero probability of pinning if p ≤ PSfrag replacements 1 2 ∂P 1 2 2 ∂ 2 P + σ S = 0.2. T ) =  0. Figure 8. EXPLAINING THE STOCK PINNING PHENOMENON 161 It is clear that the pinning probability under such assumptions will be given by the solution to the following Kolmogorov backward equation ∂P + µS − nE sgn ∂t ∂∆ ∂t ∂∆ ∂t p in conjunction with the previously calculated delta (8.7) for p = 0. The most consistent way to extend the model .9. .2 Figure 8.05 1. . otherwise. ∂S 2 ∂S 2   1.5 p=1 P 0.6).1 0 0. .3 shows the numerical solution to (8. (8. (8.1 1.6 0. . 0.3: Solution to (8.7a) if S = K.4). K = 1.4 0. it can be clearly seen that the pinning probability is monotonic increasing in p.85 0.CHAPTER 8. T − t = 0.3 0. Avellaneda et al.95 S 1 1. 2 8.8 0. P(S.

4 shows the solution to equation (8. T ) =  0. It appears that p2 has a greater affect on the solution than p1 . Note that for p1 = p2 = 1 this reduces to the model of Jeannin et al.8) for various combinations of p1 and p2 . σ σ dWt . (2006). t) and σ (S. (8. EXPLAINING THE STOCK PINNING PHENOMENON 162 would be to assume a price impact of the form dS ∼ (d∆)p S ∂∆ ∂∆ 1 ∂2∆ dS ∼ dt + dS + (dS)2 S ∂t ∂S 2 ∂S 2 p however clearly this makes little mathematical sense.8b) Figure 8. ∂t ∂S 2 ∂S 2   1.6) and the parameters p1 and p2 model the ˆ ˆ degree of nonlinearity. The corresponding Kolmogorov backward equation is thus given by ∂P 1 ∂2P ∂P + sgn(ˆ) |ˆ|p1 µ µ + sgn(ˆ ) |ˆ |2p2 σ σ = 0. 3 Note that this is effectively assuming that the change of the log price with respect to time and the Brownian motion is given by d log S p ∼ sgn(ˆ) |ˆ| 1 .6). P(S. further investigation of this model. t) are given by (8. (8. however.CHAPTER 8. is left as the subject of future research. We instead choose to model nonlinear price impact as3 dS = sgn(ˆ) |ˆ|p1 dt + sgn(ˆ ) |ˆ |p2 dWt µ µ σ σ S where µ(S. namely (8.8a) if S = K. µ µ dt d log S p ∼ sgn(ˆ ) |ˆ | 2 . otherwise.

15 1.2 .4: Solution to equation (8.8 0.5 0. S 1 1.85 0.6 0. K = 1.8 p2 = 1 0.2 p2 = 0.8 p1 = 1 PSfrag replacements p1 = 0. 1 and 1.8 p1 = 1 p1 = 1.9 0.5 0.95 (b) p1 = 1.4 0.05 1.1.2.8.5) (dotted line) for T = 0. p1 = 0.8.7 0.8 0.05 1.8) (solid line) compared to (8. σ = 0.2 0.2.1 1.CHAPTER 8. S 1 1.2.85 0 0.2 0.6 0.15 1.1 0 0.9 0.1 1.2 0. EXPLAINING THE STOCK PINNING PHENOMENON PSfrag replacements 163 P P Figure 8.3 0. and r + 1 σ 2 = 0.8 p2 = 1 p2 = 1.1 p1 = 1.3 0. 1 and 1.2 0.8 0.7 p2 = 1.4 0. 2 p2 = 0. p2 = 0.2 0.8 0.95 (a) p2 = 1.2 p1 = 0.

Chapter 9 The British Option
The most important questions of life are, for the most part, really only problems of probability. - Pierre Simon Laplace (1749-1827) Th´orie Analytique des Probabilit´s (1812) e e In this chapter we aim to investigate the mathematical properties and financial motivations of the newly introduced British option (see Peskir and Samee, 2008a,b), a new non-standard class of early exercise option; such options can help to mediate the illiquidity effects discussed in the preceding chapters.

9.1

Introduction

The no-arbitrage price of an early-exercise option uses the implicit assumption that the holder of the option will act optimally in the sense of following the optimal strategy of exercising upon first hitting the rational exercise free boundary (cf. section 1.3.5). If the holder of the option chooses to deviate from this strategy, then the expected discounted payout (under the risk-neutral measure) will be less than the amount the writer received for the option at the start of the contract.

164

CHAPTER 9. THE BRITISH OPTION

165

Recall that the risk-neutral pricing measure is used to determine the no-arbitrage price of the option, since the writer of the option can completely hedge away risk. Indeed, if we make the assumption that the writer of an early-exercise option will hedge away the risk exposure associated with selling such an option, then from the writer’s perspective at least, the exercise strategy followed by the holder is irrelevant. For the purposes of this chapter, we shall assume that writers of early-exercise options perfectly hedge their positions, hence eliminating any risk associated with the options. The holder of such an option is assumed not to be hedging the position; instead, he is interested in maximising profit given his view on the market. Peskir and Samee (2008b) define such investors as true buyers, i.e. those who have no ability or desire to sell the option; in short holders of ‘naked’ (unhedged) options. In this case, the exercise strategy for the true buyer is of paramount importance. Furthermore, since the true buyer has no interest in hedging his position, the real world drift of the underlying will play a role in determining the rational exercise strategy. Let us suppose initially that the holder of an early-exercise option knows with certainty the true drift of the underlying µ, and that it differs from the risk-neutral drift rate r. In such a situation, the optimal exercise boundary for the true buyer would deviate from the optimal exercise boundary under the assumption of a risk-free drift. In fact, the true buyer’s rational exercise boundary would be given by the free boundary of the following optimal stopping problem1 V (S, t; µ) = sup EP e−r(γ−t) (K − ST )+ , S,t
t≤γ≤T

recall that the indices of the expectation denotes that the process is started at S at time t and that the expectation is taken under the real world probability measure P . Furthermore, such a buyer would presumably not invest in a put option unless the true drift µ were less than the risk-free interest rate r, otherwise the true buyer would purchase a call option.
1

Note that here we are making the assumption of a risk-neutral investor (in the utility sense).

CHAPTER 9. THE BRITISH OPTION

166

Unfortunately, the drift of a stochastic process is notoriously difficult to measure, and so investors would not be able to know the true drift with any degree of certainty. They can however have an estimate of the true drift, or a ‘view’ on the future direction of the underlying, which they wish to take advantage of by buying such options. In this case the true buyer has become a speculator in the sense of seeking to maximise gains or minimise losses given his particular sentiment of future market conditions. In other words a speculator who chooses to invest in an early-exercise option must be under the belief that the true drift of the underlying process is less than the risk-neutral drift r. The British option, recently proposed by Peskir and Samee (2008a,b), is a new class of early-exercise option that attempts to utilise the idea of optimal prediction in order to provide the true buyer with an inherent protection mechanism should the true buyer’s beliefs on the future price movements not transpire. More specifically, at any time γ during the term of the contract, the investor can choose to exercise the option, upon which he receives the best prediction of the European put payoff (K − ST )+ (given all the information up to the stopping time γ) under the assumption that the drift of the underlying is µc , the so-called contract drift, for the remaining term of the contract. Hence the (now time-dependent) payoff profile of the early-exercise British put option is given by G(S, γ; µc ) = ER (K − ST )+ |Fγ , where the expectation is taken with respect to a new probability measure R, under which the stock price evolves according to dSt = (µc − D)St dt + σSt dWtR , where we have included (in anticipation of what will follow) a constant dividend yield D. The value of the contract drift is chosen by the holder of the option at the start of the contract and is selected to represent the level of protection (from adverse realised drifts) that the holder requires; a higher µc corresponds to a lower level of protection.

CHAPTER 9. THE BRITISH OPTION

167

9.2

The no-arbitrage price

Let us fix a probability space (Ω, F , Q), where Ω describes a financial market with a filtration (Ft )t≥0 , which represents the information structure of the financial market (see Harrison and Kreps, 1979) with the unique risk-neutral measure Q. Assume that St is an Ft -adapted stochastic process that describes the stock price process. Analogous with the American option defined in subsection 1.3.5, the no-arbitrage price of the British put option is given by the supremum over all stopping times γ (adapted to the filtration Ft generated by the process St ) of the expected discounted future payoff. In contrast with an American option, the future payoff is now itself an expectation, i.e. V (S, t) = sup EQ e−r(γ−t) ER (K − ST )+ |Fγ S,t
t≤γ≤T

.

Recall that the future payoff is defined as the best prediction of the European payoff, conditional on all the information available up to the stopping time γ. There are numerous approaches to evaluating this expectation, for example we could directly use the probability density function of the process under the measure R, to give ER (K − ST )+ |Fγ =
∞ 0

(K − z)+ f R (S, γ; z, T )dz,

where f R (S, γ; z, T ) is the transitional probability density function of the process started at time γ at the position S and finishing at time T at the position z and is given by2 f (S, γ; z, T ) =
R

σz

1 exp 2π(T − γ)

− log

z S

1 − µc − D − 2 σ 2 (T − γ) 2σ 2 (T − γ)

2

.

Tackling the above integral would provide us with the required expectation; however, we shall adopt an alternative approach in order to give some intuition behind the resulting expression. We can evaluate the expectation using direct integration with respect to the probability measure R over the probability space Ω, i.e. ER (K − ST )+ |Fγ =
2

(K − ST )+ dR.

See appendix C for a derivation.

where the probability is now conditional on the filtration of information up to the stopping time γ. where at the final step we have made the substitution u = value is thus given by V (S. Finally we have our expression for the conditional expectation   K log K−y − µc − D − 1 σ 2 (T − γ) Sγ 2  dy √ ER (K − ST )+ |Fγ = Φ σ T −γ 0 = Sγ 0 K Sγ Φ 1 log u − µc − D − 2 σ 2 (T − γ) √ σ T −γ K−y .   log K−y − µc − D − 1 σ 2 (T − γ) Sγ 2 . THE BRITISH OPTION 168 The random variable is a real valued function whose domain is given by ST ∈ [0. We can now exploit the fact that (see appendix C) K−y 0 where Φ denotes the standard normal distribution function 1 Φ(z) = √ 2π z −∞ R(z ∈ dz|Fγ ) = PR [z ≤ K − y|Fγ ] .t e −r(γ−t) Sγ 0 K Sγ Φ log z − µc − D − 1 σ 2 (T − γ) 2 √ σ T −γ dz .CHAPTER 9. Further simplification gives K 0 (K − z)R(z ∈ dz|Fγ ). . √ = Φ σ T −γ 1 2 e− 2 y dy. Sγ du. t) = sup t≤γ≤T The British option EQ S. ∞) and so the integral can be written as ∞ 0 ∞ 0 ∞ 0 (K − z)+ dR(z) = (K − z)+ R(dz) = (K − z)+ R(z ∈ dz|Fγ ). where we have also changed the order of integration. In order to evaluate this integral we rewrite the function K − z as an integral to give K z=0 K−z K K−y dyR(dz) = y=0 y=0 z=0 R(dz)dy.

