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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
Kristoer 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 Dening 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 It os 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 unied 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 Payos - 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 xed points . . . . . . . . . . . . . . . . . . 116
5.1.6 Structure of the phase portrait . . . . . . . . . . . . . . . . . 120
5.1.7 Other xed 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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 rst-order feedback (T = 1, r =
0.04, = 0.2, K = 1) for = 0, 1, 2, 5, 10; the variation with
appears to be monotonic. . . . . . . . . . . . . . . . . . . . . . . . . . 66
3.2 Value of European put options with rst-order feedback (T = 1, r =
0.04, = 0.2, K = 1) for = 0, 1, 2, 5, 10; the variation with
appears to be monotonic. . . . . . . . . . . . . . . . . . . . . . . . . . 66
3.3 Asymptotic Matching. . . . . . . . . . . . . . . . . . . . . . . . . . . 70
3.4 Inner solution minus the payo for put and call options, r = 0.04,
= 0.2, K = 1 and for = 0.1, 0.15, 0.2, . . ., 0.4. . . . . . . . . . . . 72
3.5 Value of American put options, T = 1, r = 0.04, = 0.2, K = 1 and
for = 0, 1, 2, 5, 10; the variation with appears to be monotonic. . 73
3.6 First-order feedback put (with early exercise), location of free bound-
ary (as 0) with , K = 1, r = 0.04, = 0.2. . . . . . . . . . . . . 76
3.7 Location of the vanishing of the denominator of (2.9) with = 0.1,
K = 1, r = 0.04 and = 0.2. . . . . . . . . . . . . . . . . . . . . . . 78
3.8 The rst derivative () of the Black-Scholes equation (3.2) (dotted
line) and the rst order feedback PDE (2.9) (solid line) for = 0.01,
0.015, . . ., 0.05. Compare the location of the vanishing denominator 3.7. 79
3.9 The second derivative () of the Black-Scholes equation (3.2) (dotted
line) and the rst order feedback PDE (2.9) (solid line) for = 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 dierent values of at
various times to expiry; = 0.0125, 0.0375, 0.075. For r = 0.04,
= 0.2, K = 1 and = 0.09 (solid line) and = 0.1 (dotted line).
Compare with gure 3.7. . . . . . . . . . . . . . . . . . . . . . . . . . 81
4.1 The leading order correction term V
1
(S, ) to the Black-Scholes (i.e.
= 0) European put option for various time to expiry. K = 1,
r = 0.04, = 0.2, T = 1 and = 0.1, 0.2, . . . , 1. . . . . . . . . . . . . 92
4.2 Deltas for full-feedback (European) put, K = 1, r = 0.04, = 0.2,
= 0.1 and T = 1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
4.3 Local ( 0) solution of a full-feedback put, K = 1, = 0.1, r = 0.04
and = 1, 0.95, . . ., 0.15. . . . . . . . . . . . . . . . . . . . . . . . . 96
4.4 Full feedback put, K = 1, r = 0.04, = 0.2 and = 0.1; modied
numerical scheme. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
4.5 Full feedback put, K = 1, r = 0.04, = 0.2 and = 0.1; modied
numerical scheme. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
4.6 Full feedback call, K = 1, r = 0.04, = 0.2 and = 0.1; modied
numerical scheme. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
4.7 Full feedback put, smoothed payo, K = 1, r = 0.04, = 0.1, = 0.1
and = 0.01. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
5.1 Phase portrait of the autonomous system (5.24). Note the xed point
at u =
_
243
80
_1
3
, v = 0 and the eld 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, = 0.2, = 0.25,
= 0.15 (smoothed payo), = 0, 1, . . . , 10. Note that we are in the
regime < 2 and so we should expect no singular behaviour. . . . . 128
6.2 Perpetual full-feedback American put, K = 1, r = 0.04, = 0.2,
= 0, 0.1, 0.2, . . . , 1.1; free-boundary location as indicated. . . . . . . 130
7
6.3 The rst order correction to the Black-Scholes perpetual American put
option (solid line) compared to the dierence of the fully numerical
option value with the Black-Scholes (dotted line). K = 1, r = 0.04,
= 0.2 and = 0.1. . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
6.4 The rst order correction to the Black-Scholes perpetual American put
option (solid line) compared to the dierence of the fully numerical
option value with the Black-Scholes (dotted line) for various values of
. K = 1, r = 0.04, = 0.2 and = 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 = 0.1, K = 1, r = 0.04 and = 0.2. . . . . . . . . . . . . . . 139
7.2 Local ( 0) call solution of the Sircar and Papanicolaou (1998)
model K = 1, r = 0.04, = 0.2, and

= 0, 0.05, . . . , 0.2. . . . . . . . 141
7.3 Local ( 0) put solution of the Sircar and Papanicolaou (1998)
model K = 1, r = 0.04, = 0.2, and

= 0 0.05, . . ., 0.3. . . . . . . . 142
7.4 Solution to equation (7.9) for a put option with = 0.01, 0.5, 1, . . .,
5, = 0.2, r = 0.04, K = 1, and = 1.5. . . . . . . . . . . . . . . . . 144
7.5 Local ( 0) put solution of the Bakstein and Howison (2003) model
K = 1, r = 0.04, = 0.2, = 1.5, and

= 5, -4.75, . . ., 5. . . . . . 147
7.6 Local ( 0) call solution of the Bakstein and Howison (2003) model
K = 1, r = 0.04, = 0.2, = 1.5, and

= 5, -4.75, . . ., 5. . . . . . 148
7.7 Non-smooth solution of the Black-Scholes equation. K = 1, r = 0.04,
= 0.2. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149
7.8 Location of the vanishing of the denominator for the Liu and Yong
(2005) model for various value of . K = 1, r = 0.04, = 0.2,
= 0.1, and = 1 10
5
, 2 10
5
, . . ., 1 10
6
. . . . . . . . . . . . . . 151
7.9 Local ( 0) call solution of the Jonsson and Keppo (2002) model
K = 1, = 0.2, and a = 1, -0.9, . . ., 1. . . . . . . . . . . . . . . . . 153
7.10 Local ( 0) put solution of the Jonsson and Keppo (2002) model
K = 1, = 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 = 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, = 0.2, and r +
1
2

2
= 0. . . . . . . . . . . . 159
8.3 Solution to (8.7) for p = 0.8, 0.9, . . . , 1.2, T t = 0.1, K = 1, = 0.2
and r +
1
2

2
= 0. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161
8.4 Solution to equation (8.8) (solid line) compared to (8.5) (dotted line)
for T = 0.1, K = 1, = 0.2, and r +
1
2

2
= 0. . . . . . . . . . . . . . 163
9.1 The British put option free boundary for varying values of the contract
drift. T = 1, K = 1, = 0.4, r = 0.1, D = 0, and
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,
c
= 0.125, r = 0.1, D = 0, and = 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.
c
= 0.102, 0.104, . . . , 1. T = 50, K = 1, r = 0.1, D = 0, and
= 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, = 0.4, r = 0.1,
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 gures 9.6, 9.7 and 9.8.
T = 1, K = 1, = 0.4, r = 0.1,
c
= 0.125, and D = 0. . . . . . . . . 189
9.6 The dierence 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, = 0.4,
r = 0.1, D = 0, and
c
= 0.125. . . . . . . . . . . . . . . . . . . . . . 190
9
9.7 The dierence 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, = 0.4, r = 0.1, D = 0, and

c
= 0.125. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190
9.8 The dierence 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, = 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, = 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, = 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, = 0.4, r = 0.1, D = 0, and
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,
c
= 0.08, r = 0.1, D = 0, and = 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, = 0.4, r = 0.1,
c
= 0.08
and D = 0. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199
10
The University of Manchester
Kristoer 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 rst class, we consider the eects of the inclusion of -
nite liquidity into the Black-Scholes-Merton option pricing model, which for the most
part result in highly nonlinear partial dierential 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 unied analytical framework. Detailed analysis reveals that the form of the nonlin-
earities introduced can lead to serious solution diculties for standard (put and call)
payo conditions. One is associated with the innite 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 payo
functions) is caused by a singularity in the coecient of the diusion term in the
option-pricing equation. It is concluded in this case is that the model irretrievably
breaks down and there is insucient nancial 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 eects of a nitely 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, specically 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 qualication 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
eciency, and David for his caring supervision and his condence 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 suce. 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 ourish. Finally, I thank
Hannah for everything, I hope we both nd what were 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 nance 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 nancial markets and to utilise the powerful tools of
mathematics in order to better understand such markets.
Since the denitive papers of Black and Scholes (1973) and Merton (1973), much of
the work undertaken in mathematical nance 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 innitely (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 dierential equations (PDEs) arising from the study
1
Termed underlying in the sequel.
16
CHAPTER 1. INTRODUCTION 17
of nitely elastic markets. Work that has led to this class of PDEs in nance to
date includes Whalley and Wilmott (1993) in relation to transaction costs, which
was one of the rst nonlinear PDEs to arise in the eld of mathematical nance.
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 nd a stochastic process that ts 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 aecting the price dynamics are actually the
most important. In addition, the exogenous processes required tend to be dicult to
handle mathematically, for example Levy 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 dier 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-ve
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 nancial 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 nancial world as they are usually
highly liquid, turning over vast amounts of trade every day.
Further, Rachel Lomax, the Bank of Englands Deputy Governor goes on to describe
the recent nancial 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 nancial problems are no longer simply conned
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 nancial 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 eects of reduced liquidity on all aspects of the nancial
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 eect 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 eect 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 nancial mathematics trace back to a dissertation (entitled
Theorie de la speculation
7
) published in 1900 by Louis Bachelier (1870-1946). In
it he proposed to model the movement of stock prices with a diusion process or
Brownian motion. Note that this was ve years before Einsteins 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. Feynmans 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 It 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 nance. However, it was not until 1965
that economist Paul Samuelson (1915-) resurrected Bacheliers work and advocated
It os 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 nance can be
found in Jarrow and Protter (2004).
1.3 Derivative pricing
When we discretise a problem it becomes easier to dene 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 specied and an equivalent probability measure is found that turns the
discounted underlying into a martingale. The price of the derivative is then dened
as the conditional expectation of its discounted payo under this new (risk-neutral)
measure. Alternatively, in the PDE approach, a stochastic process for the underlying
is likewise specied and then It os formula for a function of the underlying stochastic
process is used to derive a PDE involving the coecients 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 reected 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 nancial instruments) is de-
termined by the expected discounted value of some future payo, 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 prot 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)
+
:= maxS
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
)
+
:= maxK S
T
, 0. (1.2)
The functions (1.1) and (1.2) are called payo proles and will be referred to as such
throughout this thesis. There are, of course, many dierent options contracts with
more general payo proles, 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 specically 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 prot. More formally, it is the
opportunity to construct a trading strategy (i.e. buying and selling nancial 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 ecient 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
= S
t
dt +S
t
dW
P
t
, (1.3)
CHAPTER 1. INTRODUCTION 23
where r is the positive (constant) interest rate, the drift and 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 payo prole h(S
T
) can be shown to be given by
V (S, t) = E
Q
S,t
_
e
r(Tt)
h(S
T
)

