Derivatives (ECONM3017)

Lecture Ten: Options V

(Numerical Procedures)

Nick Taylor
nick.taylor@bristol.ac.uk

University of Bristol

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Table of contents

1 Learning Outcomes

2 Binomial Trees

3 Monte Carlo Simulation

4 Finite Difference Methods

5 Summary

6 Reading

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Learning Outcomes

At the end of this lecture you will be able to:

1 Appreciate the need for approximations to the BSM differential equation.
2 Understand the nature of the approximations to the BSM differential
equation.
3 Price options using numerical procedures, viz, binomial trees, Monte Carlo
simulation, and finite difference methods.

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Binomial Trees

The Representation (revisited)

The movement of stock prices (as given by geometric Brownian motion) can
be approximated by a binomial tree. Note that:
Each point in the tree is referred to as a node.
The first node corresponds to the current price.
The last set of nodes correspond to the possible prices at the maturity
of the option.

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Binomial Trees (cont.)

The Representation (cont.)

The one-step binomial model is given by
Su

p

S
@ 1−p
@
@
R
@
Sd
Starting at S, the stock price is allowed to move up (with probability p) to
Su or down (with a probability 1 − p) to Sd.
Note that increasing the number of
steps in the tree improves accuracy.

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Binomial Trees (cont.)

The Representation (cont.)

The four-step binomial model is given by
Su 4
3 
*


Su
2 
*HH

 2
Su H
j
HSu
*

 HH *


Su H
j
HSu
*H
 *HH

 HH S  
jS
H
SH
 j
H
*
 H
H
*

H   H 
H
j
H H
j
H 
Sd H
H

*

SdHH
H
j
H H
j2
H
2
Sd H
H
 Sd
*


H
j
H 3
SdH HH
j4
H
Sd
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Binomial Trees (cont.)

The Representation (cont.)

Assuming that u = 1/d and using risk-neutral valuation, geometric
Brownian motion can be approximated using the following parameter values:
a−d
p= ,
u−d
√
σ ∆t
u=e ,
√
d = e −σ ∆t
,
a = e r ∆t .

These parameters are chosen so that the tree gives correct values for the
mean and variance of the stock price changes in a risk-neutral world.

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Binomial Trees (cont.)

Backwards Induction
The logic is as follows:
The value of the option at the final nodes is known.
Therefore, we can work back through the tree using risk-neutral
valuation to calculate the value of the option at each node.
This process continues until the first (single) node is reached. At this
point the price of the derivative is determined.

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Binomial Trees (cont.)

Backwards Induction (cont.)

For an American put option on a non-dividend paying asset:
Step 1: Calculate the stock prices for each node.
Step 2: At T , calculate the option price (max(K − ST , 0)).
Step 3: The premium at the previous node will equal:
(a) The expected value of the subsequent premia discounted by the
risk-free rate.
OR
(b) The value of max(K − Si∆t , 0), if this is greater than the value
calculated in Step 3 (a) (i.e., early exercise).
Step 4: Continue backwards until the first node is reached.

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Binomial Trees (cont.)

Backwards Induction (cont.)

Example
Consider an American put option with T = 5/12, S = 50, K = 50, r = 0.1,
σ = 0.4. Divide the life of the option into one month intervals (⇒ ∆t = 1/12).
Under these conditions we have

u = 1.1224, d = 0.8909, a = 1.0084, p = 0.5073.

Thus,

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Binomial Trees (cont.)

Backwards Induction (cont.)

Example (cont.)
The entries on the last set of nodes are given by max(K − ST , 0). Entries in the
penultimate set of nodes (one month prior to maturity, the ith node at time i∆t
say) are determined as follows (labels correspond to those used in Hull, 2015):

Node E (Si∆t = 50):

option price = ((0 × 0.5073) + (5.45 × 0.4927)) e −0.1×1/12 = 2.66,

> max(50 − 50, 0) = 0, ⇒ no early exercise.

Node A (Si∆t = 39.69):

option price > ((5.45 × 0.5073) + (14.64 × 0.4927)) e −0.1×1/12 = 9.90,

= max(50 − 39.69, 0) = 10.31, ⇒ early exercise.

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Binomial Trees (cont.)

Dividends
Three dividend types can be incorporated into the binomial model:
1 Known Dividend Yield (continuous-paying)
If the yield is paid throughout the year (as on a stock index) then one
can amend parameter a as follows:

a = e (r −q)∆t ,

where q is the dividend yield.

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Binomial Trees (cont.)

Dividends (cont.)
2 Known Dividend Yield (discrete-paying)
If there is a single dividend (as on an individual stock), and the dividend
yield is known, then for all nodes observed before the ex-dividend date:

Si∆t = Su j d i−j , j = 0, 1, . . . , i.

By contrast, for all nodes observed after the ex-dividend date:

Si∆t = S(1 − δ)u j d i−j , j = 0, 1, . . . , i,

where δ is the dividend yield, and all previously-defined parameters are
maintained.
Note that the above equation can
be easily modified to account for
more than one dividend payment.

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Binomial Trees (cont.)

Dividends (cont.)
3 Known Dollar Dividend (discrete-paying)
Assume that a single dividend D is paid at time τ , which is between
k∆t and (k + 1)∆t. When i ≤ k, the nodes at time i∆t have prices
defined in the usual way. However, when i = k + 1 (first set of nodes
after ex-dividend date), the nodes have prices

Si∆t = Su j d i−j − D, j = 0, 1, . . . , i.

