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Proceedings of the National Institute for Mathematical Sciences Vol. 2, No. 10(2008), pp.

000–000

A HIGH ORDER COMPACT SCHEME FOR OPTION PRICING WITH JUMPS
HAI-WEI SUN AND SPIKE T. LEE

Abstract. In this paper we consider a partial integro-differential equation (PIDE), which arises from the option pricing problem in jump-diffusion model. A fourth order compact finite difference scheme is proposed to discretize the spatial variable of this PIDE. The computation of the discretized system involves matrix-vector multiplication, where the matrix generated from the jump integral term is Toeplitz-like. Hence fast Fourier transform can be used to perform these multiplications efficiently. Numerical results are given to show that our approach indeed has fourth order accuracy in space, which is much better than the classical second order central difference scheme.

1. Introduction In this paper, we consider option pricing under the jump-diffusion model presented by Merton [10]. In this model, the asset return follows a standard Wiener process driven by a compound Poisson process with normally distributed jumps. Furthermore, by choosing the parameters of the jump process properly, volatility smiles and skews can be generated under this model [3]. The value of a contingent claim under a jump-diffusion process satisfies a partial integro-differential equation (PIDE). This kind of equation generally contains differential operators and a non-local integral term. Numerical solutions for the PIDE were widely studied in the past several years [1, 2, 3, 8, 16]. But these methods are at most second order accuracy for both space and time. For time direction, Feng and Linetsky [6] recently suggested an implicit-explicit (IMEX) scheme, where the differential part is treated implicitly and the integral part explicitly, with a new high order extrapolation approach. Their method is independent of the choice of spatial discretization and can be added to any PIDE solver based on the IMEX scheme. For spatial direction, most of the schemes ever proposed exploit standard central difference discretization, which only has second order convergence. In this paper, we apply a fourth order compact scheme (FOCS) for pricing European call options. The PIDE is discretized in time by an IMEX method. Inspired by Feng and Linetsky’s idea [6], we employ the Richardson extrapolation, which is less accurate than theirs but comparatively straightforward, to achieve high order accuracy in time. Moreover, we exploit numerical quadrature method for evaluating the jump integral term. It guarantees the Toeplitz-like structure of the integral operator such that a fast algorithm can be applied. This rest of the paper is arranged as follows. In Section 2 we review the jump-diffusion model for option pricing and the IMEX scheme with extrapolation approach for the PIDE. In Section 3 we propose the FOCS for the PIDE. Issues regarding the evaluation of the non-local integral term are discussed in Section 4. In Section 5 we give some numerical results.
The research was partially supported by the research grant RG-UL/07-08S/Y1/JXQ/FST and CG016/0809W/SHW/FST from University of Macau. This is a brief review article for 2008 NIMS International Conference in October, 2008 joint with The 4th East Asia SIAM Conference. Some of the contents in the article may appear somewhere else.
c 2007 National Institute for Mathematical Sciences

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t) ex − Ke−rt . +∞) × [0. −∞ where y = x + z. T ]: (1) −Vτ = σ2 2 S VSS + (r − λκ)S VS − (r + λ)V + λ 2 ∞ V (Sη. 0 where r is the risk-free interest rate and g(η) is the density function of the jump size distribution. dz is the increment of a Brownian motion and dq is a Poisson process with arrival intensity λ (dq = 0 with probability 1 − λdτ and dq = 1 with probability λdτ ). hence the following property holds: y−x y−x ∞ 2 2 e−(log(η)−µ) √ 2πγη 2 /2γ 2 . T − t). 0) = max(ex − K. We consider the jump-diffusion model presented by Merton [10]. σ is the stock return volatility. +∞) × [0. 0). the initial condition is given by V (x. First the . τ )g(η)dη. Let V (S(τ ). We denote the expectation of the impulse function by κ = E(η − 1). as x → +∞. Note that European put options can be handled in a similar way. the risk-neutral dynamics of the asset price S(τ ) with τ ∈ [0. Suppose a PIDE is given by: Vt = DV + LV. As L usually makes the system dense.High Order Scheme for Option Pricing with Jumps 1 2. The jump size distribution is normal with mean µ and standard deviation γ. We refer the readers to see [8] for details. Then V (S. and g(η) is given by g(η) = After changing the variable. τ ) can be computed by solving a PIDE on [0. f (y − x)dy = 1. τ ) be the value of a contingent claim on the asset S(τ ). Option Pricing in Jump-Diffusion Model and the IMEX Scheme In jump-diffusion model. η = ez and t = T − τ. t) → 0. It is common to change the variables as follows: S = ex . T ] (T is the expiration) can be described by the following diffusion process: dS = νdτ + σdz + (η − 1)dq. where D is a differential operator and L is an integral operator. T ]: (2) Vt = σ2 σ2 Vxx + (r − λκ − )Vx − (r + λ)V + λ 2 2 V (y. For a European call option. where K is the strike price. ∞ Then equation (1) is reduced to a forward PIDE on (−∞. Boundary conditions are V (x. −∞ In the following. f (y − x) = g(ey−x )ey−x and V (y. (3) f (y − x) = g(e )e = 2πγ Note that f is the probability density function of the Gaussian distribution. S where ν is the drift rate. t) = V (ey . we have e−(y−x−µ) /2γ √ . η − 1 is an impulse function making S jump to Sη. as x → −∞. t)f (y − x)dy. V (x. we utilize the IMEX scheme which is noted for avoiding dense matrices inversion. we introduce the IMEX scheme for a PIDE.