, (1.4)
in words, the expected discounted future payo. 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, dened by the process (1.3).
9
The risk-neutral measure is dened 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 +S
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 . Consequently the drift parameter
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 dicult 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
denition of a complete market is one in which every derivative security can be repli-
cated by a self-nancing trading strategy in the stock and bond. In this model, any
security whose payo 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-nancing
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 dierential equations (SDEs), such as the
pricing equation (1.4), are linked to the solution of (linear) parabolic partial dieren-
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

2
(S, t)

2
u
S
2
+(S, t)
u
S
= 0, (1.6)
subject to the nal condition
u(S, T) = h(S),
where (S, t), (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
= (S
t
, t)dt +(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
It os formula we have
du =
_
u
t
+(S, t)
u
S
+
1
2

2
(S, t)

2
u
S
2
_
dt +(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
(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
(S, t)
u
S
dW
P
t
_
.
Finally, it can be shown that the expectation of an It 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 satised 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
rst point to note is that (1.4) involves discounting and so it is useful to make the
transformation
V (S, t) = e
r(Tt)
u(S, t)
CHAPTER 1. INTRODUCTION 26
in equation (1.6) to obtain the PDE
V
t
+
1
2

2
(S, t)

2
V
S
2
+(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(Tt)
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

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(Tt)
, (1.9b)
V (S, t) h(S)e
r(Tt)
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

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 coecients of the SDE and PDE, as-
sumptions that are often not satised 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 (S, t).
CHAPTER 1. INTRODUCTION 27
behaviour of the models presented in this thesis can be attributed to the failure of
the coecients 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 diusion coecient
(S, t) must be suciently regular. More precisely, it must be locally Lipschitz, i.e.
[(S
1
, t) (S
2
, t)[ C[S
1
S
2
[
for some C > 0, and also satisfy a linear growth condition in S, i.e.
[(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 coecient
(S, t) must be strictly positive at every point in the solution domain (S, t)
[0, T], where is the domain of the process S
t
, for example = S > 0 for geometric
Brownian motion. In other words, we have the restriction that

2
(S, t) > 0 (S, t),
i.e. the diusion coecient
2
(S, t) cannot degenerate be zero. Note that even in the
simplest cases, such as geometric Brownian motion where (S, t) = S, the volatility
term degenerates in certain regions of state space. Specically lim
S0
(S, t) = 0.
We can avoid this diculty here (and also in many other more general situations)
by making the change of variable x = log S giving (x, t) = 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 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 satised. 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
coecients means that the solutions to the corresponding SDE need no longer remain continuous;
jumps may be seen at the location where the diusion coecient 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 ltration T
t
).
The terms European and American were rst 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 prexes but reversed the ordering.
If the payo prole is given by h, and the holder of the American option decides to
exercise early then she receives the amount h(S

) at time . 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
tT
E
Q
S,t
_
e
r(t)
h(S

, (1.11)
i.e. the supremum of the expected value of the discounted payo over all random times
that are stopping times with respect to the ltration generated by the Brownian
motion used to specify the dynamics of the underlying process for S
t
. This is a rather
intuitive denition of the American option price.
Immediately from the denition (1.11) we have the inequality
V (S, t) h(S) (1.12)
since the stopping time = 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 = 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 payo 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
= T when considering the payo 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, rst 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 payo function (1.2) for suciently 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 rst 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
rst 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

:= infu t : V (S
u
, u) = h(S
u
),
i.e. the rst time that the price of the American option drops down to the value of
its payo. Alternatively, and more practically, the optimal stopping time

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

:= infu 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 payo prole 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
dierential inequalities. For a nonnegative payo function h, the price of an American
13
See, for example, Peskir and Shiryaev (2006)
CHAPTER 1. INTRODUCTION 31
option as dened 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

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 nal 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 t principle.
14
This principle states that the value
function V (S, t) must be at least C
1,1
dierentiable,
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

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 t in probability, the principle of no arbitrage in nance and the
conservation of energy law in the physical sciences can be seen as dierent formulations of the same
principle. This is alluded to in Peskir (2005b).
15
At least for points at which the payo prole h(S, t) is C
1,1
dierentiable.
16
See for example Karatzas and Shreve (1998)
CHAPTER 1. INTRODUCTION 32
value satises V (S, t) = (KS)
+
. 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 specically given
any functional relationship y = f(x) the point elasticity, , is dened 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 dened 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 dened 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 denes a relationship
between price and the quantity demanded (as dened 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-dened 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 classied 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 nd 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 aects
their ability to trade. In fact one of the most important attributes of nancial 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 nancial 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 nancial markets, including Bank for International
Settlements (1999) and Bank for International Settlements (2001).
17
See Protter (2006).
CHAPTER 1. INTRODUCTION 35
1.5.1 Dening liquidity
Market liquidity is often associated with the ability to quickly buy or sell a particular
item without causing a signicant movement in the price. However, the concept
of liquidity is multifaceted and ill-dened. 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) identies four dimensions to liquidity, namely,
trading quantity, trading speed, trading cost, and price impact. Alternatively, Sarr
and Lybek (2002) state that liquid markets exhibit ve 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, reecting the
eciency 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 nally resiliency, i.e. new orders ow quickly to correct order imbalances.
Clearly, liquidity is a tricky concept to dene (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 dierent dimension. One particular interpretation of liquidity in
the literature ts nicely with the philosophy of this thesis; Howison (2005) states
that market liquidity can manifest itself in three possible forms. First, there is a
dierence 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 aecting 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 ow, and various measures of order ow. Measures of the price impact of or-
der ow 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 ow 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 ow 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 rst is transaction cost measures that capture the costs of trading nancial
assets and trading frictions in secondary markets. One particularly intuitive measure
of transaction costs is the percentage bid-ask spread, dened 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 dened 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 specied 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 dened as
TO =
Vol
NP
where Vol is the trading volume dened 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 nal category, and the most relevant to the focus of this thesis, are market-impact
measures that attempt to dierentiate 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
dierent 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 eect, 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 nancial 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 OHara (1995). Such models are not referred to specically in this thesis
and so it suces to describe briey the role of some of the more important market
participants.
One of the most important members of any nancial market are the so-called market
makers. These are individuals or rms 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
nancial instrument or commodity but hopes to be compensated by making a prot
on the bid-ask spread.
In the United States, many markets have ocial 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 ocial 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 dicult to determine at what price one would be able to buy or sell any
of the many illiquid stocks.
In traditional exchange oor markets the burden of providing liquidity is given to
market makers or specialists. Nowadays, however, most nancial markets have be-
come fully electronic and operate on what is called a matched bargain or order driven
basis. In these markets, when a buyers bid price meets a sellers oer price the stock
exchanges 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 dierent needs of dierent 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 specied 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 specic 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 rst to use a microeconomic
approach to construct diusion models for asset price movements. They dene in-
formation traders who believe in a fundamental value of the asset, and noise traders
whose demands are from hedging requirements. They derived equilibrium diusion
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 diusion 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 rst 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 traders 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 eort of a trader to manipulate the price of a futures contract by
gaining eective 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
sucient condition to exclude protable 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 Jarrows 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 eect
(which we term rst-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 payo condition are satised). In the discrete-time framework of Jarrow (1994),
the question as to whether options could be perfectly replicated in a nitely elastic
market reduces to solving (recursively) a nite 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 payo being suciently
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 eectively, 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 modied
stochastic process under the inuence 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 dierent 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 dierence with the rst class
of models is that these are now local in time models, without long-term eects, i.e.
the actions of the traders do not inuence the underlying stochastic process. These
models eliminate the feedback eects 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 eects, 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-Labordere (2004) incorporated the feedback model of Sch onbucher
and Wilmott (2000) into the portfolio optimisation of Markowitz (1959) to nd that
CHAPTER 1. INTRODUCTION 44
portfolio optimisation has the eect 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 diusion model for price dynamics when the
drift and volatility coecient are functions of the large traders trading strategy. Fi-
nally Jonsson and Keppo (2002) derived a somewhat dierent nonlinear PDE, using
a model with an exogenously dened exponential price eect function.
According to Rogers and Singh (2006) and Cetin and Rogers (2007), the price impact
models of a large trader have numerous shortcomings. The rst 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 sucient conditions to ex-
clude protable 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 aect the price, then we
must allow the actions of all large agents to aect the price and furthermore the eect
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 indierence 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-
diusion or stochastic volatility, due in the most part to the models limited capability
to reproduce skewed probability distributions. However, the study did nd 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 identied. The rst, often called
classical asymptotics dates back to the work of Poincare (1886) on the far-eld be-
haviour of linear ordinary dierential 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 dierential 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 uid 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 nd. 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 suciently accurate, and indeed can often provide
invaluable insight into the qualitative behaviour of the problem under investigation.
During the rst 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. Prandtls idea
was to subdivide the solution domain into separate regions where dierent 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 nance 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 rst-order feedback model (an exceptional case of a linear PDE) and
CHAPTER 1. INTRODUCTION 47
furthermore highlights interesting dierences 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
briey the so-called stock pinning eect 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 dierences
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 conrmed 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 = Sdt +SdW
t
, (2.1)
where S is the price of the underlying, and 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 = Sdt +SdW
t
+(S, t)df, (2.2)
where (S, t) is an arbitrary function. Note that at this stage no assumptions need
be made regarding the form of the functions (S, t) and f(S, t), and particular nan-
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 coecients and .
We commence by using It os 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
f
S
_
dS =
_
S +
f
t
_
dt +

