4 views

Uploaded by Luca Ballestra

save

- Derivatives
- IEO_Syllabus_Third_Year-Computer_Science_Engineering.pdf
- options handbook
- Untitled
- ncfm_DMDM_prac_E
- 8. Sarmiento v. Agana
- Ch04 DiffInt
- Untitled
- SKINNY Options Analysis
- ErrataMFE-9-2p
- Derivatives Report 16th September 2011
- Understanding Stock Index Futures
- Pst Practice Test Rationale 3.27.07 English
- Star India Market Research Daily Equity Report
- Derivatives Report, 31st May 2013
- UK L2 Review Course Solutions 2013 V1-1.1
- 24 Option
- Hedging Strategy 9071 120 (1)
- Terminology
- Page 1
- 5
- Lec_1
- Binary Trading eBook
- Hedging Performance of Protective Puts and Covered Calls Portfolio : A Study of NSE NIFTY Options
- eBook
- Fos
- 24option.com eBook
- MBA-Finance-2ndYear.pdf
- CA-based Microstructure DerivativesPricing Asynchronous
- Hw2-2018(1)
- PWD - SoR 2018-19.pdf
- chapt-12incometax-corporations2013f.doc
- Huevos Rotos Con Chorizo
- Chifla PDF
- third grade standards
- Papeles de Trabajo
- The client did not receive ALL remunerations mandated by law as stipulated by the Respondent Agency on its Position Paper.docx
- Medidor PD Digital
- 7RENT CAR and TRAVEL_ September 2017.pdf
- abstrak_16482.pdf
- Ensayo.docx
- Medicina_Legala_2015.pdf
- Get Background Report
- Game
- Songwriting Worksheet 1
- 20-09-2018 dr. Saha, SpOG
- Kop
- recepti
- kartu kendali.docx
- kls 3
- A. ARJONA Delincuentos.pdf
- Earth_pt2.txt
- 2011 PHYS REV leptina e o controle do sistema nervoso central.pdf
- Laporan Pendahuluan Post
- hbbivftxxffffffffffffftgrf.docx
- eksisi cele PPK.doc
- Reghin_09
- cuestionario_auxiliar_administrativo2016
- Ajustes y tolerancias.pptx
- sdffsdfsd
- Draft
- YONG
- eserciziBallestra
- 2000.pdf
- optimal control theory
- 2000
- Leland
- LGTARV2016
- optimization
- paper3
- BoylePrices
- Backward
- Paper
- giugno1
- Calogero
- Heston Original
- Paper
- esercizisvolti
- Hes Ton 1

You are on page 1of 6

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

0

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 .

3497–3512. Spotz and G. Conjugate Gradient Methods for Toeplitz Systems.23e-7 3.593 257 1/40 5. Vol. [6] L. Inﬁnity norm error and convergence rates of FOCS with local mesh reﬁnement for pricing a European call option under Merton’s jump-diﬀusion model. 263–280. China. [16] X. pp.88e-6 3. Jin. An Explicit Fourth-Order Compact Finite Diﬀerence Scheme for Three Dimensional Convection-Diﬀusion Equation. Fourth Order Compact Scheme for 3D Convection Diﬀusion Equation with Boundary Layers on Nonuniform Grids. Vol.992 513 1/80 5. Lee and H. Department of Mathematics. pp. [11] W. 125–144. Num. Vol. [9] S. N ∆x Error at xK l∞ error Order 33 1/5 1. 191 (2002).87e-4 3. University of Texas at Austin (1995). 38 (1996). Methods Engrg. Spotz and G.High Order Scheme for Option Pricing with Jumps 5 N ∆x Error at xK l∞ error Order 33 1/5 1. High-Order Compact Finite Diﬀerence Schemes for Computational Mechanics. [7] M. 87–112. Comput. Engrg. [12] W.. 373–392.62 65 1/10 4.234 129 1/20 1. 38 (1995). 166–172. Parallel & Scientiﬁc Computationss.38e-2 2. Manuscript. Vol. Merton. d’Halluin. P. Ng. Vol. Ge and M. E-mail address: hsun@umac.51e-1 1.69e-2 2. Sun and J. A fourth-order Poisson solver.51e-1 4. Zhao.998 1025 1/160 1.82e-3 4. University of Macau. pp. Robust Numerical Methods for Contingent Claims under Jump Diﬀusion Processes. 668–690. Vol. Carey. Phys.77e-5 3. Gupta. [15] J.16e-4 3. Forsyth and K. Zhang. [8] Y. Option Pricing When Underlying Stock Returns Are Discontinuous. J. 55(1) (1984). 22(3) (1997). Journal of Financial Economics. Chan and X. 3-4 (2000). Numer. University of Macau. Macao. 25 (2005). H.67e-3 2. Zhang L. IMA Journal of Numerical Analysis. Inﬁnity norm error and convergence rates of central diﬀerence scheme for pricing a European call option under Merton’s jump-diﬀusion model. PhD Thesis. pp.083 257 1/40 2.. Vol.69e-3 1. Feng and V. pp. SIAM Review. Sun. Fourth Order Compact Scheme with Local Mesh Reﬁnement for Option Pricing in JumpDiﬀusion Model. Vol. pp.47e-4 1. 14 (1998). 427–482.20e-2 65 1/10 1. [4] R. 4661–4674. 8. Vetzal. Int.66e-8 1. Res. Linetsky.06e-1 2. Carey.999 Table 1. Zhang. [13] J. Gupta.49e-6 2. Mech.91e-3 6. pp.883 1025 1/160 4. Methods Appl.mo Department of Mathematics. pp. An Introduction to Iterative Toeplitz Solvers.802 513 1/80 6. 304–325.67e-2 1. Vol. pp. High-Order Compact Scheme for the Steady Stream-Function Vorticity Equations.61e-7 1. pp.847 129 1/20 9. Communications in Numerical Methods in Engineering. J.935 Table 2. Philadelphia (2007). [10] R. High Order Compact Scheme with Multigrid Local Mesh Reﬁnement Procedure for Convection Diﬀusion Problems. China. 3 (1976). [5] R. Macao. Zhang. Chan and M. Comput. [14] J. E-mail address: ma76522@umac. SIAM. Mathematics of Operations Research. 56 (2008).76e-2 1. Numerical Analysis of American Option Pricing in A Jump-Diﬀusion Model. Pricing Options in Jump-Diﬀusion Models: An Extrapolation Approach. Oper.67e-3 1.62 1.mo . Neural.

