Chapter 4

4.1 Lookback options and Neumann boundary condition

Lattice Methods for American Opt 4.2 ions
Applications of Lattice Methods
4.3 Options with two underlying assets
4.1 Lookback options and Neumann Boundary Condition
2
2 2
2
1
( ) 0, 0 <
Consider the floating strike (currency) lookback put option

( , , )
where and represent the domestic and
, 0
2
( ,
foreig
, ) 0
n

+ + = <

<

d f d
d f
U
U
U S
U U
S r r S r S M
M T M
t T
t S S
S
U
M M t
r r
M
interest
rates respectively.
2 2
2
2
Apply the transformation:
( , , )
ln , ( , )
we obt
1
0, 0, 0
2
1,
(0, ) 0
ain
2

.

( , )
( )

+ + = > <

| |
= =
|
\ .

| |

|
\ .

f d f
x
M U S M
V V
r r r x t T
t x
t
x V x t
S S
V
U
V
t
x T
x
M
V e
Single-state BTM for lookback options
| |
( )
) (
Recall the two-state BTM:
( , , ( , max( , ), ) (1 ) ( , , )]
where ( )
1
.
)
,

= +
= =
d f
d
r t
r t
r
U S M t pU Su Su M t p U Sd M t
p e e d u d
t
,
Consider the lattice { , } ,
and the transformation to single-state variable : ln( / ).
Consider a point in the lattice for :
ln( / ) ( ) ln( )
where ln( ) and

=
= = =
= =
=
=
i k i k
k
i k
i
j
u u k
S u M u
x
i u
M S
x
u
x j x
x t
0. = j k i
Single-state BTM for lookback options (contd)
1
( , , ) (1, / , )
= (1, , )
( , ).
Thus we have ( , , ) ( , ), and at the lattice point
( , , ) ( , ) .
=
=
=
= =
x
n
i k n i j n i j
U S M t U M S t
S
U e t
V x t
U S M t SV x t
U S M t SV x t S V
| |
1
Starting from the two-state BTM at the lattice point:
( , , ( , max( , ), ) (1 ) ( , , )]
1
)

+ =
i k n i i k n i k n
U S M t pU S u S u M t p U S d M t
Single-state BTM for lookback options (contd)
1 1
1 1
1
0 0
1
1
we could obtain a single-state BTM for ( , ) :
1
(1 ) ,
1
(1 )
with the terminal conditi
1
on: 1.

+ +
+
+ +
( = +

( = +

=

n n n
j j j
n n n
N j
j
V x t
V puV p dV j
V puV p dV
V u
Understanding BTM: explicit difference
Consider the lattice
1 ,0
, ) : , :={( }
j n j n j Z n N
Q t n x t x j x t

= =
( )
Discretize the PDE fo (*) r
1 1 1 1
1 1 2
2
1 1
1 1 2
0 :
2
1

2
/ 2

0
2
.
n n n n n
j j
n n
j
j j
j
f
j
n
f d j
j
r rV
V V V V V
t
x
V V
r
x

+ + + +
+
+ +
+

+
+

+
, and deno S t te e
2
1 1
,
2 2 2
d f
r r
x
x t a

| |

= = + + |
|
\ .
Understanding BTM: explicit difference (contd)
then we obtain the FDE (
2
1 1
1 1
(
1
(1 ) ,
)
1
)
0
:
.
n n n
j j j
f
O
V aV a V j
r
x
t
+ +
+
(
= +

+

It is easy to see
1 1 1
( (1 ) ( ), ).
1 1
f f
a a
pu O p d O
r r
t t
t t

= +

= +
+

+
This establishes a link to the earlier single-state BTM for
the same pricing p 1 roblem. for j
Explicit difference: Neumann boundary condition
0 0
1 1
0 1
0
1 1
0 1
0
with the (
What about the case of
) finite differenc
0?
We approximate the Neumann boundar
e approximation
0=
i
y condition

mplying

= =
+ +

=
+ +

= =

=
x j
n n
j
n n
V V
x x
O x
V V V
x x
V V
j
.
Explicit difference: Neumann boundary condition (contd)
Thus we can write the FDE
as
1 1
1 1
1 1
0 0 1

1
(1 ) ,
1
1
(1 )
0
1
,
.
n n n
j j j
f
n n n
f
t
t
V aV a V j
r
V aV a V
r
+ +
+
+ +
(
= + =

+
(
= +

+

0) to the
single-state BTM.
However the above approximation is only
Thus we establis
( ), which
h the equivalence of the
spoils
the accuracy of th
FD
e
E (
scheme.
j
O x