2

2
f
S
2
(dS)
2
+SdW
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
=

2
S
2
dt
_
1
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 = (S, t)dt + (S, t)dW
t
, (2.5)
where
(S, t) =
1
1
f
S
_
S +
_
f
t
+
1
2

2

2
f
S
2
__
, (2.6a)
(S, t) =
S
1
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 modied to the process (2.5). The
nancial 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/, since
at this location the drift will become innite and consequently the process might
be contained within a xed 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 modied stochastic process at such
singular locations.
We now turn our attention to option pricing under the modied stochastic process.
To do this we will use the well-known Generalised Black-Scholes equation (for a more
detailed derivation see for example Due, 1996), which leads to the following pricing
PDE for the modied stochastic process incorporating the aforementioned forcing
term
V
t
+
1
2

2
S
2
_
1
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 modied
process (S, t) does not appear in the option pricing PDE.
Thus far we have been deliberately vague about the nancial interpretation of the
forcing term in (2.1). In the context of markets with nite elasticity, we can dene
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 (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 signicantly 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

2
S
2
_
1

2
V
BS
S
2
_
2

2
V
S
2
+rS
V
S
rV = 0. (2.9)
This case we call rst-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 eect 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

2
S
2
_
1

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 can be scaled out of (2.10)
using the simple substitution V (S, t) =
1

w(S, t), this would then introduce into the


standard payo 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 dicult
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 prot from this information by front running the
anticipated trades.
Equation (2.10) has appeared in the literature several times with diering forms of
the function (S, t) according to the modelling assumptions. The simplest case occurs
in Sch onbucher and Wilmott (2000), who have (S, t) constant and a dimensionless
measure of the liquidity of the market. Frey (1998) has the similar form (S, t) =

S
where

R is again some measure of the liquidity of the market. Another form
for (S, t) can be found in Liu and Yong (2005) in which (S, t) =

(1 e
(Tt)
)
where

is a constant price impact coecient, T t is time to expiry and a decay
coecient. As far as we can ascertain there is little nancial justication for this, and
it appears to be introduced for numerical expediency to avoid diculties 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 (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
payo prole. In the rst-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 eectively 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(Tt)
(K S
T
)
+

,
where the expectation is taken under the risk-neutral measure, Q, of the modied
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 specic 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 nd
no such transform. For more on the Cole-Hopf transform solution to the nonlinear
Burgers equation see Rosenerans (1972).
2.1.2 Applicability of It os formula
In the application of It os formula it is assumed that the function f(S, t) is C
2,1
dierentiable, if it is not then we have to include local time contributions. For a
detailed denition 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 It os 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 briey describe (a slight modication of) the so-called It o-Tanaka
formula, where we wish to apply It os formula to the function f(S, t) = [SK[ where
K can be thought of as the strike price.
4
The rst point to note is that this function
does not have a well-dened second derivative at S = K and so df is ill-dened 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 );
(SK)
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-dened second
derivative in the entire domain. Evaluating df of (2.12) gives
df(S, t) =
_

_
dS, S (0, K );
(SK)
||
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
=

2
S
2
dt
_
1 sgn(S K)
_
2
,
and thus we obtain
df = sgn(S K)dS +
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 dened as
sgn(x) =

1, x < 0;
0, x = 0;
1, x > 0.
CHAPTER 2. THE MODELLING FRAMEWORK 56
We can dene 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 +
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
dierentiable everywhere in the interior of the solution domain
with non-smoothness only on the domains boundary (due to the payo prole).
Since It os formula is not being applied across the kink in the payo prole then It os
formula, without local time, is all that is required. Hence our application of It os
formula is valid for the rst-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
dierentiable in the interior of the domain then we will have to apply
a local time correction to our application of It os 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
() = e

S
t
CHAPTER 2. THE MODELLING FRAMEWORK 57
where

S
t
is some fundamental stock price (usually given by geometric Brownian
motion d

S
t
=

S
t
dt +

S
t
dW
t
), > 0 is a liquidity parameter and 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 > 0) and receive less when selling ( < 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
t
, where 0 is a parameter that measures the size of the
traders 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) +
t
= 1.
Furthermore assuming that this strategy
t
is Markovian, i.e. that
t
= f(S
t
, t) for
a smooth function f, then the market clearing condition becomes
D(S
t
, U
t
, t) +f(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
. Dierent models propose
dierent functional forms for D which lead to slightly dierent prices. We shall
return to this framework after we have considered the somewhat more intuitive nal
framework. For a very general analysis of the dynamics of self-nancing 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), Jandacka and

Sevecovic (2005) and Liu and Yong (2005). Here investors are assumed to be large
traders in the sense that their actions aect the equilibrium price and the liquidity
adjusted price process in the presence of a large trader is given directly by
dS
t
= (S
t
, t)dt +(S
t
, t)dW
t
+(S
t
, t)d
t
, (2.15)
where as before
t
is a semi-martingale representing the trading strategy. Again we
can make the assumption that the strategy is Markovian, i.e. that
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 nal term in the
SDE can be considered as incorporating price impact. Note that the model outlined
in the rst 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 unied 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 (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
f(S,t)

S
t
we can take dierentials to get
dS
t
= d
_
e
f


S
t
+e
f
d

S
t
= dfe
f

S
t
+e
f
_

S
t
dt +

S
t
dW
t
_
+O(dt)
= e
f

S
t
(df +dt +dW
t
) +O(dt)
= S
t
(df +dt +dW
t
) +O(dt)
dS
t
= S
t
dt +S
t
dW
t
+S
t
df(S
t
, t) +O(dt)
where we have not included any quadratic variation terms in the calculation as this
would aect 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 identied 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) denes 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
+ (log S
t
log S
0
) +f(S
t
, t),
where S
0
and 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 inuence
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 +
dW
t
for m, R and so we have that
dS
t
S
t
=
1
_
mdt +dW
t
+df(S
t
, t)
_
+O(dt),
hence we can identify
(S
t
, t) =
1
,
(S
t
, t) =
1
.
There is discussion about the sign of the parameter 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 dene 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
+ (log S
t
log S
0
) +H
_
f(S
t
, t)
_
,
for any function H. Again dU
t
= mdt +dW
t
so we have that
dS
t
S
t
=
1
_
mdt +dW
t
+
dH
df
df(S
t
, t)
_
+O(dt),
hence we can identify
(S
t
, t) =
1
,
(S
t
, t) =
1
dH
df
.
CHAPTER 2. THE MODELLING FRAMEWORK 61
2.3.4 Lyukov (2004)
The model of Lyukov (2004) denes 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 denes
liquidity L to be
L =
dM
t
/N
dS
t
/S
t
and
dU
t
= Nmdt +NdW
t
,
where N is the total number of shares and m, R. Putting these together we have
dS
t
S
t
=
m
L
dt +

L
dW
t
+
1
LN
df(S
t
, t),
hence we can identify
(S
t
, t) = mL
1
,
(S
t
, t) = L
1
,
(S
t
, t) = (LN)
1
.
2.3.5 Sircar and Papanicolaou (1998)
The model of Sircar and Papanicolaou (1998) dene the (normalised) market clearing
condition to be (cf. section 2.2.2)
D(S
t
, U
t
, t) +f(S
t
, t) = 1, (2.16)
where f(S
t
, t) is the normalised aggregate demand per security traded and 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 0 the demand must take the form
D(S
t
, U
t
) = (U

t
/S
t
),
where
dU
t
U
t
=
1
dt +
1
dW
t
, (2.17)
and is the ratio
=

0

1
,
where
0
is the volatility of the Black-Scholes process given by
dS
BS
t
S
BS
t
=
0
dt +
0
dW
t
,
hence 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
(z) = z,
i.e. linear, hence
D(S
t
, U
t
, t) =
U

t
S
t
. (2.18)
Therefore the market clearing condition becomes
7
dD(S
t
, U
t
, t) +df = 0,
d
_
U

t
S
t
_
+df = 0,

t
S
t
_

dU
t
U
t

dS
t
S
t
_
+df +O(dt) = 0,

dS
t
S
t
=
dU
t
U
t
+
S
t
U

t
df +O(dt).
Now it is clear from (2.16) and (2.18) that
U

t
S
t
= D(S
t
, U
t
, t) = 1 f,
and so we have
dS
t
S
t
=
dU
t
U
t
+
df
1 f
+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
=

0

1
dt +
0
dW
t
+

1 f
df +O(dt),
hence we can identify
(S
t
, t) =
0
,
(S
t
, t) =

1 f
.
With this survey complete we now proceed in the next chapter to investigate the case
of rst-order feedback (with constant for simplicity) and show how the illiquidity,
even in this case, has a signicant eect 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 aect 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 modied option price. This leads to the
linear PDE (assuming constant)
V
t
+
1
2

2
S
2
_
1

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 dierences 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 dierences with the classical Black-
Scholes model. We also consider American options in this framework which has not
previously been attempted.
This idea of rst-order feedback leading to a modied, but still linear PDE also
appears in Sch onbucher and Wilmott (2000), but under a dierent guise. They call
the solution to the PDE (2.9) the price takers price. In an illiquid market inuenced
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 aecting 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 inuence
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, = 0.2, and exercise price, K = 1)
for = 0, 1, 2, 5, 10. Here, the standard call expiry payo at t = T has been
implemented, i.e. condition (1.1) on page 21. The result with = 0 is, of course,
the classic Black-Scholes result. As 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 conrm this).
Corresponding results for put options (using the same parameters as for gure 3.1),
with the standard put payo condition (1.2) are presented in gure 3.2, and these
too strongly point to a monotonic asymptote on to the payo function (for xed T)
as the liquidity parameter increases. Although the illiquid results appear to be
rather qualitatively similar to the liquid ( = 0) results, a more detailed analysis
(applicable for times close to expiry) follows, and this highlights some subtle, but
important dierences.
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 nite dierence methods will be the preferred method of solution throughout this
thesis. Finite dierence methods have the advantage over the alternative nite element methods
because we almost exclusively work in rectangular domains (asset price and time); in such situations
nite dierence methods are much easier to implement. For more on nite dierence 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
= 0
= 10
Figure 3.1: Value of European call options with rst-order feedback (T = 1, r = 0.04,
= 0.2, K = 1) for = 0, 1, 2, 5, 10; the variation with 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
= 0
= 10
Figure 3.2: Value of European put options with rst-order feedback (T = 1, r = 0.04,
= 0.2, K = 1) for = 0, 1, 2, 5, 10; the variation with 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 oers
us some insight into the valuation dynamics, shedding more light on the value of
options as the parameter is increased. The standard substitution, setting = T t
(representing time to expiry), transforms (2.9) into
V