we have that the problem now reads V (S. G(S. For the standard American put option the gain function is simply the (time homogeneous) payoff profile i. σ T −t (9.11) and so we can directly see the links with the existing American option theory. µc ) = log log K S K S (9. µc ) . t) > G(S. µc ) − Se(µc −D)(T −t) Φ d2 (S. with the optimal stopping time defined as γ∗ = inf{t ∈ [0. µc ) = d2 (S.3 It remains to find an analytical expression for G(S. t)} (stopping set). section 1. t) = G(S. t. where d1 (S. t.CHAPTER 9. t) = S 0 K S Φ log z − µc − D − 1 σ 2 (T − t) 2 √ σ T −t dz. t) : V (S. t) = sup EQ e−r(γ−t) G(S. THE BRITISH OPTION 169 Defining the function G(S. t. GA (S. 3 . t) : V (S. t) = (K − S)+ .5) we have that C = {(S. t. S.2b) Note that the dependency on the contract drift rate µc has been stated explicitly.t t≤γ≤T This is the standard form of an American-type option (cf. General optimal stopping theory can now be applied to this problem analogous with the American option problem (cf.e.3.1) − µc − D − 1 σ 2 (T − t) 2 √ . t) = KΦ log K S − µc − D − 1 σ 2 (T − t) 2 √ σ T −t log K S − Se(µc −D)(T −t) Φ Alternatively this can be written as 1 − µc − D + 2 σ 2 (T − t) √ σ T −t . σ T −t √ − µc − D + 1 σ 2 (T − t) 2 √ = d1 (S. γ) . T ] : St ∈ D}. µc ) − σ T − t. D = {(S.2a) (9. equation 1. t) which can be done easily with integration by parts to give G(S. t)} (continuation set). t. t) = KΦ d1 (S.

 t SS S  2      V (S.       V = G in D.3) with the gain function G(S.1 The gain function This section briefly comments on the links between the gain function G(S.1). the first time that the stock price enters the stopping region.e. t) correctly. Before we continue. t. t) : S ∈ (b(t). (9. r) .CHAPTER 9. where d1 (S. the free boundary. Now applying standard optimal stopping and Markovian arguments. let us first take a closer look at the gain function. t) = G(S. t. t) on S = b(t).2. t) and the analytical expressions of the corresponding European option values. This is intuitive as the payoff is the best prediction received now and so involves no discounting. ∞)}. t) on S = b(t) (smooth fit). Note that the Black-Scholes European put value is given by P VE (S. Also note that as t → T we have that Φ(d2 ) → Φ(d1 ) → 0 for S > K and conversely Φ(d2 ) → Φ(d1 ) → 1 for S < K . t)|µc =r = er(T −t) VE (S. 9.      V > G in C. t). t) given by equation (9. again analogous to the American put option. and hence C = {(S. Note that this looks very much like the gain function and indeed if µc = r. t) = Ke−r(T −t) Φ d1 (S. The above identity can also be used to check that we are calculating G(S. t) = GS (S. THE BRITISH OPTION 170 i.2a) for µc = r. t. the problem can be conveniently expressed as the following free-boundary problem:   V + 1 σ 2 S 2 V + (r − D)SV − rV = 0 for S ∈ [b(t). unlike the European option value. then it is clear that P G(S. ∞). r) emphasises the dependence on the parameter r and is given by equation (9. It can be shown (see Peskir and Samee. r) − Se−D(T −t) Φ d2 (S. 2008b) that the stopping and continuation regions are separated by a smooth function b(t).    VS (S.

namely G(S. In fact.4) which has the effect of concentrating the grid points close to expiry. the entire . subject to the constraint V (S. In addition. In addition it is advantageous to make the transformation τ= √ T − t. For example. compare Geske (1977).e. a standard American option written on an underlying European option has simply the same value as the underlying European option. resulting in non-trivial solutions. i. the region where the solution is changing most rapidly. t) ≥ G(S. However the innovation with the British option considered here is that the two options are priced under different measures. By far the easiest to implement is the Projected Successive Over Relaxation (PSOR) algorithm. T ) = (K − S)+ .CHAPTER 9.3 Numerical treatment The (nonlinear) system (9. t) at every node and iteration. an option on an option. there exists no optimal early-exercise region. Whaley (1982) and Hodges and Selby (1987). i.e. and often leads to trivial solutions. Furthermore. which attempts to solve the appropriately discretised and linearised system (typically based on a Crank-Nicolson discretisation scheme). This type of option has been studied extensively. THE BRITISH OPTION 171 which indicates that in this limit the gain function takes on the form of the standard put payoff condition. transforming to log-space via ˆ the transform S = log S K will simplify the resulting equations.3) can be solved numerically via a number of different methods. (9. which is consistent with the fact that at t = T clearly the best prediction of the put payoff will be the payoff itself. this suggests that the British option may be considered as a compound option. Geske (1979). 9.

but to retain financial intuition. ∞). Body-fitted coordinates where first proposed by Landau (1950) and later applied to finite-difference schemes by Crank (1957). where the free boundary now becomes an additional variable in the problem. ˆ This effectively maps the continuation region S ∈ [b(τ ). increasing the computation time at a disproportionate rate to the increased accuracy gained in the free-boundary estimate.  2 ∂τ      V (S. was employed for the results given in the present chapter.5).4)). the body-fitted coordinate system. and further if a more accurate estimate of the free-boundary location is needed. some form of interpolation is needed. For these reasons a more sophisticated method. THE BRITISH OPTION 172 system (9. The drawback of this method is that we now have a more complicated equation to solve. Non-dimensionalising makes the system more parsimonious. Despite the PSOR algorithm’s ease of implementation. its major drawback (for the purposes of this exposition) is that in order to determine the location of the free boundary accurately.3) can be non-dimensionalised via an appropriate set of transformations.    ˆ  V > G for S ∈ (1. The idea behind this technique is to make the transform (in addition to the time change (9. but it . t) on S = 1 (smooth fit).       V = G for S ∈ [0. in what follows we choose to retain the dimensional form. S= b(τ ) (9. ∞) onto the fixed domain (9. ˆ ˆ ˆ    ˆ ˆ ˆ ˆ  VS (S. More recently Widdicks (2002) adapted the scheme to solve the standard American option problem and Johnson (2007) to more complex options (involving multiple free boundaries).6) where the gain function must also be transformed via (9. which for the interested reader can be found in appendix B. t) = G(S.5) ˆ S ∈ [1. t) = GS (S. then the number of grid points must be increased. S ˆ . ∞). 1].4) and (9. Making these changes of variables yields the following modified fixed boundary problem  1 1  ˆ ˆˆ ˆ ˆ ˆ  2τ Vτ − 1 σ 2 S 2 VS S − r + 2τ b(τ ) ∂b(τ ) SVS + rV = 0 for S ∈ [1. ∞). t) on S = 1.CHAPTER 9.

9 S 0.4.6 0..95 0.4 0.05 1 0. 0.4 0. 0.6 0.16.5. 1. 1. K = 1. . µc = 0.2 the variation with the volatility . since no interpolation to calculate the free boundary is required.75 0. and µc = 0.8 0.11.1.8 σ increasing 0. 0.1 0.1 1.85 0. T = 1.8 µc increasing 0. and σ = 0.7 0..9 1 Figure 9. K = 1. . Note that this method provides highly accurate results for the free-boundary locations.1 shows the location of the British put option free boundary for varying values of the contract drift µc and in addition figure 9.CHAPTER 9. D = 0.2 0.9 S 0. T = 1.1 0. .2 0.3 0.1. D = 0.65 0 0.2: The British put option free boundary for varying volatilities. r = 0.125.1 1 0.5 0 0. 0. .1.9 1 Figure 9.05.3 0.115. THE BRITISH OPTION PSfrag replacements 173 is now in a fixed domain and standard finite-difference methods for such problems are well understood and easily applicable.7 0. σ = 0. .5 t 0.12.5 t 0. r = 0.1: The British put option free boundary for varying values of the contract drift.8 0. . Figure 9.7 0. 0.7 0.6 PSfrag replacements 0.

Also the volatility appears to have a significant influence on the shape of the free boundary. there exists a value of µc below which all British option free boundaries at t = 0 lie above the current stock price. THE BRITISH OPTION 174 (for a fixed µc ).5. This non-monotonic behaviour can lead to complications in the convergence of the numerical schemes employed and in addition can result in subtle difficulties when trying to prove the regularity and smoothness of the free boundary (see Peskir and Samee. also resulted in differing free boundaries. r µc = const. hence the optimal investor would choose to exercise immediately. in particular in the asymptotic analysis. In what follows. It can be seen that as the contract drift parameter increases the free boundary (and its value at expiry) collapses downwards monotonically to zero. for some values of the contract drift at least.e. b(0) > S0 and so the investor is automatically placed in the exercise region at the initiation of the contract. the boundary behaviour is no longer monotonic. 2008b).CHAPTER 9. i. Finally.e. varying µc and keeping the ratio of the contract drift to interest rate constant. Furthermore. The most striking difference with the American option free boundary is that. i. although in the latter case all free boundaries asymptoted to the same value at expiry. In fact the exact location to which the free boundary asymptotes and its behaviour close to expiry is determined in section 9. Note that some parameters (such as volatility) have been chosen artificially high in order to illustrate the distinct behaviour of the British option free boundaries. numerical investigations showed that varying µc but keeping the difference between µc and interest rate r constant resulted in distinct free boundaries. Another interesting point to note is that for a given investor at t = 0 with current stock price S0 . More information about the relationship between the parameters could be gleaned from a consideration of the fully non-dimensionalised problem (see appendix B) but this shall be left as the subject of future research. . regularity and smoothness shall be implicitly assumed..

T − t → ∞ (effectively the perpetual limit). Since this section is concerned with the large time to expiry behaviour of the free boundary.7) which will be of use in our analysis. dependent on the choice of the parameter µc .8) where γB is defined as γB = inf{t ∈ [t. γB ) = G(S. since it is a known analytic function which we shall calculate shortly. t) > 0. t) if H(S. we will ultimately be interested in the behaviour of Sh in this limit. t + u)du .1 suggest that the free boundary for the British put option either tends to infinity or tends to zero in this limit. THE BRITISH OPTION 175 9. / i. It is a standard result from optimal stopping theory that the free boundary cannot be contained in the region in which H(S. . t) = L G(S. t) = Gt + σ 2 S 2 GSS + (r − D)SGS − rG. or at least provide an upper bound on the location of the free boundary at any given instant. 2 (9. the first exit time of the process from the domain B defined as an arbitrary small half-circular domain around the point (S. As such the solution to H(Sh . t) > 0. Φ (d2 ) = 4 K −(µc −D)(T −t) e Φ (d1 ). the numerical results showed in figure 9.e.8) it is clear that the expected future gain (the left-hand-side) must be greater than the current gain G(S. t) and so the free boundary cannot be located in the region where H(S. t) ∈ B}. indicating it would not be optimal to stop at (S.CHAPTER 9.9) See for example Peskir and Shiryaev (2006). t) + E Q 0 γB −t e−ru H(St+u . The following analysis will try to shed some light on these two distinct regimes of behaviour. S (9. t). (9.4 Free boundary analysis far from expiry Far away from expiry. From (9. t) > 0. t) = 0 will act as an analytical proxy for the free boundary. First we introduce the following function 1 H(S.e. Making extensive use of the identity. i.4 This can be easily seen by directly applying Itˆ’s formula to the discounted gain function and o taking expectations to obtain E Q e −r(γB −t) G(SγB . T ] : (St .