- DerivativesUploaded byAzhar
- IEO_Syllabus_Third_Year-Computer_Science_Engineering.pdfUploaded bynitheesh chandran r j
- options handbookUploaded byjohnsm2010
- UntitledUploaded byapi-234732356
- ncfm_DMDM_prac_EUploaded byajaykushwa
- 8. Sarmiento v. AganaUploaded byGerald Christopher Manuel Padilla
- Ch04 DiffIntUploaded bysabbysamura
- UntitledUploaded byapi-234732356
- SKINNY Options AnalysisUploaded byAnna Major
- ErrataMFE-9-2pUploaded byNafees Chagani
- Derivatives Report 16th September 2011Uploaded byAngel Broking
- Understanding Stock Index FuturesUploaded bynamhvu99
- Pst Practice Test Rationale 3.27.07 EnglishUploaded byAssel Gabdullina
- Star India Market Research Daily Equity ReportUploaded bykavita sharma
- Derivatives Report, 31st May 2013Uploaded byAngel Broking
- UK L2 Review Course Solutions 2013 V1-1.1Uploaded bySibylle Airut
- 24 OptionUploaded byTroll
- Hedging Strategy 9071 120 (1)Uploaded byharshkumar patel
- TerminologyUploaded byMathew John
- Page 1Uploaded byajayinstyle
- 5Uploaded byRonit Narula
- Lec_1Uploaded byTonny
- Binary Trading eBookUploaded bySteven Mark Cottingham Reid
- Hedging Performance of Protective Puts and Covered Calls Portfolio : A Study of NSE NIFTY OptionsUploaded byRahul Pinnamaneni
- eBookUploaded byKevin Mayne
- FosUploaded byAmol Chavan
- 24option.com eBookUploaded byrogue14
- MBA-Finance-2ndYear.pdfUploaded byRosemarie Miano Trabuco
- CA-based Microstructure DerivativesPricing AsynchronousUploaded byScott Cicada
- Hw2-2018(1)Uploaded byyoachallenge

- DraftUploaded byLuca Ballestra
- YONGUploaded byLuca Ballestra
- eserciziBallestraUploaded byLuca Ballestra
- 2000.pdfUploaded byLuca Ballestra
- optimal control theoryUploaded byLuca Ballestra
- 2000Uploaded byLuca Ballestra
- LelandUploaded byLuca Ballestra
- LGTARV2016Uploaded byLuca Ballestra
- optimizationUploaded byLuca Ballestra
- paper3Uploaded byLuca Ballestra
- BoylePricesUploaded byLuca Ballestra
- BackwardUploaded byLuca Ballestra
- PaperUploaded byLuca Ballestra
- giugno1Uploaded byLuca Ballestra
- CalogeroUploaded byLuca Ballestra
- Heston OriginalUploaded byLuca Ballestra
- PaperUploaded byLuca Ballestra
- esercizisvoltiUploaded byLuca Ballestra
- Hes Ton 1Uploaded byLuca Ballestra