2
S
2
V
SS
2 (1 V
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


1
2

2
S
2
V
BS
SS
rSV
BS
S
+rV
BS
= 0. (3.2)
We next investigate the small 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 prex outer. Mathematically this zooming is done via the following well
known transformation, hence as 0 the solution takes the form
V
BS
=
1
2
f() +O(), (3.3)
where
=
S K

1
2
, (3.4)
which is often called the inner variable and whose form can be veried 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 = O(1), is given by the
solution to the ordinary dierential equation (ODE)

2
K
2
f

+f

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 , f as
and for a call
f as , f 0 as .
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
() =
_

_
1
_
+

2
e

1
2
(

)
2
(3.6)
and likewise for a call
f
C
() =
_

_
+

2
e

1
2
(

)
2
,
where = K and () is the standard normal cumulative distribution function
dened as
(x) =
1

2
_
x

1
2
y
2
dy. (3.7)
Considering the second derivative gives
f
P

= f
C

=
1

2
e

1
2
(

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

2
e

(SK)
2
2
2
K
2
. (3.8)
We can now proceed to incorporate this into the rst-order feedback illiquid problem
(3.1). To investigate the small 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 =

g(), (3.9)
where
=
S K

, (3.10)
CHAPTER 3. FIRST-ORDER FEEDBACK MODEL 69
and is assumed to be O(1). and are constants to be determined. The rst
point to note is that if the Black-Scholes local solution described above is used, i.e.
= =
1
2
, then the second derivative term in (3.1) becomes much smaller than the
other terms in the equation in the limit 0. Therefore it would appear that close
to expiry the dynamics of the rst-order feedback model are signicantly dierent
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 gives

1
(g g

)

2
K
2

2
g

2
_
1

K

2
e

21
2
2
K
2
_
2
+rK

+r

g = 0. (3.11)
It is clear that the denominator of the second term is O(
1
) in the limit 0
(provided that 2 1 > 0, which can veried a posteriori ). Consequently the second
derivative term is O(
2+1
) as 0. To obtain an appropriate scaling we balance
this with the time derivative term which is O(
1
), leading to the conclusion that
1 = 2 + 1 = 1.
To x we exploit the fact that the inner solution

g() 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 eectively zero
since the payo prole has no curvature here. Hence the outer solution is given by
the solution to equation (2.9) without the diusion term, i.e.
V

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, ) =
_
Ke
r
S
_
+
, (3.13a)
V
C
(S, ) =
_
S Ke
r
_
+
, (3.13b)
for puts and calls respectively. Thus we require

g() = S Ke
r
for a call option
in the limit . 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(

). In addition, by construction = O(1) in the inner region, hence


(3.10) suggests we must also have S K = O(

). We conclude that
3
= = 1.
PSfrag replacements
S

K


V
P
(S, ) = 0
V
C
(S, ) = S Ke
r
V
P
(S, ) = Ke
r
S
V
C
(S, ) = 0
V
P
(S, ) = g
P
()
V
C
(S, ) = g
C
()
O()
Figure 3.3: Asymptotic Matching.
Note that the scaling here implies a region O() in asset space S, close to the strike
price, that is somewhat smaller than the classical Black-Scholes model, (3.3), which is
O(
1
2
) as 0 (see (3.4)); this is clearly an important dierence from the standard
Black-Scholes model behaviour close to expiry. Substituting for and into (3.11)
gives
g g


2
K
2

1
g

2
_
1

K

2
e

2
2
K
2
_
2
rKg

+rg = 0,
and taking the O(1) terms leads to

4
K
4

2
g

+ ( +rK) g

g = 0. (3.14)
Note that on the relatively short = O(1) scale, we are eectively replacing (3.8)
with
V
BS
SS
=
1
K

2
. (3.15)
3
Note that this satises our a priori assumption that 2 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, g() in the limit [[ to
match with the outer solution (3.13). A schematic of this is given in gure 3.3, and
formally the matching condition is dened as
lim
SK,0
V
OUTER
(S, ) = lim
||
g(). (3.16)
Practically we re-write the outer solution in terms of the inner variable and then
equate the result to the inner solution g() to give the appropriate boundary con-
ditions. This procedure leads to the boundary conditions for a put:
g 0 as , g ( +rK) as ,
and for a call:
g +rK as , g 0 as .
Equation (3.14) can be solved analytically; for a put, the solution is
g
P
() = ( +rK)
_

_
+rK

_
1
_
+

2
e

1
2
(
+rK

)
2
, (3.17)
where =

2
K
2

, and for a call


g
C
() = ( +rK)
_
+rK

_
+

2
e

1
2
(
+rK

)
2
, (3.18)
where () is the cumulative normal distribution function dened by (3.7). Note
that increasing illiquidity ( ) implies 0 and this in turn indicates that
(3.17) and (3.18) become increasingly focused about = rK, i.e. S = K(1 r),
taking on the payo form away from this point, consistent with our observations
above regarding gures 3.1 and 3.2. Furthermore dierentiating (3.17) and (3.18)
with respect to directly gives
g
P

=
g
C

2
K
2

2
2
e

1
2
(
+rK

)
2
< 0,
conrming that, on the inner scale at least, the option value is monotonic decreasing
in the liquidity parameter .
CHAPTER 3. FIRST-ORDER FEEDBACK MODEL 72
Figure 3.4 shows the dierence between the inner solution and the payo function for
both put and call options for various values of the liquidity parameter . In addition
to conrming the monotonic behaviour in , it can be seen that call values always lie
above the payo curve (i.e. g
C
[]
+
> 0 for all ). 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
[]
+
< 0 (i.e. V payo < 0) for
certain ranges of , which opens up the potential for the optimal early exercise (on
the 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
(

]
+
g
C
(

]
+

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
(

]
+
g
C
(

]
+

0
(b) Call
Figure 3.4: Inner solution minus the payo for put and call options, r = 0.04, = 0.2,
K = 1 and for = 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
nitely liquid underlying if early exercise is permitted. In the context of rst-order
feedback, the most consistent model has the delta in (2.8) on page 51 computed
using the liquid ( = 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 nancial 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 rst-order feedback
PDE (2.9) subject to (1.2). Again we see the collapse of the option value on to the
payo as the liquidity parameter is increased (which implies the location of the
free boundary always moves towards the exercise price as increases). However,
although the results appear to be qualitatively similar to the = 0 case, there are
subtle dierences, 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
= 0
= 10
Figure 3.5: Value of American put options, T = 1, r = 0.04, = 0.2, K = 1 and for
= 0, 1, 2, 5, 10; the variation with appears to be monotonic.
Analysis of the liquid ( = 0) American put option close to expiry leads to a somewhat
complicated structure, as detailed by Kuske and Keller (1998). Here, the scale
dened 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(

log )) from
the exercise price (with a signicant price variation in a region O(
_
/ log ) of this
exercise boundary). It was shown by Widdicks (2002) that as 0, on the = O(1)
scale, the solution of the liquid ( = 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
= O(1) or smaller, which is relatively distant from the free boundary.
However, recall that for the case when ,= 0, with = O(1) we have clear indications
of the possibility of early exercise (on the scale) for the illiquid put. In other words
the scaling for the rst-order feedback equation encompasses the free boundary
(unlike the scaling for the liquid ( = 0) case). Therefore, the American problem
in this case reduces to the solution of (3.14), subject to the conditions
4
g 0 as , (3.19a)
g = and g

= 1 on =
f
, (3.19b)
where we have used the usual smooth pasting conditions (continuity of the option
value and its derivative) and
f
denotes the location of the free boundary (on the
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
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 = + rK which transforms the system (3.14),
(3.19) to

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 is as before and z
f
the free boundary on the z-scale. To proceed we seek a
solution of the form,
g(z) = z g(z)
4
Note that here the outer solution is given by V
P
(S, ) = (K S)
+
rather than V
P
(S, ) =
(Ke
r
S)
+
since we are dealing with the American option and so the outer solution will be
trivially the payo prole.
CHAPTER 3. FIRST-ORDER FEEDBACK MODEL 75
which upon substitution leads to
g
zz
g
z
=
2
z

z

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

1
2
(
z

)
2
,
where A is a constant of integration. Integrating once more gives
[ g]

z
=
_

z
A
y
2
e

1
2
(
y

)
2
dy,
g() g(z) =
_

A
y
e

1
2
(
y

)
2
_

2
_

z
e

1
2
(
y

)
2
dy,
g(z) =
A
z
e

1
2
(
z

)
2
+
A

2
_

z
e

1
2
(
y

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

1
2
(
z

)
2
+
Az

2
_

z
e

1
2
(
y

)
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 dierentiate equation (3.21) to obtain
g
z
(z) =
A

2
_

z
e

1
2
(
y

)
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

)
2
+
Az
f

2
_

z
f
e

1
2
(
y

)
2
dy, (3.22)
g
z
(z
f
) = 1 =
A

2
_

z
f
e

1
2
(
y

)
2
dy. (3.23)
From (3.23) we have
A =

2
_

z
f
e

1
2
(
y

)
2
dy
,
hence substituting into (3.22) gives
z
f
+rK =

2
e

1
2
(
z
f

)
2
_

z
f
e

1
2
(
y

)
2
dy
z
f
,
rK
_

z
f
e

1
2
(
y

)
2
dy =
2
e

1
2
(
z
f

)
2
,
CHAPTER 3. FIRST-ORDER FEEDBACK MODEL 76
which can be written in the form of the standard cumulative normal distribution
function as