the same qualitative behaviour that can be seen for the true free boundary. which after substitution into (9. This is an important point. (9.12) for Sh = Sh (t). Guided by numerical differentiation it appears that the solution for Sh for large values 5 Note also that the dividends do not occur anywhere but in the exponents. suggesting a critical value of µc which separates two distinct regions of asymptotic behaviour of Sh (t). namely tending to infinity or to zero. we are able to infer that the free boundary must also tend to zero in that limit.12) obtained using standard Newton-Raphson iteration. (9. . t) − rKΦ d1 (Sh . Figure 9.3 shows the solution of equation (9. t) = µc Se(µc −D)(T −t) Φ(d2 ) − rKΦ(d1 ).7) yields5 H(S. Note that the converse is not necessarily true. we can directly compute each term in the H-function as Gt = − σKe− 2 d1 2 2π(T − t) Ke− 2 d1 σS 2 2π(T − t) 1 2 1 2 + (µc − D)Se(µc −D)(T −t) Φ(d2 ). since if we can show under what circumstances the value of Sh (t) tends to zero for large times to maturity. It is hypothesised that if Sh → 0 as T − t → ∞ then since the free boundary must lie below Sh (t) then the free boundary must also tend to zero as T − t → ∞.11) This pleasingly simple expression for the H-function can now be used to provide us with an upper bound on the location of the free boundary. To do this we are interested in the solution to the equation µc Sh e(µc −D)(T −t) Φ d2 (Sh . and furthermore in the limit T − t → ∞.CHAPTER 9. It can also be seen that for large enough values of the contract drift. Sh (t) appears to tend to zero with no visible turning point.10) GS = −e(µc −D)(T −t) Φ(d2 ). t) = 0 (9. THE BRITISH OPTION 176 where primes denote derivatives. GSS = . The first point to note is that Sh is not monotonic for some values of the contract drift µc .

r = 0. σ (9. 0. for varying values of the contract drift. σ Now it is clear that in the limit T − t → ∞.2 (Sh . .5 0 0 10 20 t 30 40 50 Figure 9. . t) = log K A (9.2 (Sh .2 will tend to ±∞ depending on the sign of the parameter ν± . of T − t takes on an exponential form.104. T = 50. i. t) = − 1 σ The equation for Sh (t) in the limit T − t → ∞ thus becomes µc Ae(µc −D+β)(T −t) Φ − 1 (µc − D + 2 σ 2 + β) √ T −t σ 1 (µc − D − 2 σ 2 + β) √ = rKΦ − T −t . 2 which as T − t → ∞ the second term dominates giving T −t→∞ lim d1. Therefore making this ansatz we can see that d1.3: The zero of the H-function.CHAPTER 9. Sh (t) ∼ Aeβ(T −t) as T − t → ∞. . µc = 0. THE BRITISH OPTION rag replacements 177 2 1. i. In order to provide an appropriate . K = 1. the functions d1. 1.4. and σ = 0.13) − µc − D ± 1 σ 2 + β (T − t) 2 √ .5 Sh 1 µc increasing 0.102. σ T −t √ 1 µc − D ± σ 2 + β T − t. Sh (t).1.e. .14) For convenience in what follows we shall define 1 µc − D ± 2 σ 2 + β ν± = .e. D = 0.

to obtain µc e(µc −D)(T −t) dSh ∂d1 σµc − (µc − D)Sh Φ(d2 ) + KΦ (d1 ) (µc − r) + √ dt ∂t 2 T −t = 0.. only provides us with one equation for two unknown constants A and β.. 1968) that for large negative values of the arguments z.. .3 . .2 → −∞ in the limit. the cumulative normal distribution function Φ(z) has the following asymptotic expansion e− 2 z Φ(z) = − √ z 2π 1 2 (9. . Equation (9. THE BRITISH OPTION 178 balancing of terms in the following analysis we assume that both functions d1.14) becomes µc Ae(µc −D+β)(T −t) − 1 ν+ (T −t) 2 = e 2 ν+ 2π(T − t) ν− that 1 (µc − D + 2 σ 2 + β)2 1 2 µc − D + β − ν + = µ c − D + β − 2 2σ 2 (µc − D − 1 σ 2 + β)2 2 =− 2σ 2 1 2 = − ν− . noting that Sh is a function of t. . z2 z z 2n (9. .+ +.12). . i. (2n − 1) 1 + 4 +.15) 1− 3 (−1)n 1..18) This. Next we use the well known result (see for example Abramowitz and Stegun. In order to determine their value uniquely we can obtain another equation by differentiating (9.17) Finally considering the exponent of the exponentials on the left-hand-side we can see which remarkably allows us to cancel through all exponential terms leaving the much simpler equation rK µc A = .16) note that a similar expression exists for large positive z. 2π(T − t) e− 2 ν± (T −t) + .. This can only be achieved if ν± > 0. ν± 2π(T − t) 1 2 (9.. ν+ ν− (9. if 1 1 β > σ 2 − µc + D > − σ 2 − µc + D.. however. .e. 2 2 a condition which can (and will) be checked a posteriori. 2 1 2 rK e− 2 ν− (T −t) + .16) gives to leading order that √ Φ −ν± T − t = therefore equation (9.CHAPTER 9.

i. Sh .21) is consistent with the initial assumption (9.15). Also note that since µc +r µc −r > 1 for µc > r. and so to summarise we have found that for T − t → ∞ the zero of the H-function. 2 1 ⇒ 2r (µc − D + β) = (µc − r) µc − D − σ 2 + β 2 1 + σµc µc − D − σ 2 + β .20) Finally solving the (quadratic) equation (9. THE BRITISH OPTION 179 Once again making the ansatz (9. substitution of the found value for β. we can arrive at the following expression. Finally.21) is also consistent with the observation (as seen in figure 9.21).15). Also note that this result is consistent with the fact that as µc → r the free boundary appears to be tending to infinity at an increasing rate. back into equation (9. suggesting that it is always optimal to early exercise immediately.21) where we have taken the positive root in order not to violate the assumption (9. again provided ν± > 0 µc K (µc − D + β) A = (µc − r)ν− + σµc .19) leads to the following 2 2r (µc − D + β) = (µc − r)ν− + σµc ν− . adding credence to the obtained result.13) and performing a similar analysis to the above. ν+ 2 (9. (9. equation (9.CHAPTER 9.21). will behave as Sh (t) = Keβ(T −t) where β is given by equation (9. Equation (9. The more useful corollary of this result however is that clearly if β > 0 then Sh (t) → ∞ for large values of T − t and conversely if β < 0 then Sh → 0.2) that the volatility appears to greatly affect the behaviour of the free boundary.18) and (9. the positive root. i. c .20) for β yields 1 β = σ2 2 µc + r µc − r − µc + D (9.e. 2 (9. The critical value of the parameter µc which separates these two distinct regimes is given by the solution to the equation 1 β = σ2 2 µ∗ + r c ∗ −r µc − µ∗ + D = 0.18) gives immediately that A = K.e.19) Now eliminating the unknown A from equations (9.

We have shown that in the limit Sh (t) takes on the form Keβ(T −t) . however only c 2 the positive root will be greater than r.5 Analysis close to expiry Also of great interest is the behaviour of the free boundary close to expiry. suggesting that the transformation ˆ S = Se−β(T −t) (9. 9. In fact as the function Sh (t) ˆ provides an upper bound for the location of the free boundary. it is clear that in (S. regardless of the value of the contract drift µc . t)-space will be better behaved in the absence of any numerical breakdowns.23) may help remove any exponentially growing behaviour. The large time to expiry behaviour can be used to make an appropriate transformation that removes the observed blow up to infinity of the free boundary for large T − t. but can also be used to improve the efficiency of the numerical calculations of the option value and its corresponding free-boundary location. t)space. In addition the square root will always stay positive for all value of D and so we will always have a critical value. Knowledge about the large time to expiry behaviour of the H-function is not only useful in determining different regimes of behaviour of the free boundary. Furthermore any numerical treatment of the free-boundary ˆ problem in (S. THE BRITISH OPTION 180 hence 1 µ∗ = σ 2 c 2 or 1 1 r + D + σ2 µ∗ = c 2 2 1 + 2 1 r + D + σ2 2 2 µ∗ + r c µ∗ − r c + D. will tend to finite or zero values. + 4r 1 2 σ −D 2 1 2 .22) 1 If D < 2 σ 2 then we are required to take the positive square root in order to obtain a positive µ∗ . If D > 1 σ 2 then we could have two positive solutions. all free boundaries.CHAPTER 9. We must determine the value to which the free boundary asymptotes and also the functional . (9.

Johnson (2007) or the recent survey article by Howison (2005).11). Alternatively the differential form of the free-boundary problem can be tackled directly and matched asymptotic expansions can be used to investigate the solution behaviour close to expiry. In order to convince ourselves that it should in fact coincide with Sh (T ) we consider a situation in which the process is an arbitrarily small time away from expiry and that the current price is below the . which investigates the standard American put option. For example the analysis of Kuske and Keller (1998). providing the correct location of the free boundary at expiry can be crucial in the scheme’s success. (1995). which is then solved asymptotically for times close to expiry. Hence we have that Sh (T ) = rK .CHAPTER 9. T ) = µc S − rK. The value to which the British option free boundary asymptotes can be obtained simply via a cursory inspection of the H-function defined in the previous section and given by (9. and for S < K is given by H(S. In addition to being interesting in its own right. knowledge of the free boundary behaviour close to expiry can be exploited to improve the efficiency of numerical schemes used in determining the free boundary. there are a multitude of approaches that can be taken. t) > 0 cannot contain the free boundary. When investigating the small time to expiry behaviour of free boundaries arising from derivative securities with early-exercise features. µc rK µc and that the H-function is positive in the region S > and so we can conclude that the free boundary must lie at or below this value. for example see Wilmott et al.3. exploits the Green’s function for the heat equation to convert the resulting boundary value problem to an integral equation. Using this information as t → T we have that the H-function is trivially zero for S > K. For example when using the body-fitted coordinate system described in section 9. Recall that the region in which H(S. THE BRITISH OPTION 181 form in which it asymptotes to that value.

THE BRITISH OPTION rK . T − δt) ∂t ever becomes positive. rK . T − δt) − G(S.24) Note that the inclusion of dividends does not affect the location to which the free boundary asymptotes as one might expect. namely (9. More specifically if the quantity ∂ V (S. T ) − G(S. T ) = G(S. t) > 0. ∂t ∂t By definition V (S. t) < 0 and so the investor is accumulating negative gain. Hence there exists a (possible) early-exercise region when rK − µc S > 0 ⇒ S < in agreement with (9. T − δt) − G(S. T ) + δt ∂t ∂G ∂V (S. with no early exercise) lies below the payoff function (gain function). One of the hallmarks of the existence of an early-exercise region is the existence of a region in which the value of the early-exercise option’s European counterpart (i.e. hence the optimal investor would stop in this region leading to the conclusion that b(T ) = rK . at t = T . Close to expiry this amounts to determining if the dynamics of the PDE move the option price below the gain function at a small time prior to expiry. T − δt) ≈ V (S. T − δt) − G(S. T ) = (K − S)+ leads to ∂ V (S. T ) and we can also directly evaluate the expression for Gt .10). with no possibility of the process reaching the region in which H(S.24).CHAPTER 9. In addition rearranging the governing PDE directly to obtain an expression for Vt and using the fact that V (S. The above result can be shown using a different approach which we shall briefly outline below. this fact is easily confirmed numerically. T ) − (S. µc (9. since the process is extremely close to expiry. T ) . T − δt) ≈ δt(rK − µc S) ∂t for S < K and trivially zero otherwise. µc . µc 182 value In this region H(S. A simple Taylor expansion leads to ∂ V (S.