An improved finite difference scheme

A simple modification to the earlier scheme could result in an
improved (more accurate) finite difference scheme.
Modified mesh
1 ,0
: ) : , (
1
,
2
j j n n
j Z n N
x x j x Q t n t t

| |
= +

= =
`

|
\ .
)
=0
To approximate the Neumann boundary condition, we use the
finite difference approximation

Let
0 =
2( )

2
1 1
0 1
1
2
( )
( , ).
n
j j n
n n
j
O x
V x t
V
x
V
V
V
x
+ +

=
An improved finite difference scheme (contd)
1 1
0 1
.
Thus the modified finite difference scheme clo
which ag
sely resembles
the previous o
ain gives

n

e:

+ +

=
n n
V V
0 0
1 1
1 1
1 1
1
1
(1 ) ,
1
1

1
(1 )
1
n n n
j j j
f
n n n
f
V aV a V j
r
V aV a V
r
t
t
+ +
+
+ +

(
= +

+
(
= +
+


but with the modified terminal condition :
( 1/2)
, 0 1 .
N j x
j
V e j
+
=
The corresponding Modified BTM
1
2
0
1 1
1 1
1 1
0 1
1
(1 ) ,
1
(1 )
with the terminal cond
1
1, itio n 0 : .

+ +
+
+ +
+
( = +

( = +

=

n n n
j j j
n n n
j N
j
V puV p dV j
V puV p
u j
dV
V
Numerical results
4.2 Lattice methods for American options
BTM
{ }
2 2 2
2
, ( ) ( , ), [0, )
Explicit difference scheme based on the transformed PDE
min 0,

( , )
where

( )
.
2 2
x
x
u u e t T
e
u u u
u r r
x
u x T
u
t x x

| |

= + +
|

\ .

Explicit difference for American options

= =
,0
, ) : : , } {(
i i n n i Z n N
t x i x x t n t Mesh
Denote ( , ).
n
i i n
u x t u =
}
1 1 1 1 1 1 2 2
1 1 1
1
1
2
,

2
min
2 2 2
( ) 0.
n n n n n n n
n
i i i i
i
i i i
x
i
n
i
u u u u
r ru
t x x
u u u
e u

+ + + + + +
+ +
+
| | +
+

\ .
=
{ }
1 1
( , 1}
, min ( ) 0,
n n i x
i n i
u u e
+ +
+
=
Explicit difference for American options (contd)
1 1 1
1 1
max (1 ) ) ( )
, 0 and , whe
This gives rise to
1
(1 , ,
1
for e , r 1
n n n n i x
i i i i
a u u au e
Z n i
u
N
t r

+ + +
+

(
= + +
`

+
)
=

2
2
2 2
1
, .
2 2 2

t x
a r
x

| |
= = +
|

\ .
The computation proceeds in the typical backward time manner,
starting with the terminal condition:
( ), .
N i x
i
e i u Z

=
What is the significance of the case 1? =
Implicit schemes for American options
( , )
( , )
( , )
1 2
1 1
2
0


We aim to find a solution such that (variationa
] 0,
where

l inequality)


2
2

[
n
n i
n
n
n i i
n
n i
n n n n n
i i
n
i i i
u
u
u u u u u
t
u
x
u
u

+
+

=
+

= +

2
1 1
2 2
n n
n i i
i
u u
r ru
x

+
| |
+
|

\ .

In matrix form, we

have






[ ][ ] 0.

n
n
n n

=
b
u
u u
Mu
M b

Explicit Treatment of the constraint

1
First, with known, we solve for the intermediate values
through solving the linear system


+ n
n
n
b.
u
u
Mu =
( )
{ }
Then, we compare it against the immediate payof
max
f to yield

.
, ,
where ( )
n n
i x
i
e

=
=
u u

Another treatment of the constraint: Projected

SOR method
Recall the projected SOR method and apply it to

n
= Mu b.
Partition the matrix as
,
where is matrix holding the main diagonal, holding
the lower triangular portion and the upper triangular portion.
=

M
M D L U
D L
U
( )
{ }
, 1 1 , 1 ,
, 1 , , 1
max (1 ) , (0, 2
Use the "modified" projected SOR iteration:

). ,
+ +
+ +
= + +
= +
n k n k n k
gs gs
n k n k n k
gs
u Lu b
u u
D Uu
u
4.3 Options on two assets
We consider options with two underlying assets, and their
payoffs could be of the following forms:
1 2
1 2
1 2
1 2
1 2
1 2
, ) ) , maximum call
, )) , maximum put
, )
, ) ) , minimum call
, )) , minimum pu
(max(
( max(
(
(min(
( min(
(
t
) , spread option
+
+
+
+
+