_
z
f

_
= 1

rK

2
e

1
2
(
z
f

)
2
.
Transforming back to the original variable yields

f
+rK

_
= 1

rK

2
e

1
2

f
+rK

2
,
or further

_
(
f
+rK)

2
K
2
_
= 1

2
K

2r
e

2
2

f
+rK

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
(

f
)

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

log ); consistent with this as 0,


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, ) variables using
equation (3.10) we can see that
S
f
() = K +
f
+. . .
CHAPTER 3. FIRST-ORDER FEEDBACK MODEL 77
where
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 rst-order feedback model is that we have
the possibility of the denominator of the volatility term vanishing, hence a possible
breakdown in the diusion term of the rst-order feedback PDE.
5
Considering equa-
tion (2.9) one might naively think that a singularity occurs when 1 V
BS
SS
= 0.
Using the analytic solution for the Black-Scholes equation we nd that
V
BS
SS
=
e

1
2
d
1
(S,)
2
S

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

2
_

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

1
2
d
1
(S

,)
2
S

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

() = K exp
_

_
r +
3
2

2
_

2
2

_
(r +
2
) log
_

K

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

K

2
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

0
Figure 3.7: Location of the vanishing of the denominator of (2.9) with = 0.1,
K = 1, r = 0.04 and = 0.2.
For >
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

0
can be obtained (see section 7.1). Also note that the location of the singularity at
= 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
(n1)
, V
(n2)
, . . . , 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

2
S
2
(V

rSV
S
+rV )
_
1 V
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, ) = (K, 0). Hence it is expected that no singularities
will appear in the solution for > 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

S
= 0.01
= 0.05
Figure 3.8: The rst derivative () of the Black-Scholes equation (3.2) (dotted line)
and the rst order feedback PDE (2.9) (solid line) for = 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

2
V

S
2
= 0.01
= 0.05
S

Figure 3.9: The second derivative () of the Black-Scholes equation (3.2) (dotted
line) and the rst order feedback PDE (2.9) (solid line) for = 0.01, 0.015, . . ., 0.05.
Compare the location of the vanishing denominator 3.7.
Figures 3.8 and 3.9 show the rst 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
dierentiable and further that V
SS
remains
positive, just skimming zero as S

is approached, thus indicating that the solution


remains convex as 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
(S, ) as we have here, will be convexity preserving. The numerical investigations
of the rst-order feedback equation described above indicate that the solution prole
does indeed remain convex, i.e V
SS
0 for all (S, ), in agreement with the stated
results.
One nal subtlety of the behaviour of the rst-order feedback equation comes when we
take a closer look at the hypothesised monotonic decreasing behaviour of the option
value with the liquidity parameter . We have shown that for small times to expiry
the solution is indeed monotonically decreasing in the parameter , however this in
not the whole story for = O(1). Figure 3.10 shows the solution to equation (3.1)
for two slightly dierent values of (the dotted line representing the higher value)
and also at three dierent 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 suciently large times
away from maturity.
We can begin to see what may be happening if we take a closer look at the modied
volatility term of the rst-order feedback case, i.e.

2
(S, ) =

2
S
2
(1 V
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
= 0.0125
= 0.0375
= 0.075
Figure 3.10: First-order feedback put option value for two dierent values of at
various times to expiry; = 0.0125, 0.0375, 0.075. For r = 0.04, = 0.2, K = 1 and
= 0.09 (solid line) and = 0.1 (dotted line). Compare with gure 3.7.
Recall that the results of Ekstr om et al. (2005) suggest that the solution to the PDE
(3.1) (for convex payo proles) remains convex for all (S, ). 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 we need only determine the
dependence of the modied volatility on . Dierentiating (3.26) with respect to
yields

2

=

2
S
2
V
BS
SS
2 (1 V
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 is
monotonic increasing in regions in which V
BS
SS
< 1/ and monotonic decreasing for
V
BS
SS
> 1/. However in the limit as the region V
BS
SS
> 1/ expands to ll
the whole domain and so this will become the dominant behaviour for a xed time
to expiry. The above agrees well with the results shown in gure 3.10, since for the
parameters used, gure 3.7 indicates that the denominator of equation (3.1) does not
vanish for 0.04 and so we are in the region in which V
BS
SS
< 1/ and we should
thus expect monotonic increasing behaviour in , 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



2
S
2
V
SS
2 (1 (S, )V
SS
)
2
rSV
S
+rV = 0, (4.1)
where the trading strategy assumed to aect 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 modied 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 eect 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 (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 payo prole) 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 payos 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 diculties 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 diculties with the liquidation value.
Nonlinear diusion 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 nance. As such the aim of this chapter
is investigate thoroughly the properties of the nonlinear PDE (4.1), with the standard
put and call payo proles (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


1
2
F(S, , V
SS
)S
2
V
SS
rSV
S
+rV = 0,
and as such is fully nonlinear. Equations of this form were rst studied by Barenblatt
and co-workers in the context of hydrodynamics and more recently have arisen in
models occurring in quantitative nance, 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 dierences with linear equations is that
the sum of two or more solutions is no longer necessarily a solution itself. As such
there is a signicant dierence 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 eect 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 payo 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 dierence being that of the total transaction
costs incurred.
When faced with a partial dierential 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 (diusion) equations, existence and uniqueness results are well known, and in
fact the Black-Scholes equation can be shown to be a suciently 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 dierentiable, 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 dened 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 payo proles, 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
(S, ) =

S and for suciently smooth payo proles. This was done by dieren-
tiating the fully nonlinear PDE in V to obtain a quasi-linear PDE in the hedging
strategy (S, ) 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 payo proles, 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
r
into the nonlinear equation for the put value V
P
(S, ), i.e.
V
P



2
S
2
V
P
SS
2 (1 V
P
SS
)
2
rSV
P
S
+rV
P
= 0,
and the payo prole
V
P
(S, 0) = (K S)
+
.
Doing so we obtain
V
C



2
S
2
V
C
SS
2 (1 V
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) diers from the Black-Scholes equation by a function of the
second derivative of the option value only, i.e. = (S, , 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 nd 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 (S, ) in equation (4.1) is a function of only, i.e. = (), then we can seek
a solution of the following form
V (S, ) = S
2
h().
Substitution into (4.1) gives
h



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

2
2r
ln
_
(1 2h)
2
+

2
r
_
+

r
arctan
_
r

(1 2h)
_
= (r +
2
) +A,
where A is a constant determined by the payo prole. It should be emphasised here
that we have been restricted to a constant (S, t) in order to obtain this solution
(without any real nancial justication), and furthermore is only valid for payo
proles depending quadratically on S. Note too that regularity issues arise if h =
1
2
,
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 dicult to resolve numerically.
The idea behind similarity solutions is to exploit the fact that the equations and
the initial (nal) and boundary conditions are invariant under a certain scaling, for
example S S,
2
for any real number . Such a scaling is called a
one-parameter group of transformations. Under this transformations an equation is
invariant and so
S

is the only combination of S and that is independent of and


hence the solution must be a function of
S

only.
The global similarities (of Lie type) to equation (4.1) can be found in Bordag (2007).
In that paper, under the assumption that = (S), it is proved that 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 (S, ) =

S
k+1
,
there exists a global similarity transform of the form
V (S, ) = S
1k
u(z) where z = log S +a, a ,= 0. (4.2)
Note that k = 1 corresponds to the model of Sch onbucher and Wilmott (2000), i.e.
with constant liquidity parameter . 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

2
_
u
zz
+ (1 2k)u
z
k(1 k)u
_
2
_
1

_
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

2
_
u
zz
u
z
_
2
_
1

(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

2
_
u
zz
+u
z
_
2
_
1

(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) = ABe
z
where A and B are constants to be determined by the boundary and payo conditions.
After transforming back to the nancial variables this gives
V (S, ) = AS Be
r
which is indeed a valid solution of equation (4.1), however it does not satisfy any
practical boundary and payo 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 dierentiable payo proles, which dier
from the majority of the payo proles considered in the present thesis (which are
more nancially 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

2
_
u
zz
+ 3u
z
+ 2u
_
2
_
1

_
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.
_

_
u
2
zz
+
_

2
2
2

+ 2

_
u
zz
+
_

2
+ 2

2
_
= 0
where = 3u
z
+ 2u and = (r a)u
z
ru. If we solve this using the quadratic
formula we obtain
u
zz
=
1



2
4

_
_
1
_
1
8

2
_1
2
_
_
,
from which it is clear that diculties 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
nd an approximate solution for small values of the parameter . This can be done
by exploiting the techniques of asymptotic expansions. First we re-write equation
(4.1) in the more convenient form
(1 V
SS
)
2
(V

rSV
S
+rV )
1
2

2
S
2
V
SS
= 0. (4.6)
Now we expand V (S, ) as follows
V (S, ) = V
0
(S, ) +V
1
(S, ) +
2
V
2
(S, ) +. . .
where V
n
(S, ) are functions to be found. Substituting this expansion into (4.6) and
collecting together terms of the same order in gives
3
O(
0
) : V
0

1
2

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

1
2

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

1
2

2
S
2
V
2SS
rSV
2S
+rV
2
= 2V
0SS
(V
1
rSV
1S
+rV
1
)
+
_
2V
1SS
V
2
0SS
_
(V
0
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
n1
).
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
sucient regularity in the function V (S, ), specically we need the derivatives of
V (S, ) to be bounded.
4
This cannot be guaranteed a priori and the unbounded
second derivative of the payo prole 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 rst-order correction term V
1
(S, ) to the price of a European
put option. These results indicate that (similar to rst-order feedback in the regime
[V
SS
[ < 1/) 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/ in the entire solution domain (corresponding to suciently
smooth payo proles) then the solution to equation (4.1) is monotonic increasing in
the liquidity parameter ; this is in agreement with the result shown in gure 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
,