t) = .e. then the governing PDE becomes 1 ˆ ˆ ˆ Vt + σ 2 S 2 VS S + (r − µc ) SVS − rV = 0.24).25) log K ˆ S Notice that the parameter µc has been taken out of the gain function (and hence the boundary conditions) and placed into the PDE. σ T −t √ ˆ ˆ d2 (S. It is clear 1 ˆ log lim d1 (S. where it appears as a pseudodividend. i. The first point to note is that in this limit ˆ that as T − t → 0 (i. t) = lim √ t→T σ T − t K ˆ S . the proof of which is given below. we are therefore interested in the behaviour of the gain function as we approach expiry. Since we are interested in the behaviour of the free boundary as we approach expiry. . of more interest is the functional form in which the free boundary approaches (9.e.25). (9. the leading-order behaviour is identical to that of the standard American put option with dividends. ˆˆ 2 and the gain function is transformed to ˆ ˆ ˆ ˆ G(S. t) will dominate giving t→T d2 → d1 and so it will suffice to determine the behaviour of d1 in this limit. indicating that dividends have a rather benign affect on the dynamics of the British put option. with 1 + 2 σ 2 (T − t) ˆ √ d1 (S. for small values of T − t. t) − σ T − t. t) = d1 (S. If we make a subtle change of variable. t) . It transpires that the answer is pleasingly simple.CHAPTER 9. t → T ) the first term in d1 (S. THE BRITISH OPTION 183 However. namely ˆ S = Se(µc −D)(T −t) . t) = KΦ d1 (S. t) − SΦ d2 (S. Also note that the actual dividend yield D has been completely removed from the problem by the scaling (9.

where the dividend amount (yield) Note that there is a breakdown if S < Ke−B T −t or S > Ke+B T −t .26) in the region close to expiry. .. t) = (K−S)+ −σ T −t log 2π K ˆ S −1 2 1 log exp − 2 2σ (T − t) K ˆ S ˆ (K−S)+. . such that these breakdowns do not interfere with the free boundary at expiry.3).. . Using the above and further the fact that Φ(d1 ) → Φ(d2 ) as t → T . . . d1 2π ⇒ Φ(d1 ) = 1 − σ T −t log 2π K ˆ S −1 1 2 exp − 1 log 2 (T − t) 2σ K ˆ S 2 + . (9.. . Clearly this decays much faster than the terms arising from the asymptotic (power series) expansion of the PDE and consequently the gain function can be approximated to6 ˆ ˆ G(S. ˆ Similarly for the region S < K where d1 → +∞ we can use the symmetry of Φ(·) to obtain e − 2 d1 Φ(d1 ) = 1 − √ + . 6 √ √ 1 A + ..CHAPTER 9. the gain function can be approximated by ˆ ˆ G(S. . which as t → T tend to 0 and ∞ respectively.. . THE BRITISH OPTION 184 Since log K ˆ S ˆ ˆ and conversely for S < K then d1 → +∞ as t → T . . under the transformation (9. the standard put option payoff.25). Hence to leading order as t → T we have that the British put option free-boundary problem (9. then in this region it is clear that d1 → −∞ as t → T 1 log exp − 2 2σ (T − t) K ˆ S 2 + .16) to give e − 2 d1 Φ(d1 ) = − √ + . where A must be a positive constant. In the region S > K if d1 → −∞ then we can exploit the asymptotic expansion of the cumulative normal distribution function (9. t) = K − S i.26) decays as (T − t) 2 e− T −t in the limit t → T . d1 2π ⇒ Φ(d1 ) = −σ T −t log 2π K ˆ S −1 1 2 ˆ < 0 for S > K.. is identical to the standard American put option free-boundary problem with dividends.e. Note that the second-order term in (9.

Therefore the asymptotic form of the British put free boundary. numerical investigations performed by the author indicate that (9. Figure 9. Fortuitously the asymptotic form of the American put with a constant dividend yield close to expiry has been studied extensively.3. (9. however.e. Note that if we are interested in higher-order asymptotics then the behaviour will differ to that of the American put with dividends. and the leading order behaviour is given by b(t) ∼ rK 1 − σα0 ˆ D 2(T − t) ˆ for constant dividend yield D > r. i. after transforming back to the original variables via (9.4517. This is most likely due to the fact that for larger σ the turning point of the free boundary occurs closer to expiry and the free boundary would diverge from the parabolic approximation over a shorter timescale. 4 which can be calculated to give α0 ≈ 0. the free boundary approaches expiry parabolically. for D = r . (2002). is given by b(t) ∼ rK 1 − σα0 µc 2(T − t) e−(µc −D)(T −t) . This is due to the various terms we have neglected as t → T from the gain function and also from the exponential transform. THE BRITISH OPTION 185 is given by the contract drift rate µc .CHAPTER 9. see for example Evans et al.25).27) i.4 shows the above approximation compared with the free boundary obtained via a full numerical treatment using the techniques described in section 9.27) becomes a better approximation (over the same scale) as the volatility is decreased. where the constant α0 is the solution to the transcendental equation 3 2 α0 e α0 ∞ α0 e−u du = 2 1 2 2α0 − 1 . Hence the behaviour of the British put option free boundary will coincide with that of the American Put option with dividends.25). Note. that to leading order the behaviour of the free boundary remains unchanged by the transform (9. In addition. Also note that for the American put the free boundary takes on a very ˆ different functional form for different values of the dividend parameter.e.

σ = 0.8 0. µc = 0.6 Financial analysis of the British put option The protection feature of the British option that was so crucial in motivating its introduction led Peskir and Samee (2008a. Indeed. T = 0. Furthermore. Here we reproduce this analysis in more detail by exploiting the advanced numerical techniques employed to obtain relative-return surfaces of the options.125. the value of the dividend D does not qualitatively change the asymptotic behaviour of the British put free boundary since the scaling (9. in particular the potential return on investment in the British (and other) options. it was with these very traders . (9. r = 0. rag replacements 186 t 0.27) (dotted line) compared with fully numerical value (solid line).e.795 b(t) 0.775 0 0. THE BRITISH OPTION 0. or more specifically that the realised drift will be less than the risk neutral rate r.004 Figure 9.008 0.01.25) has removed the parameter completely from the system.785 0.006 0. and D = 0.78 0.1. i.b) to investigate further the motivations of a British option investor.4. Any speculator (as opposed to a hedger) who chooses to invest in a put-style option will inevitably hold the view that the underlying will experience downward price movements at some time in the future.CHAPTER 9.4: The asymptotic approximation for the British put option free boundary close to expiry.79 0. however for the British put option we have the natural restriction that µc > r and so the parabolic regime is the only one of interest. ˆ or D < r.01 9.002 0.

then which available option will provide the greatest return on the price paid for the option. defined as R(S. i. however any rational investor would never choose to exercise the option ‘out of the money’. American and British put option written on the same underlying. but there is some ambiguity in the value of the money received at a future time. given the current stock price S0 . whilst maintaining a protection feature should these price movements not transpire. The rational strategy of such an investor would be to choose the option that has the greatest return under the future price movements that are most in-line with the sentiment of that particular investor. as noted by Peskir and Samee (2008a. let us construct an idealised market consisting solely of a European.CHAPTER 9. the British option provides an instrument that can be used to ‘milk’ profits from the speculators view of future price movements. t) × 100%. with the same expiry date. THE BRITISH OPTION 187 in mind that the British option was developed. The option price of all three options is easily calculated at t = 0 given the current price S0 .b). Of great interest from the point of view of such an investor is the expected return on their investment for all possible future stock prices at any point in time prior to maturity. option price paid at t = 0 The idea of this section is to produce a return surface for all the available options in the market. To further illustrate possible situations in which a British option might be favourable over other options available in the market. if an investor believes that the stock price will fall by approximately 20% in the next 6 to 9 months. For a European option we are unable to exercise the option until expiry and so there can be no payout of the option at any time prior to maturity. .e. t) = money received at (S. say one year and strike price K which for simplicity we shall assume is equal to the current stock price and scaled to unity. Furthermore. Now an investor in such a market has the choice of investing in either of the three options and as such has to pay the corresponding option price. Alternatively for an American option we can choose to exercise at any time prior to maturity and receive the payoff (K − St )+ . S0 = K = 1 and hence all options are ‘at the money’. For example.

t) = VE (S. despite the option having a zero gain function in such a situation. i.CHAPTER 9. VE (S0 . but that the initial price paid for the option will have varied. . THE BRITISH OPTION 188 i. since if the investor is exposed to market frictions then they will inevitably obtain a worse price than the no-arbitrage values used in the above calculations. 0) > VE (S0 . Similar assumptions allow us to define the return on the British option as RB (S. t) = max (K − S)+ . if St > K for any time before maturity. (K −ST )+ . VA (S. t) × 100%. t) × 100%. In some sense this corresponds to a ‘best case’ scenario for the American and European option. precisely the no-arbitrage price of the American option at that particular price and time. 0) hence the European option investor’s only choice is to sell the option at times prior to maturity. 0) hence we are allowing the investor to sell the option in the market and receive the current ‘no-arbitrage’ value of the option in addition to allowing for the exercise of the option upon which the payoff is received. VB (S0 . 0) and the return on the European option as RE (S. it still has some intrinsic value. t) = max GB (S.e. t). We note that at maturity the return on all three investments are not equal. 0) > VB (S0 . VA (S0 . The British put on the other hand will not incur such costs (in the exercise region) as there is no need for the investor to enter the market. VB (S. Also note that for these purposes we are assuming the investor to behave rationally in the sense that the option should be exercised at a stock price in the rational exercise region and to sell the option at a stock price in the continuation region.e. For this reason the most consistent measure of the expected return on an American option is given by RA (S. t) × 100%. However. 0). the money received will be the same. more specifically we must have VA (S0 . Note that this assumption assumes that the investor has access to the market in order to sell and that he incurs no transaction or liquidation costs.

75 0.9 1 . t) − RA (S. 1 PSfrag replacements b(t) Figure 9.95 0.8 0. σ = 0.2 0.1 0.5: Location of the free boundary for the British (solid line) and American (dotted line) put option under investigation in figures 9.CHAPTER 9.4.6 0.125.e.8 compares the American and European put option. The most striking feature of figure 9.6 is that the British put option appears to be providing a greater expected return in the majority of the stopping regions.7 and 9. then they have ‘wasted’ the early-exercise premium priced into the American and British option prices. This surface indicates the differences in the returns (as a percentage of the initial investment) should the investor close out their position by exercising or selling. for a contract drift of µc = 0.125 0.85 µc = 0.6.5 t 0. Figure 9.8 0.5.125.8.4 0. i.7 0. 9.7 compares the return of the British put to the European put and finally for reference figure 9. RB (S.65 0 0. and D = 0.1. whereas in some regions the British put option can provide up to 60% µc = 0. Similarly figure 9.6 shows the difference in returns of the British put option and the American put option. µc = 0.3 0. t). whichever provides the greatest return (or is permitted).135 0. For comparison the rational exercise boundaries can be found in figure 9.7 0. THE BRITISH OPTION 189 This is natural since if an investor waits until maturity to exercise an early-exercise option. The American option only provides the investor with a better return on their investment if it transpires that the investor chooses to stop and close out their position in a ‘wedge’ shaped region below the current stock price and extending just beyond half way to maturity. T = 1. K = 1. Even then the difference in the American put return is no greater than 20%. r = 0.9 0.

CHAPTER 9. THE BRITISH OPTION

Figure 9.6: The difference in the percentage return of the British put option and the American put option at every possible stopping location. The solid lines denote contours at increments of 10% from -10% to 60%. The dotted line represents the zero contour. S0 = 1, T = 1, K = 1, σ = 0.4, r = 0.1, D = 0, and µc = 0.125. PSfrag replacements

Figure 9.7: The difference in the percentage return of the British put option and the European put option. Again the solid lines denote contours at increments of 10% from 0% to 70%. The dotted line represents the zero contour. S0 = 1, T = 1, K = 1, σ = 0.4, r = 0.1, D = 0, and µc = 0.125.