When i = k + 2, the nodes have prices

Si∆t = (Su j d i−1−j − D)u, or (Su j d i−1−j − D)d, j = 0, 1, . . . , i − 1,

such that there are 2i rather than i + 1 nodes. Furthermore, when

i = k + m, there are m(k + 2) rather than k + m + 1 nodes.

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Monte Carlo Simulation

Discounted Expected Cash Flows

The price of any asset is given by the discounted expected cash flows
(payoffs) to the asset.
In the case of derivatives, risk-neutral valuation allows us to assume
that the discount rate is given by the risk-free rate; thus,

f = e −rT E(fT ),

where f is the price of the derivative, fT is the payoff to the derivative

at maturity (given by its price), and E(.) is an expectations operator.
Monte Carlo simulation is used to estimate the expectation. This is
achieved by generating a number of possible price paths, and then
averaging the implied payoff at maturity.

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Monte Carlo Simulation (cont.)

Discounted Expected Cash Flows (cont.)

For a European put option on a non-dividend paying asset, the following
steps are taken:
Step 1: Generate a geometric Brownian motion series of length T .
Step 2: Calculate the payoff (fT ) at T using max(K − ST , 0).
Step 3: Repeat Steps 1 and 2 (usually 10000 times).
Step 4: Calculate the arithmetic mean of the fT ’s generated to give
E(f
b T ).
Step 5: Discount this expected value using the risk-free rate to give an
estimate of the price of the European put (fb).

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Monte Carlo Simulation (cont.)

Variation Reduction Procedures

Monte Carlo simulation is computationally time expensive. The following
procedures can dramatically reduce this expense.
Antithetic Variable Technique
Control Variate Technique
Importance Sampling
Stratified Sampling
Moment Matching
Use of Quasi-Random Sequences

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Finite Difference Methods

The Framework
Finite difference methods provide an approximate (risk-neutral valuation)
solution to the BSM differential equation:

∂f ∂f 1 2 2 ∂2f
+ rS + σ S = rf .
∂t ∂S 2 ∂S 2
This is achieved by converting this differential equation into a set of
difference equations, which are then solved iteratively. The method proceeds
by dividing time and prices into N and M equally spaced intervals of length
∆t and ∆S, respectively. If the option life is T then ∆t = T /N, and if the
maximum stock price is Smax then ∆S = Smax /M.

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Finite Difference Methods (cont.)

The Framework (cont.)

The discretisation of time and prices can be represented in the following grid:
Stock Price S
Smax•6• • • • • • • • • •
• • • • • • • • • • •
• • • • • • • • • • •
• • • • • • • • • • •
• • • • • • • • • • •
• • • • • • • • • • •
• • • • • • • • • • •
• • • • • • • • • • •
2∆S• • • • • • • • • • •
∆S• • • • • • • • • • •
0• • • • • • • • • • •-
0 ∆t T Time t

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Finite Difference Methods (cont.)

Implicit Finite Difference Method

This method assumes the following approximations to the partial derivatives
in the BSM differential equation:
∂f fi,j+1 − fi,j
= ,
∂S ∆S
∂f fi+1,j − fi,j
= ,
∂t ∆t
∂2f fi,j+1 + fi,j−1 − 2fi,j
= .
∂S 2 ∆S 2
Substituting these into the BSM differential equation gives,

aj fi,j−1 + bj fi,j + cj fi,j+1 = fi+1,j ,

where aj , bj , and cj are functions of r , j, ∆t, and σ (see Hull, 2015, for
details).

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Finite Difference Methods (cont.)

Implicit Finite Difference Method (cont.)

The value of the derivative along three of the edges of the grid are known;
specifically,

t = T : fN,j = max(K − j∆S, 0), j = 0, 1, . . . , M.

S =0: fi,0 = K , i = 0, 1, . . . , N.
S = Smax : fi,M = 0, i = 0, 1, . . . , N.

Starting at T − δt (i.e., i = N − 1), the other values of f are calculated by

solving the following M − 1 simultaneous equations:

aj fN−1,j−1 + bj fN−1,j + cj fN−1,j+1 = fN,j , j = 1, 2, . . . , M − 1.

for fN−1,1 , . . . , fN−1,M−1 . This process is repeated until f0,1 , . . . , f0,M−1 , are
obtained.

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Finite Difference Methods (cont.)

Explicit Finite Difference Method (cont.)

To simplify the approach, this method assumes that ∂f /∂S and ∂ 2 f /∂S 2 at
point (i, j) on the grid are assumed to be the same as at point (i + 1, j).
This is achieved by letting
∂f fi+1,j+1 − fi+1,j−1
= ,
∂S 2∆S
∂2f fi+1,j+1 + fi+1,j−1 − 2fi+1,j
= .
∂S 2 2∆S 2
These are then substituted into the BSM differential equation, and solved as
in the implicit finite difference method.

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Summary

The Binomial Model

Useful for American and European options, but cannot be used when the
payoffs depend on the past history of the underlying asset price, and can be
excessively complicated when nominal dividends are paid.
Monte Carlo Simulation
Useful for options with complex payoffs (not American options). However,
computationally time expensive.
Finite Difference Methods
Useful for American and European options, but cannot be used when the
payoffs depend on the past history of the underlying asset price. Moreover,
computationally time expensive when three or more state variables are
involved.

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Reading

Essential Reading
Chapters 21, Hull (2015).
Further Reading
Boyle, P., Broadie, M., and P. Glasserman, 1997, Monte Carlo methods for
security pricing, Journal of Economic Dynamics and Control 21, 1267–1322.

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