)
S
increasing
Figure 4.1: The leading order correction term V
1
(S, ) to the Black-Scholes (i.e.
= 0) European put option for various time to expiry. K = 1, r = 0.04, = 0.2,
T = 1 and = 0.1, 0.2, . . . , 1.
4.5 Numerical solutions
Consider next a numerical treatment of (4.1) with constant for simplicity, subject
to the put payo condition (1.2). Figure 4.2 shows results obtained using a simi-
lar Crank-Nicolson scheme to that successfully employed on the rst-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 ne grid (time-step of 10
3
, grid-size
S 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 nite-dierence
scheme (see Duy, 2004).
This sort of diculty is understandably sidestepped in published works (for specic
details see chapter 7) but a study of its causes will surely be helpful for the next
phase of modelling in the eld. In fact there are two problematic issues with regard
to these diculties, which are not unconnected. The rst is linked to the inevitable
innite behaviour of the gamma with standard payo 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 diculty (again revealed by a cursory inspection of (4.1)) is the likelihood of
diculties if there is a zero in the denominator of the volatility term. A discussion of
this issue, which is associated with smoothed payo 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

S
S
= 1
= .1
Figure 4.2: Deltas for full-feedback (European) put, K = 1, r = 0.04, = 0.2,
= 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 ( 0) can yield signicant 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 justied a posteriori )
V (S, ) =
1
2
H() +() +. . . (4.7)
where is dened in (3.4). H() denotes the Heaviside function, which is necessary to
mimic the behaviour of the payo, close to expiry. Consequently, we have a dierent
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(
1
2
)
of the exercise price as 0 (a result determined through asymptotic analysis),
similar to the = 0 liquid options (as discussed in the previous section), which is
rather broader than the scale appropriate for the rst-order feedback options (where
S K = O()).
In the region S > K (i.e. > 0) the following equation describes :


2


2
K
2

2 (1

)
2
= 0, (4.8)
with 0 as . In the region S < K (i.e. < 0) the appropriate equation is


2


2
K
2

2 (1

)
2
+rK = 0, (4.9)
with rK as . At = 0, smooth pasting (,

continuous) is
appropriate. Sample results for a put option are shown in gure 4.3 (obtained via a
straightforward Runge-Kutta fourth-order shooting method). These results indicate
that the option values all lie below the payo
5
(the repercussions of this will be
discussed below). Note also the slower decay to the [[ asymptotes as the
volatility increases due to the O(
2
K
2
) scaling that emerges from (4.8) and (4.9) in
these limits.
It is helpful to shift as follows:
=

rK
2
,
which leads to the equation

2
K
2

2
_
1

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

with respect to = 0 (and so


sgn()
2
rK as [[ ). 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, ) (K S)
+
().
CHAPTER 4. FULL-FEEDBACK MODEL 95
the results for calls from the results for puts, namely

C
() =
P
() + 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(Tt)
.
For the nonlinear problem, the chosen scaling for the inner region is given by
S = K +
1
2
,
V
P
=
1
2
H() +
P
() +o(),
V
C
=
1
2
H() +
C
() +o(),
e
r
= 1 r +o().
Note that the scaling for a call was obtained by replacing by in the put scaling.
Substitution thus gives, after a little rearranging

1
2
[1 H() H()] +
_

P
()
C
()

= rK,
which reduces to

C
() =
P
() + rK,
which corresponds to the symmetry obtained for the inner equations, namely (4.11),
conrming put-call parity for the nonlinear case.
The key observation in the above is the discontinuity in the delta ( =
V
S
) at = 0
as indicated in (4.7), and it is the neglect of this that is undoubtedly responsible for
the apparent spurious results observed in gure 4.2. Another point to be noted is
that gure 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 (i.e.
at times away from expiry), it turns out that yet another anomaly occurs, this time
in the limit as decreases (with other parameters held xed). For values of just
below 0.15 (taking the other parameters used in gure 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
decreasing

Figure 4.3: Local ( 0) solution of a full-feedback put, K = 1, = 0.1, r = 0.04


and = 1, 0.95, . . ., 0.15.
To understand this, we rewrite (4.8) and (4.9) in the form of a quadratic in

;
2
2

_
4 +
2
K
2
_

+ 2 = 0,
where =

2

+ rKH(). Using the quadratic formula we can write the


solution for

as

=
1

+

2
K
2
4
2

_
1
_
1 +
8

2
K
2
_1
2
_
,
where we have taken the negative root in order to satisfy the condition that

0
as [[ . Indeed, this is the form that was taken as the basis of the numerical
treatment used to treat the results shown in gure 4.3, and inspection of the results
indicated that diculties arose if
1 +
8

2
K
2
< 0.
CHAPTER 4. FULL-FEEDBACK MODEL 97
Hence, we may expect this regime to arise for large values of the ratio /
2
K
2
, i.e.
for suciently large , or suciently small (since must be an odd function about
= 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 gure 4.2, which led to the
aforementioned diculties. 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 modied procedure involved writing (4.1) as
a system of two rst-order equations namely in V (S, ) and V
1
(S, ) = 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 eectively 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 gure 4.4, showing dis-
tributions of V (S, ) max(K S, 0), i.e. the dierence between the option value
and payo, and as such can be compared directly with the small-time-to-maturity
solutions displayed in gure 4.3. Furthermore, gure 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-
nicant 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 gure 4.4, namely
that this indicates the put option value (close to expiry) is always less then the option
payo. This has implications for the pricing of American options in this framework,
because if the European option value is always below the payo 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
= T), i.e. the solution to the American put will trivially correspond to the payo
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 gure 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 nancial
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 payo. 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 eectively creates
another free boundary on the PDE at S
b
where the conditions V (S
b
(), ) = 0 and
V
S
(S
b
(), ) = 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 - payo) for the corresponding call. This
clearly reveals that call values not only remain positive, but are also always above
the payo 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
= 1
= .1
Figure 4.4: Full feedback put, K = 1, r = 0.04, = 0.2 and = 0.1; modied
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
= 1
= .1
Figure 4.5: Full feedback put, K = 1, r = 0.04, = 0.2 and = 0.1; modied
numerical scheme.
4.7.1 A second solution regime
Returning now to the other regime outlined in section 4.6, i.e. when 1 +
8

2
K
2
< 0,
which turns out to be even more problematic, since here even the 1 regime is
unclear. It was therefore decided to mount an homotopy type of approach in this
regime, specically by considering a payo 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
= 1
= .1
Figure 4.6: Full feedback call, K = 1, r = 0.04, = 0.2 and = 0.1; modied
numerical scheme.
in conjunction with the full problem (4.1). In this way, it is possible to mimic a
standard put payo as the smoothing parameter 0.
In Frey and Stremme (1997) and Frey (1998) this smoothed payo prole was used
to represent an idealised option payo, which represented a well-diversied portfo-
lio containing a multitude of dierent payos with dierent strikes which combine
to produce a suciently smooth payo to satisfy the smoothness assumptions im-
posed for existence and uniqueness. Here its use is slightly dierent, it is merely a
mathematical tool to investigate the limit of smoothness. Results corresponding to
the parameter choice of gure 4.4, but instead with = 0.1 and at a time shortly
before expiry ( = 0.1) and for three choices of are shown in gure 4.7. These
results were based on the method employed for gure 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 0, the solution for the
put takes the trivial form:
V (S, ) =
_
_
_
0 for S > K,
Ke
r
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
= .0005
= .001
= .00025
S
V
-
p
a
y
o

Figure 4.7: Full feedback put, smoothed payo, K = 1, r = 0.04, = 0.1, = 0.1
and = 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 diusion
term eectively eliminates itself completely and the discontinuity at S = K and = 0
cannot propagate away from this point for > 0 since there is no diusion. 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 eect of the nonlinearity, for
standard (non-smooth) payo proles, is to suppress the diusion term of the equation
in regions of non-smoothness, thereby failing to smooth out any discontinuities in the
derivative of the payo prole, 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 payo proles. Such a breakdown can be seen to be a
direct result of the singular nature of the diusion coecient in the the governing
equation.
Chapter 5
Smoothed Payos - Another
Breakdown
The diculties encountered in the previous chapter have been, so far, attributed
to the discontinuous delta (i.e. innite gamma) of the payo prole. If we instead
assume smoothness in the payo (i.e. nite gamma), it can be seen that there is the
potential for further diculties to arise due to the vanishing of the denominator in
(4.1), i.e. when
1
V
SS
=
1

. (5.1)
Firstly, note that for standard put and call payo proles, condition (5.1) must always
be satised somewhere in the domain T R
+
[0, T]; since the solution must pass
from V
SS
= at (K, 0) to V
SS
0 as . Secondly, note that for suciently
smooth payo proles, condition (5.1) may never be satised in the solution domain.
To illustrate the circumstances under which we should expect such singular behaviour,
we will once again consider the smoothed payo prole
V (S, 0) =
1
2
_
K S +
_
(K S)
2
+
2
_
(5.2)
where 0. This function is smooth, but in the limit as 0 recovers the
discontinuous payo prole of a put option. One can consider this as parameterising
1
Note that for simplicity here is a constant but can be generalised in what follows.
102
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 103
the smoothness of the payo prole by , with the limit 0 representing highly
non-smooth functions (in the sense of very large second derivatives in the region of the
strike) and conversely the limit 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 (S, ), i.e. we must have
(S, ) sup
(S,)D
_
1
V
SS
_
,
or alternatively as placing a restriction on the payo prole, i.e.
sup
(S,)D
V
SS

1
(S, )
.
For the analysis in the remainder of this chapter (S, ) 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 = 0, in other words,
sup
(S,)D
V
SS
= sup
(S,)D
0
V
SS
,
where T
0
= R
+
0. In fact it is intuitively clear from the diusive nature of
equation (4.1) for increasing 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 = 0, i.e. the payo prole. Returning to
the smoothed payo prole (5.2) direct computation gives
V
S
(S, 0) =
1
2
_
1 +
(K S)
_
(K S)
2
+
2
_
, (5.3a)
V
SS
(S, 0) =

2
2
_
(K S)
2
+
2
_3
2
, (5.3b)
V
SSS
(S, 0) =
3
2
(K S)
2
_
(K S)
2
+
2
_5
2
, (5.3c)
V
SSSS
(S, 0) =
3
2
2
_
_
4(K S)
2