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CHAPTER 9. THE BRITISH OPTION

Figure 9.8: The difference in the percentage return of the American put option and the European put option. The solid lines denote contours at increments of 10% from -70% to 30%. The dotted line represents the zero contour. S0 = 1, T = 1, K = 1, σ = 0.4, r = 0.1, and D = 0. Note the change of orientation. extra return over the American put option (although these regions are many standard deviations away from the current price of the underlying). More importantly, numerical investigations have shown that the return profile seen in figure 9.6 and indeed the region in which the expected return on the American is greater than the British put option remains relatively constant in shape and size for varying values of the contract drift µc . Note that the above observations are in total agreement with Peskir and Samee (2008a,b). When comparing the British with the corresponding European put option (figure 9.7) the return differentials are the greatest for low values of the stock price and large times to expiry, as we might expect. However it can be seen that rather surprisingly the British put option will provide a greater return for the vast majority of stopping locations below strike K; with the only exception being relatively close to maturity where the European option would provide (at most) a 10% greater return. Figure 9.9 attempts to encapsulate all of the above observations into schematic form. It plots the regions in which the ordering of the expected returns (given any stopping

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CHAPTER 9. THE BRITISH OPTION

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Figure 9.9: Schematic representation of the regions in which at-the-money European, American and British put option would provide the greatest return on an investment. The dotted lines represent the free boundaries of the American and British put option for reference. T = 1, K = 1, σ = 0.4, r = 0.1 and D = 0. location) for the British, American and European put option are different.7 The freeboundary location of the British and American put have been included for reference. It appears that there is a region, centred around the American early-exercise boundary in which the American option would provide a greater return on the initial investment than the other two options. This region gets smaller as maturity approaches and disappears at approximately three-fifths of the way to maturity. This also highlights what could be described as an ‘unexpected’ additional benefit of the British option, which is somewhat counter to the protection feature for which the option was originally created. If the stock price falls sharply, then the British option is able to ‘milk’ more money out of such a situation than the holder of the corresponding American option. In fact any stopping location below strike in the second half of the contract will inevitably result in a higher return for the British option holder, over the American option holder. Considering this fact, in conjunction with the the empirical observation that the majority of American options are exercised in the second half of
7 The three curves correspond to the zero contours of the three figures 9.6, 9.7, and 9.8 obtained for the parameter value µc = 0.125, although the same qualitative behaviour is seen for other values.

CHAPTER 9. THE BRITISH OPTION

193

the contract’s term,8 the British option can be considered an attractive alternative. In addition, if the options are far out of the money, i.e. St K then the European

option would provide the greatest return, however the values of all three options are so small in this region that any comparison becomes a purely academic issue. Finally, figure 9.10 shows how the location of the wedge-shaped region (in which the American put option provides greater returns over the British put option) changes as the initial value of the stock price is varied, whilst keeping the strike constant. In other words as we increase the moneyness of the option. Figure 9.10(a) shows that as we increase the moneyness by decreasing the ratio S0 /K from 1 to 0.7 in steps of 0.1 this region becomes progressively smaller until it actually disappears for a ratio of 0.6, at which point the British option is guaranteed to provide a greater return on an investment. Figure 9.10(b) shows the shape of this region when we continue to increase the moneyness by changing the ratio from 0.5 down to 0.2. In this case the region grows steadily, however this time any immediate downwards stock price movements will result in the British option providing the greatest return, whereas an upward movement would be better served by an American put option. This is the opposite of the behaviour seen in figure 9.10(a). It should be noted that for the majority of the values of S0 /K presented in figure 9.10 the option holder is placed immediately in the exercise region, and so should ‘optimally’ exercise. However, the comparisons are still of interest, since the investor need not follow the optimally strategy.

9.7

The British call option

We now turn our attention to the British call option (cf. Peskir and Samee, 2008a). Unlike the American call option (without dividends) the British call option (with or without dividends) no longer has a trivial solution; there exists an early-exercise
See for example Diz and Finucane (1993), who investigate the early-exercise behaviour of options on the the S&P 100 index. They show that over 82% of all call options and 77% of all put options that are exercised are done so during the final week before maturity (inclusive of maturity).
8

. 0.  SS S t  2       V (S.2. . . THE BRITISH OPTION rag replacements rag replacements 194 1. The no-arbitrage pricing procedure is identical to that of the British put described in section 9.4 1. 0.9. Note the relationship between the call and put option gain functions GC (S.6 0.8 1 (a) S0 K = 1.5.2 Increasing Moneyness 0 0.2 0.9 Again we can note that the gain function approaches the standard call option payoff as t → T . Figure 9. .6 0. for increasing moneyness.6 0. t) = Se(µc −D)(T −t) − K + GP (S.10: Figures representing the region in which American put options would provide a greater expected return that its British option counterpart. t) = G(S. t) on S = b(t)   VS (S.4 0.8 S t 0. t. VE = Se−D(T −t) − Ke−r(T −t) + VE . µc ) − 1 (9. t) = K Φ d1 (S. b(t)]. (b) S0 K t 0. t) = GS (S. r = 0.8 1 = 0. K = 1. i.4 0.29) where all of the notation is as previously defined.6 0. T ) = (S − K)+ . t) where GC and GP denote the gain functions of the British call and put respectively.1.CHAPTER 9.2 and in fact leads to the following free-boundaryproblem representation of the British call option price:   V + 1 σ 2 S 2 V + (r − D)SV − rV = 0 for S ∈ (0.2 1 1 S 0.4 1. t.e.. σ = 0. t) on S = b(t) (smooth fit)      V > G in C       V = G in D GC (S. i. T = 1.4 0 0. 0.2 0.4.8 0.e.8 and 0.2 Increasing Moneyness 1.28) where now the gain function is given by (9. Notice the similarity of this expression with the put-call parity relationship described in section C P 4.4 0 0 0. 9 G(S. µc ) − 1 − Se(µc −D)(T −t) Φ d2 (S.7.1 and D = 0.2 0. boundary for all µc < r.

8 0 0.1. 1. K = 1. 2. . 0. 0.4 0.9 0.2 σ increasing b(t) 1.7 0. T = 1. and σ = 0.12 also shows its variation with the volatility parameter σ.4 1. K = 1. and µc = 0. D = 0.1 0.6 µc increasing 1.3 0.08.05.12: The British call option free boundary for varying volatilities. .6 0.3 0. D = 0. is no longer monotonic.7 0. r = 0.11: The British call option free boundary for varying values of the contract drift.1 1 0.8 b(t) 1.1 0. again showing that the nature of the free boundary is highly dependent the volatility of the underlying stock.2 0.. T = 1. .4 1.09.2 0. THE BRITISH OPTION 195 Figure 9.3 1.1.5. .5 t 0.05.CHAPTER 9.4 0. Again note that the free boundary of the British call option. r = 0.8 0.4. .2 2 1. . 0.055.9 1 Figure 9.1.2 PSfrag replacements 1 0. µc = 0..06. .4 PSfrag replacements 2.5 t 0.8 0. σ = 0.6 0. 0.8 0 0. Figure 9. like the British put.11 shows the variation of the free boundary for varying values of the contract drift µc showing again a monotonic collapse of the free boundary as µc is increased to r. 0.9 1 Figure 9.

hence µc Sh e(µc −D)(T −t) Φ d2 (Sh . (9. .e. t) − 1 = 0. . hence our ansatz for the form of the solution does not permit β > 1 σ 2 − µc + D.31) for convenience of algebra. i. Again making the ansatz that the solution for Sh (t) behaves as ¯ ¯ Sh (t) = Aeβ(T −t) ¯ ¯ as t → T we wish to solve for the constants A and β. For the British call the H-function can be shown to be H(S. 2 The second regime corresponds to a situation when ν+ > 0 and ν− < 0.1 Analysis far from expiry For the British call we can apply the same analysis as for the British put in order to determine the large time from expiry behaviour of the free boundary.30) and hence we are interested in the large T −t behaviour of the solution to H(Sh . indicating that there can be no solution to this equation for β in the ¯ limit. t) = 0. ¯ must be positive. when ¯ ¯ 1 1 ¯ 1 ¯ 1 − σ 2 − µc + D < β < σ 2 − µc + D ⇒ − σ 2 < β < σ 2 .30) yields √ √ ¯ ¯ ν µc Ae(µc −D+β)(T −t) Φ −¯+ T − t − 1 = rK Φ −¯− T − t − 1 . We wish to look at the asymptotic behaviour as T − t → ∞ and it transpires that there are three different regimes in which the solution is quantitatively different. THE BRITISH OPTION 196 9. 2 2 2 2 ¯ and since in this regime β > 1 σ 2 − µc + D.7. the exponent of the exponential term 2 . t) = µc Se(µc −D)(T −t) [Φ(d2 ) − 1] − rK [Φ(d1 ) − 1] . Substitution into the equation (9. . ν where we have defined ν± = ¯ 1 ¯ µc − D ± 2 σ 2 + β σ (9. t) − 1 − rK Φ d1 (Sh .CHAPTER 9. If ν± > 0 then both the cumulative normal distributions ¯ tend to zero in this limit and the leading order terms become ¯ ¯ µc Ae(µc −D+β)(T −t) = rK + .

. i.e.17). since for the British call option the H-function is positive below Sh (t). i. i.. Furthermore the large T − t behaviour of the time derivative of equation (9. . and so there can be no become ¯ ¯ µc Ae(µc −D+β)(T −t) − 1 ν+ (T −t) 2 e 2¯ = ν+ 2π(T − t) ¯ ν− ¯ 1 2 rK ¯ e− 2 ν− (T −t) + . . On the other hand.CHAPTER 9. However this is not helpful from the viewpoint of determining the behaviour of the free boundary in this limit.19) and so it is is clear that a balancing of terms does exist for the call option in ¯ the limit T − t → ∞ and moreover that β will be given by ¯ 1 β = σ2 2 µc + r µc − r − µc + D. Recall that for a British call we must have that µc < r and all parameters must be positive so we have that µc + r < −1. 1 D > Dcrit = µc + σ 2 2 r + µc r − µc .e. µc − r 1 ¯ which confirms our original assumption β < − 2 σ 2 − µc + D. . hence the function Sh (t) for the British call must always decay to zero for large times to expiry in this regime. the same behaviour as for the British put.. and so in this regime we cannot say anything about the free-boundary behaviour for large times to maturity. in this regime the leading-order terms ¯ which is identical to equation (9. ν− 2π(T − t) ¯ 1 2 where we have used the approximations for Φ(·) introduced earlier. ¯ An interesting corollary to this result is that when the dividend yield D is zero.. we ¯ have that β < 0 for all possible values of µc . Finally we have that ν± < 0. THE BRITISH OPTION 197 in this regime the first cumulative normal distribution function tends to zero but the second tends to unity in the limit. Again it is clear that there can be no balancing in this regime as T − t → ∞. 2π(T − t) ¯ solution for β.e. hence the leading-order terms become ¯ rKe− 2 ν− (T −t) ¯ ¯ µc Ae(µc −D+β)(T −t) = + . if D = 0 then the function Sh (t) will tend to infinity (and so must the free boundary) provided that the dividend is greater than some critical value.31) under the assumption that ν± < 0 is identical to ¯ (9. that ν± < 0.