S
X S
f S
S
X S
S X
S
S
S X
S
S S X
1
1 1 1
1
2
2
2
2
2
1
2
2
Assumptions (GBM):


where E( ) 1, 2,

) 0, E(
) E
,
(

= =
= +
= +
=
=
t
t
t
t
i i
dS
dt dW
S
dS
dW
dt dW
S
dW dt
dW
i
dW dt
being the correlation coefficient between the two
random w
wit
.
h
laks

Pricing model of options on two assets

1 2
1 1 2 2
1 1 2 2
, , ) denote the option value at time .
In delta hedging, one sets up a portfolio with
Let (
,
and consider the inc
value given by

rement


d .
=
=
S t t
V S S
dV S d dS
V S
2 2 2
2 2 2 2
1 1 1 2 1 2 2
2 2
1
2
2
2
1 2 2
1
1
The term comes from applying Ito Lemma involving
two variables:
+ +
1 1
2 2


+ + +

(
=
(



V V V V
S S S
t S S S S
V V
d
dV
dV S d
S S
t
S dS
Pricing model of options on two assets (contd)
Proceeding with the no-arbitrage argument as in the
1-asset case leads us to the two-asset version of the BS PDE:


+ + +



+ + =

2 2
2 2 2
2 2 2 2
1 1 1 2 1 2
2 2
1 2
1
1 1 2
1 2
2
2
1 1
2 2
( ) ( ) 0,
V V V V
S S S
t S S
S S
V V
r q S r q
S
S rV
S S
1 2
1 2 1 2
0, 0, [0, )},
and subject to the terminal conditon:
in the domain {
( , , ) ( , ).
> >
=
S t T
V S S T f S S
S
Finite difference schemes for options on two
assets
1, 2, 1 2
, , ) ( , , ) : 0,1, , ;

:
0,1, , ; 0,1, , }
{(
i j n
S t ih jh n t n N
i I j J
S = =
= =
Mesh
, 1 2
( , , ). Denote
n
i j
V ih jh n V t =
Two questions:
the discretization of the cross derivative;
boundary conditions.

Discretization of the cross derivative

2
1, 1 1, 1 1, 1 1, 1
1 2 1 2
2
1, 1 1, 1 , 1, 1, , 1 , 1
1 2 1 2
2
1, 1 1, 1 , 1, 1,
1 2
1.
2
2.
2
3.
4
2

n n n n
i j i j i j i j
n n n n n n n
i j i j i j i j i j i j i j
n n n n n
i j i j i j i j i j
V V
V V V
V V
V
S S h h
V V
V
S S h h
V V
V
S
V V
V V V
S
+ + + +
+ + + +
+ + +
+

+
+
, 1 , 1
1 2
2
n n
i j i j
h
V V
h
+

Boundary conditions
1 2
Consider the spread option with payoff ( ) . S S X
+

Let ( , be the price function of a European vanilla put.
at time for a given asset with current price , v
, , )
and
continuous
olatili
dividend yi
ty
eld .
E
P S
t
q t
S
q

1
2
1 2
1
2 2 2
0
1 1
0
Boundary conditions for the spread option can be imposed
as follows:
( , , , ),
( , ,
0
, ),
.
E
E
I S J
S
S
S
S q t
S q
V P
t V P
V V

=
=
= =
=
=
= =
Implicit difference scheme
Proceed with similar choice of FD formulae as for the 1-asset
case and with FD formula (1) for the cross derivative yields
the FDE:
1
, , 1, , 1, 2 2 2
1 1
2
1
1, 1 1, 1 1, 1 1, 1
1 2 1 2
1 2
, 1 , , 1 2 2 2
1
2
1
2 2
2
+


2
1
2
4
2
1
(
2
)

+
+
+ + + +
+
+
+

+
+
+

n n n n
i j i j i j i j i j
n n n n
i j i j i j i j
n n
i j i j i j
V V V V
i h
t
V V
ij
V
h
V V
V
j
h
V
r
h h
h h
q
V V
h
ih
1, 1, ,
2
1
1
2
, 1
2
,
1, , 1, 1, 2, , 1. 2,
( 0,
2 2

)
+ +
= =
+

=
n n n n
i j i j i j i j n
i j
I J i j
V
r q rV
h
V V
jh
h