... where the differential part is treated implicitly and the integral part is treated explicitly for j = 0. .1 J V2... . 2p−1 − 1 Graphically.. .. . +∞) × [0. ∆t or (4) V j+1 − ∆tDV j+1 = V j + ∆tLV j .. Denote the solution obtained at time J T with step size ∆t/2p−1 . xI0 }. .1 . 14].2 . x1 . First the infinite x-domain (−∞. 2. it can be illustrated as follows: J V1. . Our ultimate goal is to find V J = V (T ) . with ∆t = T /J and tj = j∆t. where s is the stage number. The FOCS was proposed by Gupta [7]. At each time step. s. c = −(r + λ). Lee time interval [0. . We then apply the IMEX scheme. q = 2.... 3.. xI0 −1 . 2. the linear system (4) is solved to determine the vector V j+1 with V 0 being the given initial guess..... . we have achieved a better approximation Vs.1 . where a= and V ∗f = −∞ 1 2 σ2 σ . x2. . T ] is given by Vt = aVxx + bVx + cV + λV ∗ f.. 12..2 . 2 2 ∞ V (y. b = r − λκ − . s.. T ] is divided into J time steps. j = 0. J Vs. j = 0. J − 1: V j+1 − V j = DV j+1 + LV j . Recall that the PIDE (2) on (−∞. 3. ∞) is truncated to a finite computational domain [xmin . 3. p = 2..q = J J 2p−1 Vp. 13. 1.s J By this process. xmax ] using mesh size xmax − xmin . . Let V j = V (tj ). 1... J. t)f (y − x)dy. we can employ the Richardson extrapolation method to achieve higher accuracy. If the IMEX scheme is unconditionally stable.s which is of order O(∆ts ) after s extrapolation stages.. 2.2 H.. Sun & S. .1 J V2..q−1 . . J Vs. Then the Richardson extrapolation formula is given by (5) J Vp. The Fourth Order Compact Scheme We now proceed to consider the FOCS for option pricing. However. .. p.q−1 − Vp−1. . which is known for restraining the numerical oscillations [11. 2. xK . by Vp. J. 1.. J Vs. the IMEX scheme is only first order accurate in time. ∆x = I0 Then the computational grid with N0 = I0 + 1 points is denoted by Ωx = {x0 . p = 1..

−∞ where αi = 1 b∆x − . 1. 4. The truncation is achieved by extending Ωx to a uniform grid Ωy with mesh size ∆x as follows: xmax − xmin Ωy = {yk ∈ R : yk = ymin + k∆y. ... [9] For the kernel function ϕ(y − x. 2 2 12 24a ∆x 2∆x ∆x 2∆x b2 ∆x2 c∆x2 bc∆x2 di = a + + ..1. βi = − . Then the IMEX scheme is applied as discussed in Section 2: V j+1 − V j j+1 j+1 = aVxx + bVx + cV j+1 + λV j ∗ f. we have ∞ ϕ(y − x. tj )ϕ(y − xi . 1.. ∆x)dy = 1. Let Vij = V (xi . In order to achieve high order accuracy for the time direction. ei = b + 12a 12 12a αi = b∆x2 ∂f (y − x) ∆x2 ∂ 2 f (y − x) + . . Since the right-hand side of the above equation is given for the current time step.. Divide the time interval [0.1. Evaluation of the Integral Term Evaluation of the integral term is required to solve the linear system (9) at each time step.. we have the following theorem by using the Fourier stability analysis. in the following we study the unconditional stability of the IMEX scheme with the FOCS (7). 2. I0 . J. ∆t We then consider the following semi-discretized equation: (6) j+1 j+1 −a∆tVxx − b∆tVx + (1 − c∆t)V j+1 = V j + λ∆tV j ∗ f.... Lemma 3. Define V j = V (x. 2.... . 2.. where Vj = (V1j .High Order Scheme for Option Pricing with Jumps 3 where x0 = xmin . J. Thus FOCS can be applied for (6).2. T ] into J time steps. (7) j+1 j+1 Vij+1 [1 − (αi + αi ) + ∆t(βi + β i + r + λ)] + (αi − ∆tβi )Vi−1 + (αi − ∆tβ i )Vi+1 j j = Vij [1 − (αi + αi )] + αi Vi−1 + αi Vi+1 + λ∆t ∞ V (y. with ∆t = T /J and tj = j∆t. After solving the linear system (9). we can write the discretized equation (7) in matrix form for j = 0. ∆x)dy. j = 0. Therefore a higher order approximation to the convolution integral is also necessary. ∆x) in (8). 12a ∂x 12 ∂x2 and (8) ϕ(y − x. ∆y = ∆x = }.. j = 0. tj ). At each time step. VIj0 −1 ) . 1. βi = + . k = 0. tj ) for i = 1. the resulting VJ = V(T ) is regarded as the approximation to the true solution. −∞ According to lemma 3.. . .. n. Note that M1 and M2 are tridiagonal matrices when the computational grid is uniform. The numerical quadrature method is used for evaluating the integral term in our case. it can be treated as a convection-diffusion equation. 1. We derive the three point FOCS as follows. . I0 − 1. [9] The FOCS (7) is unconditionally stable. ∆x) = f (y − x) + Consequently. xK = log K and xI0 = xmax . J − 1: (9) M1 Vj+1 = M2 Vj + λ∆tVj ∗ ϕ. V2j . Theorem 3. 12 24a b∆x di ei ei 1 di + ... a tridiagonal system can be solved by using the LU decomposition. 2. as discussed in Section 2.