32) when compared with the fully numerical free boundary. where α0 is as before.7. Using the same transformation we can transform the British call option to the standard American call option problem with dividends (in the limit t → T ). (1992) . The best we have done is to use the behaviour of the H-function in this limit as an analytical proxy of the free boundary and infer that the free boundary must tend to zero in certain parameter regimes. As a step to determining the asymptotic behaviour of the free boundary itself.8 9. the function Sh (t) can show positive exponential growth for large times to expiry. c 9. THE BRITISH OPTION 198 If the dividend is greater than this value.1 Integral representations of the free boundary The American put option The value of an American option can be written using the so-called early-exercise premium representation.13 once again shows the accurately of the approximation (9. (2002) state that the American call option with dividends behaves as b(t) ∼ rK 1 + σα0 ˆ D 2(T − t) . more specifically if the contract drift is less than the critical value µ∗ given by (9. the following considerations may prove to be useful.2 Analysis close to expiry The close to expiry analysis for the British call option is identical to that of the British put option. Again the results of Evans et al. due to Kim (1990). 9.32) Figure 9. Hence the British call free boundary behaves as b(t) ∼ rK 1 + σα0 µc 2(T − t) e−(µc −D)(T −t) . (9. So far we have been unable to determine the large time to expiry behaviour of the British option free boundary directly.8.CHAPTER 9.22). Jacka (1991) and Carr et al.

t e −r(T −t) G(ST .e.006 0. amongst others. To determine the location of the free boundary we evaluate equation (9.008 0. √ σ u (9.34) at S = b(t) for which e−ru Φ   log b(t+u) S  − r − 1 σ2 u 2  du.285 1. i.CHAPTER 9. T = 0. T ) + rK 0 T −t e−ru PQ [St+u ≤ b(t + u)] du. Identifying the first term in the equation as the European put value (without any early exercise). S.33) where G(ST .13: The asymptotic approximation for the British call option free boundary close to expiry. An explicit expression for the probability in the integral is well known and furthermore is derived in appendix C and using this expression (with D = 0 for simplicity) reduces the above representation to T −t 0 V (S. t) = VE (S. (9. the second term can be seen intuitively as the extra value of the option due to the ability to exercise early.255 1. THE BRITISH OPTION 1. r = 0. t) = EQ S. t) = (K − St )+ for a put. σ = 0. for a full exposition of this representation (including existence and uniqueness results) see Peskir and Shiryaev (2006). t) + rK Note that in order to evaluate the integral above and hence determine the option value we require knowledge of the location of the free boundary b(t).e. G(St .265 1.26 1.01.08 and D = 0.002 0.27 1.28 1.t (9. T ) is the gain function of the American option. This representation is given by V (S.34) .01 Figure 9. K = 1. i.4. and PQ [St+u ≤ b(t + u)] is the probability that the process is below the S.275 rag replacements 0 199 b(t) 1.25 0.004 t 0.32) (dotted line) compared with fully numerical value (solid line). µc = 0.1.t free boundary at time t + u (conditional on the information available up to time t).

Setting VE (b(t). hence we are interested in the behaviour of equation (9. This leads to the so-called free-boundary equation which completely characterises the free boundary K − b(t) = VE b(t). Firstly we note that in the limit T − t → ∞ the value of a European option trivially tends to zero (due to discounting).35) in the limit T − t → ∞. (9. we shall consider the simple case of a perpetual American put option. To illustrate that this equation does indeed lead to the location of the free boundary. however it can be reduced to an explicit equation by exploiting the fact that the American free boundary at large times to expiry tends to a constant value. leading to 2rK K − b(t) = 2 k1 ∞ 0 se − rs 2 k1 2 Φ(s)ds. t) = 0 still leaves an implicit equation for b(t). and further integrating by parts yields 2rK K − b(t) = 2 k1 2 2 k1 k1 + √ 4r 2r 2π ∞ 0 e − 1 + r 2 2 k1 s2 ds . THE BRITISH OPTION 200 we know the value of the option (by definition) must be equal to K − b(t). Therefore we would expect the ratio b(t + u)/b(t) to be equal to one. Hence lim log b(t + u) b(t) =0 T −t→∞ This is effectively the same as making the assumption (or ansatz) that the free boundary to be found is a constant.CHAPTER 9. b(t) = b∞ say. . t + rK T −t 0 Note that this is a Volterra integral equation (of the second type) and solving this e−ru Φ   log b(t+u) b(t)  − r − 1 σ2 u 2  du. ∞). for all values of u ∈ [0.35) √ σ u (implicit) equation for b(t) will give the location of the free boundary. since if we are at time t then the free boundary at any time in the future will be the same as it is now. The integral representation thus reduces to K − b(t) = rK ∞ 0 e −ru Φ √ This integral can be solved (with a little work) by firstly setting s = k1 u where k1 = σ 2 −2r 2σ √ (σ 2 − 2r) u 2σ du.

b). In terms of the original parameters we can see that k2 = 1 2 σ 2 + 2r σ 2 − 2r . k2 1 2k2 2 we arrive at b(t) = K 2 1− √ . and so substitution gives the location of the free boundary as b(t) = where α = 2r . In order to show this we can apply Itˆ’s formula to the discounted option value to obtain o s e−rs V (St+s . ∂u 2 ∂S ∂S Applying the operator to the discounted process we can simplify the above expression to s e−rs V (St+s . where Mt is a local martingale.CHAPTER 9. t + u) du + Mt . found in section 6. t + u) du + Mt . LSt is the infinitesimal generator of the process defined by L St = ∂ 1 ∂2 ∂ + σ 2 S 2 2 + (r − D)S .3). σ2 2rK αK = . Peskir and Samee. = V (S. t) + 0 LSt e−ru V (St+u . t + s) = V (S.8.2 The British put option Analogous with the American option. 9. the optimal stopping boundary of the British option can be characterised as the unique solution of a nonlinear Volterra integral equation of the second type (cf. 2008a. equation (6.1. THE BRITISH OPTION 1 2 r 2 k1 201 Finally setting k2 = + and using the identity ∞ 0 e−k2 s ds = 2 1 2 π . t + u)du + Mt e−ru L V (St+u . t) + 0 s e−ru (LSt − r) V (St+u . t + s) = V (S. 2 2r + σ α+1 This agrees exactly with the well known value of the perpetual American put free boundary. t) + 0 .

z. We now consider the expectation under the integral sign which can be expressed as EQ H(z. I(·) is the indicator function and b(·) denotes the location of the free boundary separating the continuation and stopping regions. T ) − =E Q T −t 0 T −t 0 e−ru EQ L G(St+u . Finally letting s = T − t and rearranging yields an expression for the option value V (S. Now by definition V (ST . t + s) = V (S. t + u). t + u) du. t. t) + 0 e−ru EQ L V (St+u . t + u) = G(St+u . This modifies the expression to V (S.36) For a derivation see appendix C. Hence we have the following representation of the British put option value. . t + u) = 0 in the continuation region and is only non-zero in the stopping region where we have V (St+u . t + u)I z ≤ b(t + u) f (S. t + u)dz. b(t + u). t) = EQ e−r(T −t) V (ST . z. t + u) is the transitional probability density function of the process started at position S at time t and finishing at position z at time t + u given by10 log 1 exp − f (S. t) = EQ e−r(T −t) G(ST . z. where we have taken the expectation under the integral sign and used the martingale property that E [Mt ] = 0. t) where L is the Black-Scholes differential operator. T ) and also we have that L V (St+u . t + u)I St+u ≤ b(t + u) du. t. t + u) du. t. t. t + u) = √ σz 2πu z S − r − D − 1 σ2 u 2 2σ 2 u 2 .CHAPTER 9. t + u)du (9. where f (S. V (S. T ) = G(ST . THE BRITISH OPTION 202 where we have used the fact that (LSt − r) V (S. t) − 10 T −t 0 e−ru L(S. du e −r(T −t) G(ST . The next step is to take expectations giving s EQ e−rs V (St+s . T ) − where we have used the definition of the H-function. t) = J(S. t) = L V (S. t + u) I St+u ≤ b(t + u) e−ru EQ H(St+u . t + u)I z ≤ b(t + u) = 0 ∞ H(z. T ) − T −t 0 e−ru EQ L V (St+u .

t + u)dz. THE BRITISH OPTION 203 where we have defined J(S. (9.t P = VE (S.33). t + u) = −rK and the early-exercise premium representation for the American put option. i. (9. t. t + u)du. As such this shall be left as the topic of future research. S.36) at the free boundary S = b(t) where we know that V (b(t). t) = (K − S)+ will yield H(z. The equations involved are clearly much more complicated and so it will not be a trivial matter to extract such asymptotic behaviour. S. i. z. t) − T −t 0 e−ru L(b(t). t). much in the same way as we did for the function Sh (t).t = EQ e−r(T −t) (K − S)+ .e. immediately follows. t).CHAPTER 9. t + u)dz. At this stage we can see that using the gain function of the standard American put option. t + u) = 0 ∞ H(z. hence P G(b(t). b(t + u). We can attempt to utilise the nonlinear integral equation (9. t + u)I z ≤ b(t + u) f (S. z. t) as defined by equation (9.b). T ) . t.37) For the proof of the uniqueness of the above representation see Peskir and Samee (2008a.11 Now to determine the free boundary we can evaluate equation (9. b(t+u) = 0 with H(S. t. t) = EQ e−r(T −t) G(ST .37) in order to determine the large T −t behaviour of the free boundary. t + u)f (S. GA (S. H(z. the corresponding European put option value and L(S. t. b(t + u). 11 . t) = VE (b(t). t) = G(b(t).e.11).

A feature common to a number of these models is that the overall dispersion term. Allied to this. It is concluded that there is insufficient financial modelling to describe the true price dynamics in such situations. However. which is exacerbated by the possibility of negative option values for puts. The upshot of this is that models of this general class cannot exhibit fully differentiable solutions at times prior to expiry. instead. the powerful tool of asymptotic analysis has been used to extract important information about the behaviour of such models close to expiry. incorporating the appropriate discontinuities into the numerical scheme. It is clear that the period close to expiry is the most critical for option-pricing models 204 . involving the option gamma. Here. Indeed. invariably these solution features lead to completely spurious solutions if standard numerical procedures are adopted. diminishes in magnitude as the gamma increases in magnitude (as indeed it must as standard payoff conditions are approached).Chapter 10 Conclusions In this thesis we have investigated a number of models which have been proposed to incorporate finite liquidity of the underlying asset into the classical Black-ScholesMerton option pricing framework. the vanishing of the denominator in the dispersion term can also be a serious issue. we must allow solutions with discontinuous deltas. this analysis also gives guidance on how to tackle these problems numerically at times away from expiry (the full problem). This is clearly a somewhat undesirable feature.