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
2
3
0
since 0 by denition. Therefore the maximum of the second derivative of the
payo prole is given by
sup
D
0
V
SS
= V
SS
(K, 0) =
1
2
,
and we can exclude the denominator from vanishing if we place the restriction that
2, (5.4)
from which it can be seen that the smoother the payo prole the more liquidity the
model can handle. Also a corollary to this result is that if we have a payo prole
with a discontinuous rst derivative (delta), which includes the majority of the payo
proles used in practise, then to restrict the denominator from vanishing it is required
to set = 0 and so this model cannot treat non-smooth payo proles.
Condition (5.4) may seem rather restrictive and indeed it is when considering standard
put and call payo proles. In what follows we shall assume smooth payo proles
and investigate the nature of the singularities that arise if this restriction is not
imposed, i.e. when we are in the regime that > 2.
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 suciently large
such that the denominator in the diusion 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 diusion term of the equation in an ad hoc
manner, more specically they set
(S, ) = max
_

0
,
S
1 min
1
, V
SS

_
for suciently large
0
and suciently small
1
. This is done in order to bypass
any problems associated with the limits 0 or , hence ensuring the
denominator is nonzero and that the denominator does not become too large to
annihilate the diusion term. Finally Liu and Yong (2005) suggest a form of the
liquidity function (S, ) that is hoped to suppress such singular behaviour, this has
the eect of fundamentally changing the option price dynamics close to expiry, see
section 7.5. Here we make no such modications 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
satised. For the smooth payo prole (5.2) we can calculate the explicit locations
of any singularities (denoted S
0
) at = 0 by equating the second derivative (5.3b)
to 1/. Doing so yields
S
0
= K

2
2
_2
3

2
.
Hence for the payo (5.2) there are two singularities, each equally spaced either side of
the strike K. Note that the solutions at = 0 are not themselves singular, but what
remains is to determine if and how singularities propagate through the solution for
> 0. To solve the full equation (4.1) near these singular points will be particularly
dicult, 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 payo prole, which we have determined to have an
isolated singularity in the payo prole 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 is sought
about the point where the equation becomes singular, i.e. where V
SS
= 1/. Since
we are assuming a smooth payo prole, the solution in the vicinity of the singular
point S
0
must be analytic (at least for = 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)+(SS
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 = 0 we also require that
V
SS
(S
0
, 0) =
1

.
Next we seek a similarity solution for small of the form
V (S, ) = V (S, 0) +

V (), (5.6)
with
=
S S
0

,
where and 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 expansion (5.6) we therefore seek a similarity solution in the vicinity
of the singularity of the form
V (S, ) = V
0
+

V
1
+
2

2
2
+

V () +. . . , (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 payo prole. Direct substitution of (5.7) into (4.1) gives

1
_

2
S
2
0
_

1
+
2

_
2
2

24
V
2

rS
0
_
V
1
+

_
+r
_
V
0
+

V
1
+

2

2
2
+

V
_
= 0.
(5.8)
2
Note that for the case of the put or call payo prole (i.e. = 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 diusion term and the time derivative term in (5.8) it is clear that we
require
1 = 4 2 3 4 = 1. (5.9)
To x the values of and , 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 [[ (i.e. as 0) must match with the Taylor series expansion of
the solution at = 0, i.e. (5.5). Hence
lim
||
_
V
0
+

V
1
+
2

2
2
+

V () +. . .
_
= V
0
+(SS
0
)V
1
+
(S S
0
)
2
2
+
(S S
0
)
3
6
V
3
+. . . ,
where we have dened V
i
=

i
V
S
i
(S
0
, 0). Since the rst three terms on both sides are
identical (by construction) this reduces to
lim
||
_

V () +. . .
_
=
(S S
0
)
3
6
V
3
+. . .
lim
||
_

V ()
_
=

3

3
6
V
3
+. . . .
For a non-trivial inner solution

V () we require that

V = O(1) as 0, this forces
us to set
= 3. (5.10)
Note that the above matching procedure has also provided us with the appropriate
boundary conditions (for large ) of the inner solution, i.e. that

V ()

3
V
3
6
as [[ . (5.11)
Substituting (5.10) into (5.9) we nd that
=
1
5
, =
3
5
,
hence the appropriate form of the solution to try around the singularity is given by
V (S, ) = V
0
+
1
5
V
1
+
2
5

2
2
+
3
5

V () +. . . ,
which after substitution into (4.1) and evaluating in the limit 0 yields
3

5
2
S
2
0
2
3
V
2

= 0. (5.12)
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 108
Before attempting to solve (5.12) given the appropriate boundary conditions (5.11),
we rst 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

V () =

3
V
3
6
+A

, (5.13)
where A and are constants to be found. Note that the second term is a higher order
correction as [[ i < 3. Substitution into (5.12) gives
(3 )A

5
2
S
2
0
2
3
_
V
3
+( 1)A
2
_
2
= 0.
Since we are interested in the solution as [[ we can approximate the denomi-
nator as follows
(3 )A

5
2
S
2
0
2
3

2
V
2
3
_
1 +
(1)A
V
3

3
_
2
= 0,
(3 )A

5
2
S
2
0
2
3

2
V
2
3
_
1
2( 1)A
V
3

3
+. . .
_
= 0.
Hence in the limit [[ we must have = 2, which leads to the equation
_
5A
5
2
S
2
0
2
3
V
2
3
_
1

2
= 0(
5
),
therefore we have that the constant A must be given by
A =

2
S
2
0
2
3
V
2
3
.
It is clear that we have an innite asymptotic series solution as [[ 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 starting
from
3
and decreasing by powers of ve; these further terms can be determined
by performing the same procedure adopted above. To summarise, the matching
condition (5.11) is modied to

V () =

3
V
3
6
+

2
S
2
0
2
3
V
2
3

2
+O(
7
) as [[ . (5.14)
The signicance of the extra term can be seen if we transform the large behaviour
(5.14) back to the outer variables. Doing so we have that

V () =
V
3
(S S
0
)
3
6
3
5
+

2
S
2
0

2
5
2
3
V
2
3
(S S
0
)
2
+O
_

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, ) =V
0
+ (S S
0
)V
1
+
1
2
(S S
0
)
2
+
V
3
6
(S S
0
)
3
+

2
S
2
0
2
3
V
2
3
(S S
0
)
2
+O
_

2
(S S
0
)
7
_
.
(5.15)
This shows that the matching procedure results in integer powers of , suggesting
strongly that the scaling used is the correct scaling for this problem.
One nal point to note is that the sign of V
3
may aect the qualitative behaviour of
the solution. V
3
is identied as the third derivative of the payo prole evaluated at
the location of the singularity. Returning to the smoothed payo for a moment we
can see with a little work that
V
3
=
3
2
2
_
2

2
_5
3

2
2
_2
3

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

V
2

_
3

_
= (5.16)
where =
5
2
S
2
0
2
3
. The rst point to note is that can be scaled out of the problem
by setting

V =
1
3

V , however this scaling would then place the constant into the
boundary conditions (5.14). If we are a little more sophisticated we could perform
the transformation

V =
3
5

V ,
=
1
5
,
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

V () = B

where B and are constants, leads to = 4/3 and to the exact solution

V () =
_
243
80
_1
3

4
3
=
_
3
2
_5
3
(S
0
)
2
3


4
3
. (5.17)
However this clearly does not satisfy the matching condition (5.14), i.e.
3
leading-
order behaviour as [[ . Therefore in order to obtain a solution with the required
boundary conditions we must turn to numerical techniques, such as shooting or nite
dierence methods.
Unfortunately, numerical solutions of (5.16) with the boundary conditions above
proved fruitless; shooting methods oundered and nite-dierence 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 dierential 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 rst order ODEs by dening 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 dierential
equations and their solutions rather than nding 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 eld 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 eld 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 identied as xed points (also called
equilibrium or stationary points) of the system, so called because if a solution starts
at (or reaches) a xed 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 xed 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 xed point of such systems are at u = v = 0. It can be shown
that the nature (and stability) of the xed point is determined by the solution of the
linear system (5.19) and, as it transpires, the determinant of the coecient 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
1,2
=
1,2
+i
1,2
, then the general solution is given by
_
_
_
u(x) = u
0
e

1
x
(cos
1
x +i sin
1
x),
v(x) = v
0
e

2
x
(cos
2
x +i sin
2
x).
Three qualitatively dierent classes of xed points can be identied, namely nodes,
spirals and saddle points, which are entirely determined by the values of
1,2
and
1,2
.
Nodes If
1,2
= 0, i.e. the eigenvalues are real and if both
1,2
have the same sign
then we have a nodal xed point. Furthermore if
1,2
< 0 we have an stable
node (sink) since in the limit x the solution will tend to the xed point
and if
1,2
> 0 then we have a unstable node (source) since the solution will
move away from the xed point as x .
Saddle Points If again
1,2
= 0, i.e. real eigenvalues and
1
and
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
1,2
,= 0 we have a complex conjugate pair of eigenvalues, i.e.
1
=
2
=
and
1
=
2
= . In this case we have a spiral xed point, so-called because,
due to the periodic functions (sin and cos) in the solution, the solutions will
spiral into or out of these xed points. Furthermore if < 0 then we have a
stable spiral (sink) and if > 0 at unstable spiral (source).
In addition if
1,2
,= 0 but
1,2
= 0 then the solutions become periodic but the
trajectories are closed, in this case the xed point is called a centre.
For a nonlinear system, however, the structure of the phase portrait is not obvious,
since there can be multiple xed 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 nite number), the combination of which
entirely determines the qualitative behaviour of the ODE and its solutions. Moreover
each singularity (xed 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 xed orbits that attract (or repel) nearby
paths and correspond to xed 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 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
= e
x
. (5.20)
Immediately we can see that the choice of the positive sign corresponds to a mapping
from x (, ) to (0, ) and the negative sign corresponds to the negative
semi-innite plane in . Hence we are eectively making two separate transformations
on two dierent Riemann surfaces. Substituting (5.20) into (5.16) yields (for both
transformations)
(V
xx
V
x
)
2
(3V V
x
) = e
4x
,
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 115
and further making the transformation
V = e
x
u(x),
gives (after substitution)
_
( 1)u + (2 1)u
x
+u
xx
_
2
_
(3 )u u
x
_
e
3x
= e
4x
,
from which it is clear that the equation will become autonomous if we set =
4
3
,
resulting in
_
4
9
u +
5
3
u
x
+u
xx
_
2
_
5
3
u u
x
_
= ,
where x = ln 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