4V (y1. . t). The local mesh refinement strategy [9] is employed for numerical testing in the next section to guarantee the high accuracy. Vol.  ϕ(y0 − x2 . t)ϕ(y − xi . . 2V (y2. (10) ∆y V (y.I0 − 1. References [1] A. we have to make sure the error in temporal direction is small enough not to affect the convergence rate of the spatial discretization. ∆x) ϕ(yn − x1 .. 231–262. . ∆x) + V (yn . [3] L.. Error at xK is the difference between the true solution (in [10]) and the approximation at strike price xK . N is the number of points in the x-direction and ∆x is the mesh size. 3 Note that we have the following relation for i = 1. we can see from Table 2 that the FOCS with local mesh refinement restores fourth order convergence. . ∆x)]. As comparison. t)) . . .9 and γ = 0. t). ∆x) ϕ(y1 − xI0 −1 . ∆x) ϕ(y2 − xI0 −1 . Jump-Diffusion Processes: Volatility Smile Fitting and Numerical Methods for Option Pricing. 5. 5]. ∆x) k=1 +4 k=1 V (y2k−1 . Thus L is a Toeplitz matrix. Almendral and C. ∆x). t)ϕ(y0 − xi . Lee where y0 = ymin and yn = ymax . The value V6. r = 0. ∆x) . 2V (y4. σ = 0.  L= . t). we give the numerical results of pricing European call options under Merton’s jumpdiffusion model [10]. [2] K. Oosterlee. where  ϕ(y0 − x1 . pp. ∆x) = ϕ(yk+1 − xi+1 .. 1833–1863. Amin. Review of Derivatives Research. . 53 (2005). ∆x)dy = [V (y0 . The results in Table 1 show that the standard central difference scheme clearly attains second order accuracy. Consequently it will affect the high order accuracy. Remark 4. ∆x) ϕ(y2 − x2 . Sun & S. .. pp. (10) can be written in matrix form LVy . t)ϕ(y2k − xi .25. ∆x) ϕ(y2 − x1 . .  Furthermore. n: xi+1 − xi = ∆x = ∆y = yk+1 − yk . Numerical Valuation of Options with Jumps in the Underlying. t). Numerical Results In this section. Note that ∆y equals to the mesh size ∆x. . ∆x) ϕ(y1 − x1 .. and Vy =     ϕ(yn − xI0 −1 . 2.25. There exists a non-smooth region around the strike price xK when pricing a European call option. 2. Andreasen.4 H. t)ϕ(y2k−1 − xi ..I0 − 1. ∆x) . 4V (y3. Applied Numerical Mathematics. Andersen and J. Vol. . ∆y (V (y0. Journal of Finance..  . Thus it is necessary to concentrate grid points near xK .45.. Vol. V (yn. ∆x) .6 in (5). 4 (2000). ∆x) ϕ(yn − x2 .. ∆x) . .. pp.. Jump Diffusion Option Valuation in Discrete Time. . 1–18.. . . Thus sixth order Richardson extrapolation method is utilized to obtain sixth order accuracy in time. Hence we can write the integral in discrete form by using fourth order composite Simpson’s rule for i = 1. Therefore yk − xi = yk+1 − xi+1 and ϕ(yk − xi . ∆x) ϕ(y1 − x2 . l∞ error denotes the infinity norm error between the true solution and the approximation.1. Assume the J extrapolation stage number s = 6 and ∆t = 10−2 at the first stage. µ = −0.05.. 48 (1993). K = 100. ∆x) + 2 3 −∞ n/2 ∞ n/2−1 V (y2k .. . t)ϕ(yn − xi . In our numerical tests. and the fast Fourier transform can be applied to compute LVy [4. t). The input parameters are T = 0. 1. which is of order O(∆t6 ) after six extrapolation stages is accepted as the approximation to VJ . k = 0. ϕ(y0 − xI0 −1 .

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