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205

and any model that successfully treats this regime should also successfully replicate the option value dynamics for all time. The approach detailed in this thesis should give guidance for the development of models incorporating finite liquidity without the undesirable features observed in a number of the existing models. Several models in the past have circumvented these difficulties close to expiry but generally using ad hoc, rather than intuitively justifiable arguments. The hope is that the analysis presented in this thesis will help in this respect; in addition, below we discuss briefly some preliminary ideas about how this may be achieved in future research. One problem with the modelling framework introduced in chapter 2, from a financial viewpoint, is that the change in price dS becomes unbounded when the ‘forcing’ term df becomes unbounded, and for the case in which f = ∆ this will happen when d∆ becomes unbounded. Unfortunately, for option contracts with non-smooth payoff profiles, the unbounded nature of d∆ is unavoidable and so if we are to incorporate these (common) situations into such modelling frameworks then it is suggested that a nonlinear response of df to d∆ may well overcome such difficulties. We could choose to incorporate such nonlinearity into our definition of the forcing term f . i.e. instead of setting f = ∆ we could set the forcing term to be some function of ∆, i.e. f = g(∆). However it is not the function f which ultimately affects the price, but rather its infinitesimal change df , hence it is the term λdf which we require to remain bounded (irrespective of the trading strategy ∆). Furthermore, when considering option pricing, the only term in df that filters through into the option price is the therefore it is desirable to bound
∂f ∂S ∂f dS ∂S

term,

rather than f . This can be done if we model

the derivative of the forcing term (f ) with respect to the asset price as a bounded (nonlinear) function of the derivative of the trading strategy (∆), i.e. ∂f =g ∂S ∂∆ ∂S (10.1)

where g(·) is bounded above. An example of such a function is the ratio of two

CHAPTER 10. CONCLUSIONS nth -order polynomials such as g(x) = αn xn + αn−1 xn−1 + . . . + α0 , βn xn + βn−1 xn−1 + . . . + β0

206

which in the limit x → ∞ is bounded above by the ratio αn /βn . If the aim is to prevent the denominator from vanishing then we require this ratio to be 1/λ or below, hence the function g(x) = x λx + β

would suffice, where β can be chosen to obtain the desired shape of the response curve. Note also that since the response function g(x) is concave, this model is consistent with the empirical evidence of (nonlinear) price impact discussed in section 8.2. The functional form of this dependence, however, has been chosen arbitrarily and so again this extension to the model can be seen as merely an ‘ad hoc’ fix to the difficulties associated with the vanishing of the denominator. It is possible, however, that the ideas presented above could be sufficiently formalised with further research. Another area of future research could be to exploit the links of the existing models with the theory of linear and nonlinear elasticity (of solids).1 Indeed, in some sense, the models formulated in chapter 2 are analogous to Hooke’s law in linear elasticity, the more we push the market the more it will move, and in a linear fashion. It may be that this force/extension relationship can be approximated as linear, however it is likely that this will only be the case provided the force remains within reasonable limits. Hence, just as current models are analogous to Hooke’s law for elastic media, there may also be an analogy to the ‘elastic limit’ of a material, i.e. the elastic limit of the market, beyond which the market will respond in a nonlinear fashion. This limit point might correspond to the current market depth, or a point much further away. However, ultimately the affect on the price must be bounded, since there are only a finite number of shares (and hence a finite force) available. It is hoped that if the above considerations are incorporated into the current modelling framework then the problems associated with the vanishing of the denominator may be overcome.
This is touched upon in the paper by Sch¨nbucher and Wilmott (2000), in which it was suggested o that the problems of the vanishing denominator may disappear if some ‘elasticity’ is incorporated into the response of the market price to large trades.
1

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207

Finally, it may be possible to preclude the denominator from vanishing if we utilise the techniques outlined in Soner and Touzi (2007), who extended the ideas originally introduced in Broadie et al. (1998). These works deal with cases in which the gamma of the replicating portfolio is bounded above (or below) by some trading constraint. In such situations, not all options can be perfectly replicated due to the inability of the replicating portfolio to replicate the option value in regions of large gamma. However, the minimal super-replicating price can be defined as the cheapest replicating strategy that dominates the option value in the entire domain. For the classical Black-Scholes-Merton framework it can be shown that such a minimal superreplicating price corresponds to the perfect-replicating price (i.e. with no constraints) of the same option, but with a suitably ‘face-lifted’ payoff profile. Such a face-lifted payoff profile corresponds ostensibly to a sufficiently smoothed payoff profile. It is thought that applying the constraint VSS < 1/λ to the nonlinear PDE (4.1) may help to regularise the solutions. However, it is not obvious that these techniques can be extended to the illiquid situation, since the results rely on the stochastic representation of the option value (cf. equation (1.4)), a representation that does not exist for the fully nonlinear equation (4.1). In addition, the super-replicating price is only one possible paradigm for option pricing in incomplete markets, and so it is not clear cut that this is the paradigm to use. Furthermore, it is a generally held consensus that the premium paid to super-replicate (i.e. remain entirely risk-free) is, in practise, too high. If it transpires that the problems associated with the vanishing of the denominator cannot be remedied by the above suggestions, or by some other means, then it is asserted that, of the three models that were shown to admit well-posed solutions close to expiry, the Bakstein and Howison (2003) model is one that would be the most desirable alternative model; the reason for this is two-fold. Firstly, whilst remaining well-posed close to expiry the option price behaviour also remains sufficiently different from that of the corresponding Black-Scholes (liquid) option. Secondly, in the limit of no price slippage, this model reduces to the model of Cetin et al. (2004) which has

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208

become a popular model for liquidation costs in recent years. An alternative would be to specify an entirely new framework for incorporating price impact onto option pricing theory. The aims of such a model would be: (i) to fix the problem with the denominator vanishing, resulting in well-posed problems for standard payoff profiles, and (if possible) (ii) to incorporate the empirical evidence of nonlinear price impact. Criteria such as consistency with empirical data, flexibility in application and also computational aspects (such as the regimes close to expiry considered in this thesis) would be crucial to the success of such a model. Also in this thesis, and on a related theme, we have investigated the properties of the newly introduced British option;2 a new non-standard class of early exercise options. Such options help to mediate the effects of a finitely liquid market since the contract does not require the holder to enter the market and hence incur liquidation costs. Here, once again, the powerful tool of asymptotic analysis, coupled with advanced numerical methods have been used to shed light on the behaviour of the early-exercise boundary for both large and small times from expiry. Furthermore, a pleasingly simple variable transform was found that helped to reduce the associated free-boundary problem to that of the standard American option (with dividends) in the regime close to expiry. Finally, most researchers in quantitative finance have an opinion on the direction of future research in the field, some more outspoken than others. Wilmott and Rasmussen (2002) hypothesise that future models will move away from the simplicity of traditional stochastic models and their assumptions about probabilistic behaviour. They also suggest that future models will inevitably draw from a wider range of mathematical tools. Lipton (2001) goes further to suggest that future research needs to pay much more attention to the issue of determining the spot price and to predict its short term evolution, in other words, to provide a sufficiently formal framework in which to study the market microstructure including supply and demand and liquidity
2

See Peskir and Samee (2008a,b).

. 3 See http://www. a gap which at present is particularly large. In addition. eminent physicist turned ‘quant’ Emanual Derman states in his blog3 that hopefully future work will aim to narrow the gap between the invisible microstructure of markets and the observable macroscopic properties such as market prices.wilmott.com/blogs/eman/. CONCLUSIONS 209 effects. It is hoped that this thesis is at least a step in that direction.CHAPTER 10.

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1 (A. i. when m = n = 1.Appendix A Maximum Principles Maximum principles are extremely useful tools to investigate the properties of the solutions to partial differential equations. for example. uniqueness and convexity. Nirenberg (1953) states (and proves) the maximum principles applied to equations that can be written in the form1 L(V ) + cV = D where L(V ) = n m n m aij VSi Sj + i.e. τ ). and hence we can apply the maximum principles to equations of the form AVSS + BVτ τ + aVS + bVτ + cV = D(S. If we restrict ourselves to the one dimensional case.1) Also see. These principles date back to as early as 1839 and for a readable overview of their history and a more in-depth exposition see Protter and Weinberger (1984).j=1 α. 223 . such as monotonicity in parameters.β=1 bαβ Vτα τβ + i=1 a i VS i + α=1 b α Vτ α . Evans (1998) and Protter and Weinberger (1984). this reduces to L(V ) = a11 VSS + b11 Vτ τ + a1 VS + b1 Vτ .

In the case m = n = 1 this reduces to 2 a11 η1 > 0 ⇒ a11 > 0 ⇒ A > 0 and also 2 b11 ξ1 ≥ 0 ⇒ b11 ≥ 0 ⇒ B ≥ 0. A > 0. MAXIMUM PRINCIPLES 224 In order to do this we require the differential operator L to be elliptic in the Svariables and parabolic in the τ -variables.β=1 bαβ ξα ξβ ≥ 0 hence positive semi-definite for any real vectors η. τ ). Before we state the maximum principle we can formally define the solution domain as Ω ∈ R+ and assume that it is open.2) (for any c) to one in which c = 0 by making the transformation V = ecτ u to arrive at an equation of the form ˆ L(u) = AuSS + auS − uτ = e−cτ D(S.3) which we now wish to apply the maximum principle to.j=1 hence positive definite and m α. Therefore we require n aij ηi ηj > 0.1) provided A > 0 and B ≥ 0 with no restriction on the sign of a and b. (A. τ ) = D(S. Let ΩT = Ω × (0. τ ). where T > 0 and also define ∂ ∗ ΩT = ∂Ω\Ω × {T }. ξ = 0. T ].APPENDIX A. i. Hence we can apply the maximum principle to equations of the form (A. In what follows (for simplicity) we shall assume that B = 0 and b = −1 to obtain a forward parabolic (diffusion) equation of the form AVSS + aVS − Vτ + cV = D(S.2) Furthermore we make the assumption that c = 0 in the above. This last simplification may seem a little restrictive but it should be noted that it is possible to reduce equation (A. . connected and bounded. (A.

ˆ we have that. We are now ready to formally state the maximum principle applied to equations of the form (A. sup u = max u = max u. i. τ ). since at such a point uSS ≤ 0 ˆ boundary ∂ ∗ ΩT .3). provided A > 0. Suppose that u(S. τ ) ≥ 0 and A > 0 everywhere in the closure of the domain. ΩT . To summarise. and furthermore that the coefficients of equation (A.APPENDIX A. An outline of the proof of such maximum principles is easily seen by considering the heat equation operator L(u) = uSS − uτ . ˆ The maximum principle states that if D(S.1 in the interior of ΩT ) must occur on the boundary ∂ ∗ ΩT .e. and alternatively if D ≤ 0 then the minimum must occur on the .3) are bounded in ΩT . then if D ≥ 0 then the maximum occurs on the ˆ boundary. ∗ ΩT ∂ΩT ∂ ΩT By analogy we can find the minimum principle by making the substitution u = −u ˆ to obtain ˆ L(−ˆ) = −AˆSS − aˆS + uτ = D(S. ∂ ∗ ΩT corresponds to the boundaries τ = 0. then the maximum of the solution (which is assumed to be C 2. u applying the maximum (minimum) principle to the equation ˆ L(u) = D(S. u u ˆ u ˆ ˆ Hence the maximum principle states that if −D ≥ 0 or D ≤ 0 then u has its maximum ˆ on the boundary and hence u = −ˆ has its minimum on the boundary. S = 0 and S = Smax . τ ). u u u ˆ ˆ ⇒ AˆSS + aˆS − uτ = L(ˆ) = −D(S. τ ) satisfies the inequality L(u) > 0 in the domain ΩT then u cannot have a (local) maximum at any interior point. MAXIMUM PRINCIPLES 225 hence for a one-dimensional rectangular domain. Furthermore if D = 0 then both the maximum and minimum must occur on the boundary. τ ).

3. τ ) will satisfy a forwards parabolic PDE and the solution to this differential equation must have it’s maximum on the boundary ∂Ω\Ω × {T } = ∂ ∗ Ω. it is possible to interpret the maximum principle from a probabilistic point of view. in other words L(u) = A(S.e. It follows immediately that m ≤ G (SγΩ . γΩ ) |St = S] ≤ M. thereby violating L(u) > 0. uS )uS − uτ . u. where γΩ denotes the first exit time of the process from the domain Ω.APPENDIX A. A. ∂Ω\Ω × {0}. γΩ ) ≤ M. uSS )uSS + a(S. . τ ). MAXIMUM PRINCIPLES 226 and uτ = 0. t) is the value of the function on the boundary of the domain. t) will also satisfy a backwards parabolic PDE via the Feynman-Kac representation theorem outlined in subsection 1. t) ≤ M.1 Nonlinear equations The maximum principles outlined above also hold for any nonlinear equation that can be expressed in the form ˆ L(u) = D(S. Aside As an interesting aside. u. uS . i. i. τ. Hence u(S. St = S we have that m ≤ E [G (SγΩ . Taking expectations given that the process starts at S. ⇒m ≤ u(S.e.3. Let us consider a process started at S and time t and furthermore let M denote the maximum value of the function on the boundary and m the minimum value. and G(S. τ. see Protter and Weinberger (1984). where u(S. for a more formal proof. where the coefficients of the derivatives in the operator can now be functions of the solution and its derivatives.

hence we have 1 1 2 2 Vτ1 − Vτ2 = F (S. VS . where we assume that ellipticity has been shown. p11 ) 2 ∂F (S. u.4) Using the the mean value theorem we can rewrite the right-hand-side of equation (A. VS . p. VS < V S < VS and VSS < V SS < VSS . τ.q=1 i. τ. τ. consider a general nonlinear PDE of the form uτ = F (S. For the one dimensional case (n = m = 1) we have ∂F (S. (A. ∂plq l. uSS ). V. We can apply the maximum principles provided that the function F is elliptic in all values of its arguments in ΩT . Let V 1 and V 2 denote two solutions of the above PDE. τ. p1 . τ.APPENDIX A. MAXIMUM PRINCIPLES 227 As an example. Hence the equation takes the form L(V 1 − V 2 ) + c(V 1 − V 2 ) = D(S. positive definite. uS . V 2 . u. VS .2 Uniqueness of PDEs We can use the maximum principle to prove the uniqueness of the solution to a PDE of the general form Vτ = F (S. V VS V SS 2 1 2 1 where V 2 < V < V 1 . (A. pi .4) as a linear combination of V 1 − V 2 and its first and second derivatives with respect to S. VSS ). Doing so we obtain (V 1 − V 2 )τ = ∂F ∂V (V 1 − V 2 ) + ∂F ∂VS (V 1 − V 2 )S + ∂F ∂VSS (V 1 − V 2 )SS . ∂p11 ∂uSS n A. V 1 .5) . τ ). VSS ). p. In other words in general form ∂F (Si .e. uSS ) ξ1 > 0 ⇒ > 0. uS . τ. pij ) ξl ξq > 0. τ. VSS ) − F (S.

2. Therefore provided A > 0 and that the coefficients remain bounded. recall that this can be reduced to an equation of the form L(u) = 0 by making the transform u = e−cτ (V 1 − V 2 ) and so we can now apply the relevent maximum principle.5) becomes 1 2 1 σ (V − V 2 )xx + r(V 1 − V 2 )x − (V 1 − V 2 )τ − r(V 1 − V 2 ) = 0.1 The linear Black-Scholes equation If we wish to apply the maximum principle to the Black-Scholes equation we have the problem that the coefficient of the diffusion term will become degenerate at S = 0. Vxx ). Evaluating the derivatives of F . Fortunately we can make the change of variable x = log S which reduces the equation to 1 Vτ = σ 2 Vxx + rVx − rV = F (x. VS . We know that on the boundary V 1 − V 2 must equal zero. hence V 1 ≡ V 2 proving uniqueness. V. V Finally. 2 . since both solutions must satisfy the same boundary conditions.APPENDIX A. equation (A. MAXIMUM PRINCIPLES 228 where A= a= c= ∂F ∂VSS ∂F ∂VS ∂F ∂V . then the maximum principle will ensure that u ≡ 0 ⇒ V 1 − V 2 ≡ 0 ∈ ΩT . 2 hence a constant coefficient linear PDE. which exhibits no such degeneracy. A. V SS . Vx . hence we must have that u = 0 on the boundary.

MAXIMUM PRINCIPLES and letting u = e−rτ (V 1 − V 2 ) leads to 1 2 σ uxx + rux − uτ = 0.2 The nonlinear (illiquid) Black-Scholes equation The problem of the degeneracy of the diffusion coefficient at S = 0 is also present in the fully nonlinear equation (4. τ. which reduces equation (4. uxx ) . in other words the restriction that the denominator in equation (4. τ ) = 0 and so the application of the 2 maximum principle ensures that the maximum of the solution must occur on the boundary and so we must have that u ≡ 0. The next step is to check that the function F in (A. τ ). This is natural since. A. 2 229 ˆ Hence we can identify A = 1 σ 2 > 0 and D(S.1) to uτ = σ 2 (uxx − ux ) 2 2 1 − λe−2x+rτ (uxx − ux ) = F (x. Frey. (A.APPENDIX A.2.6) and we are now in a situation where the equation is no longer degenerate. 1998). we make the transform S = ex−rτ and V = ue−rτ . hence V 1 ≡ V 2 giving uniqueness.e. Differentiating F with respect to the second derivative gives σ 2 1 + λe−2x+rτ (uxx − ux ) ∂F = 3 ∂uxx 2 1 − λe−2x+rτ (uxx − ux ) (A. The consequence of this is that we are not able to use maximum principles in the regime where the denominator is allowed to vanish.1) but again making the same log transform as for the Black-Scholes case will remove such a degeneracy. i.6) is elliptic in all values of its argument. ux . |uxx − ux | < λ Transforming the above back to the original variables it is clear that this corresponds to |VSS | < 1/λ for all (S. hence to see under which situations we can apply the maximum principles.7) which can be seen to be strictly positive (and hence elliptic) if and only if we have e2x−rτ ∈ ΩT .1) cannot vanish (cf. For simplicity we shall make a further transform to the forward prices for the stock and the option. if the denominator is allowed to vanish then we .

of (4.8) It is advantageous at this point to rewrite the above using the following inverse transform uxx − ux = S 2 uSS = e2x−2rτ uSS = e2x−rτ VSS = e2x−rτ Γ.5) becomes σ 2 (1 + λe−2x+rτ (uxx − ux )) 2 1− λe−2x+rτ (uxx − ux ) 3 (u 1 − u2 )xx − (u1 − u2 )τ = 0.1) on the liquidity parameter λ.APPENDIX A. Applying the maximum principle to the above equation yields the required uniqueness result. A. Next.1). (A.3 Monotonicity in λ Having proved uniqueness we now wish to determine the dependence of the solution to equation (4. We can do so by differentiating (directly) the transformed equation (A. However. This can be done simply by using (A.6) with respect to λ. we wish to provide an alternative uniqueness proof for equation (4. we shall proceed to prove uniqueness of the solution. smoothness of the solution can also not be determined a priori if the denominator is allowed to vanish. In addition. V 1 ≡ V 2 in ΩT .7) in which case equation (A. from which it can be seen that (provided the denominator does not vanish) then we will have that A > 0. τ ). and investigate other properties.1) in the regime where |VSS | < 1/λ everywhere within the domain. .6) back into equation (4. Note that this result still stands for any functional form of the liquidity parameter λ(S. which also contradicts the requirement for the applicability of such maximum principles. since uniqueness is preserved under the inverse transforms required to convert equation (A. MAXIMUM PRINCIPLES 230 have unbounded coefficients of the equation. provide we do not allow the denominator to vanish.1) to that proposed by Frey (1998). Doing so and setting w = to the following second order (linear) PDE for w σ 2 (1 + λe−2x+rτ (uxx − ux )) 2 1 − λe−2x+rτ (uxx − ux ) 3 ∂u ∂λ leads (wxx − wx ) − wτ = 1 − λe−2x+rτ (uxx − ux ) σ 2 e−2x+rτ (uxx − ux )2 3.

we must have w(x. i. w ≥ 0 in the interior of the domain ΩT . MAXIMUM PRINCIPLES 231 where we have defined Γ := VSS .e. gives that the solution w must have its minimum on the boundary. and thus equation (A.9) is negative. in other words ∂V ∂u ≥0⇒ ≥ 0 ∈ ΩT . or more specifically the minimum principle since the right-hand-side of (A. 2 (1 − λΓ)3 2 (1 − λΓ)3 (1 − λΓ)3 parameter λ. Now applying the maximum principle.9) Since the initial condition of any option contract will be independent of the liquidity .APPENDIX A. ∂λ ∂λ hence the solution is an increasing function of λ.8) becomes σ 2 (1 + λΓ) σ 2 e2x−rτ Γ2 σ 2 (1 + λΓ) wxx − wx − w τ = − . (A. It should be emphasised that this result only holds in the regime |VSS | < 1/λ.e. when the denominator is not allowed to vanish. i. 0) = 0 and more generally w = 0 on the boundary ∂ ∗ ΩT .

3) can be nondimensionalised by making the following substitution1 S = Kex−(µc −D)(T −t) .Appendix B Non-dimensionalisation of the British Put The free-boundary formulation of the British put option value (9. τ ) = (ex − 1) eρ1 τ as x → ∞. which it trivially must satisfy due to the specifies of the option contract. where ρ1 = 2r σ2 and ρ2 = 2(µc +D) . 232 . τ ) = ex+ρ1 τ Φ √ ∂x 2τ on x = xf . t) = K e− σ2 τ v(x. τ ) + 1 − ex . σ2 In addition we have the condition that xf (0) = log r µc if µc ≥ r. 0) = (ex − 1)+ . (x. v(x. v(x. v(x. 1 Note that the strike price K is scaled out of the problem (completely) by a simple linear scaling. t=T − 2τ . The resulting non-dimensional system becomes vτ − vxx + (1 − ρ1 + ρ2 )vx = eρ1 τ (ρ2 ex − ρ1 ) . σ2 2r V (S. τ ) = ex+ρ1 τ Φ x+τ x−τ √ − e ρ1 τ Φ √ 2τ 2τ ∂v x+τ on x = xf .

2 St   z 1 log St − r − D − 2 σ 2 u . Hence we have that the probability that St+u .e. i.1) where we have assumed the process was started at position St . We are given the stochastic process dSt = (r − D)St dt + σSt dWtQ which is the process under the measure Q. the value of the stock price at time t + u given that it started at St is under some value z is given by 1 PQ [St+u ≤ z] = PQ St exp σ(Wt+u − Wt ) + r − D − σ 2 u ≤ z 2 1 z = PQ exp σ(Wt+u − Wt ) + r − D − σ 2 u ≤ 2 St 1 z = PQ σ(Wt+u − Wt ) + r − D − σ 2 u ≤ log .Appendix C The Probability Density Function In order to determine the probability density function under the risk neutral measure Q we adopt the following procedure. ⇒ PQ [St+u ≤ z] = PQ Wt+u − Wt ≤ σ 233 . This process has the closed form solution 1 St+u = St exp σ(Wt+u − Wt ) + r − D − σ 2 u 2 (C.

t. z.2) with respect to z yields log 1 exp − f (S. z. The transitional probability density function is given by the derivative of the above with respect to z. hence ∂ ∂ PQ [St+u ≤ z|St = S] = ∂z ∂z z f (S. t + u) = √ σz 2πu under the measure Q. from the normally distributed independent increment property of the √ Wiener process Wt .APPENDIX C. t + u) is the transitional probability density function of the process at time t + u and position y. z ≤ z] = Φ   log z St  − r − D − 1 σ2 u 2 . t + u)dy 0 = f (S. y. y. t. t + u). √ σ u  − r − D − 1 σ2 u 2 .2) PQ [St+u ≤ z|St = S] = f (S. Now directly computing the derivative of (C. t. y. t + u)dy. THE PROBABILITY DENSITY FUNCTION 234 It is known. √ σ u z St (C. that Wt+u − Wt follows the same law as uW1 hence we have PQ [St+u ≤ z] = PQ W1 ≤ ⇒ P [St+u Q  log where we have used the standard result that P [W1 ≤ y] = Φ(y). t. z S 1 − r − D − 2 σ2 u 2σ 2 u 2 . t. 0 where f (S. given that it started at S at time t. this can be seen from the definition.