_

5
3
u u
x
.
As outlined in the previous section, this second order ODE can be expressed as a
system of coupled rst order equations. Setting v = u
x
we arrive at the coupled
system
_
_
u
v
_
_
x
=
_
_
_
v

4
9
u
5
3
v
_

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

5
3

1
v
_

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 xed 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 eld direction cannot
be determined. The nature and stability of the xed point can be determined by
investigating the linearised system in the vicinity of the xed point. The next section
outlines the linearisation procedure and the classication of the xed points in more
detail. However before proceeding we note that a further simplication can be made
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 116
to the system (5.21), the parameter can be scaled out of the equation entirely by
another appropriate transformation. If we seek a solution of the form
u =

1
u, (5.23a)
v =

2
v, (5.23b)
then it can be shown that the equation in ( u, v)-space will be independent of the
parameter , if we choose

1
=
2
=
1
3
.
Hence for all intents and purposes we can set = 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 planes structure
is entirely determined by the location and nature of its xed points, hence the aim of
the next section is to nd and classify the xed points of the nonlinear system (5.21).
5.1.5 Behaviour of the xed points
We wish to nd and classify the xed 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 xed points are
dened by f(u
0
, v
0
) = g(u
0
, v
0
) = 0 and so it can be seen from (5.24) that the xed
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 xed 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

2i
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
2i
3
, (5.25b)
u
03
=
_
243
80
_1
3
e

2i
3
. (5.25c)
Interestingly, the real part of the xed points above in (u, v)-space corresponds to the
exact solution of (5.12) in (V, )-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 xed points, we need to undertake analysis in the local neigh-
bourhood of the xed 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 xed 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 rst term in the above equation disappears as it is a derivative of a constant
(xed 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 xed points which by denition 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 xed point can dier qualitatively from the
long term behaviour near a xed point of the fully nonlinear system. Fortunately
however there are only two situations where this can occur. One is when the xed
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 xed 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 xed point in turn. Considering rst 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 1

2
3

23
15

_
_
= 0,
which has two (complex) solutions

1,2
=
1
30
_
23 i

71
_
. (5.28)
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 119
Systems with complex eigenvalues correspond to spiral node xed points and since
the real part of the eigenvalue is negative (see section 5.1.3) we have a stable xed
point, usually called a spiral sink.
Next consider the xed 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

1
=
2
15
, (5.29a)

2
=
5
3
. (5.29b)
It also turns out that the nal xed 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 xed points are in the complex domain we are
strictly required to perform a full (four-dimensional) complex stability analysis about
these xed 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 xed points can be omitted from our analysis. To conclude
we have determined that the (real) xed point is a (stable) spiral sink.
Figure 5.1 shows the phase portrait of the the autonomous system (5.24) (with
scaled out of the problem completely). The results were obtained using MATLAB and
the pplane ODE software package
5
which employed the Dormand-Prince modication
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 xed points, every
path (each corresponding to a dierent boundary condition) passes through this xed
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 xed point, and so will be unable to
satisfy the boundary conditions as and . 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 xed point at
u =
_
243
80
_1
3
, v = 0 and the eld 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 (, 0) and jumped to the current phase plane.
Solving from = 0 corresponds to shooting in the current phase plane (Riemann
surface) from x = . This path (like all paths) must pass through the xed point
and by denition it must remain there for all x as x , corresponding to .
However, since the solution at the xed point is xed as , and in fact takes
the form V
4
3
(i.e. (5.17)), we have no hope of satisfying the boundary condition
(5.14) as .
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 rst check that all xed points of the system have been found and indeed
that every path must pass through the xed 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
3
in the original
variables. Similarly solutions of the form V
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
has the form
V = A
0

3
+
A
1

2
+. . .
where A
0
and A
1
are known constants. We wish to determine whereabouts on the
phase plane this condition corresponds to. We rst 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 gure 5.1 that the eld 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
)

2
to give

2
C
2
2
(u u
1
)
2
2
1
=
4
9
u
5
3
C
2
(u u
1
)

2
+
1
_
5
3
u C
2
(u u
1
)

2
.
We are interested in the limit u u
1
, here we have that u
1
(u u
1
)

2
provided

2
> 0. This gives

2
C
2
2
(u u
1
)
2
2
1

4
9
u
1
+
_
3
5u
1
,
and so we must have
2
2
1 = 0
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 xed point. If we are interested in calculating the behaviour to
the right of the xed point then a solution of the form
v = C
2
(u
1
u)

2
should be used.
5.1.7 Other xed points
Recall that in phase plane analysis, once we have determined the location and be-
haviour of all the xed points of the system we have entirely determined the qualita-
tive behaviour of the solution. However, there may still be xed points which we have
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 123
still not considered, namely those at [u[ = [v[ = . To investigate any xed points at
innity it is convenient to transform the problem into plane polar coordinates. This
is done via the transformation
u = r cos ,
v = r sin ,
and dierentiation gives
r
x
=
uu
x
+vv
x
r
,

x
=
uv
x
vu
x
r
2
.
Substitution of equation (5.24) into the above yields
r
x
=
5
9
r cos sin
5
3
r sin
2
+
sin
r
1
2
_
5
3
cos sin
_1
2
, (5.33a)

x
=
4
9
cos
2

5
3
cos sin +
cos
r
3
2
_
5
3
cos sin
_1
2
sin
2
. (5.33b)
Next in order to investigate the behaviour at innity we make the transformation
6
=
1
r
,
= ,
and dierentiating gives

x
=
2
r
x
,

x
=
x
.
This leads to the following system in (, )-space

x
= f(, ) =
5
9
cos sin +
5
3
sin
2
+

5
2
sin
_
5
3
cos + sin
_1
2
, (5.34a)

x
= g(, ) =
4
9
cos
2

5
3
cos sin

3
2
cos
_
5
3
cos + sin
_1
2
+ sin
2
. (5.34b)
6
Note that this corresponds to the transformation z = z
1
in complex space z = re
i
.
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 124
Clearly the only xed point of this system is when = 0 and when satises the
following equation

x
=
4
9
cos
2

5
3
cos sin + sin
2
= 0. (5.35)
Equation (5.35) can be factorised as follows
_
4
3
cos sin
__
1
3
cos sin
_
= 0.
Hence this has solutions when either tan =
4
3
or tan =
1
3
which have innitely
many solutions, however we are only interested in the principle branch when 0
2, and so we have only two solutions. Transforming these xed points back to the
original (u, v) coordinates it can be shown that these two xed points corresponds to
the point at innity along the lines u =
4
3
v and u =
1
3
v.
All that remains is to determine the nature of these xed points. For simplicity we
shall remain in the transformed space (, ). The nature of the xed points in this
space will remain unchanged under the transformation back to the original coordinate
system. Again to investigate the nature of the xed point it is required to perform a
linearisation about the xed points. Doing so leads to the following linear system in
( ,

)
_
_

_
_
x
=
_
_
f

(
0
,
0
)
f

(
0
,
0
)
g

(
0
,
0
)
g

(
0
,
0
)
_
_
_
_

_
_
.
Evaluating the partial derivatives of our system yields
f

=
5
9
cos sin +
5
3
sin
2
+
5
3
2
sin
2
_
5
3
cos + sin
_1
2
,
f

=
10
3
cos sin +
5
9
_
cos
2
sin
2

5
2
_
1 + sin
2
+
5
3
cos sin
_
2
_
5
3
cos + sin
_3
2
,
g

=
3
1
2
cos
2
_
5
3
cos + sin
_1
2
,
g

=
10
9
cos sin
5
3
_
cos
2
sin
2

_
+

3
2
_
1 + sin
2
+
5
3
cos sin
_
2
_
5
3
cos + sin
_3
2
.
CHAPTER 5. SMOOTHED PAYOFFS - ANOTHER BREAKDOWN 125
First we will consider the xed point at (, ) = (0, arctan
4
3
) (0, 0.9273). Here the
linearised system becomes
_
_

_
_
x
=
_
_
4
3
0
0 1
_
_
_
_

_
_
which, since the matrix is diagonal clearly has eigenvalues

1
=
4
3
, (5.36a)

2
= 1, (5.36b)
with eigenvectors along the -direction and the -direction. These eigenvalues are
both real and positive which corresponds to a nodal source xed point, which is
unstable.
Finally considering the xed point at (, ) = (0, arctan
1
3
) (0, 0.3218) leads to the
following linearised system
_
_

_
_
x
=
_
_
1
3
0
0 1
_
_
_
_

_
_
which has eigenvalues

1
=
1
3
, (5.37a)

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 -direction) and an unstable
direction (the -direction). In other words any perturbation in the -direction will
result in the solutions being pushed away from this xed point.
One nal point of interest is that the analysis of the xed points at innity has
revealed a path which does not terminate at the xed point near the origin. We can
move from the nodal source at innity along the direction and arrive at the saddle
node (also at innity) 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
xed node near the origin. Hence any solution of a numerical shooting method given
any condition at any boundary will asymptote to the xed point solution u =
_
243
80
_1
3
,
which corresponds to the solution
V =
_
243
80
_1
3

4
3
in the original variables. Hence the xed 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 payo prole, non-smoothness
has been induced into the solution for > 0. The corollary to this is, therefore, that
there is insucient nancial modelling in (4.1), for standard option payo proles,
to prevent such behaviour, indicating (another) failure in the underlying modelling.
Finally, it should be pointed out that strictly the parameter values taken in gure
4.7 are in the range <

2
, as discussed in the present chapter. However, there is
a further subtlety as 0 (which we do not explore), insofar as in this limit yet
further asymptotic analysis is applicable, involving another small parameter, namely
itself. Note too that as 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 innite 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
dierent, 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
dierential equation is reduced to an ordinary dierential 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 payo conditions,
in particular those which do not have discontinuous deltas (and assuming the dif-
culties raised in chapter 5 can be bypassed). The next set of results (obtained
using a straightforward PSOR scheme), shown in gure 6.1, correspond to a calcu-
lation obtained taking the smoothed payo condition (5.2). This set of results (for
an American-style put option) corresponds to the payo condition with = 0.15
(together with K = 1, r = 0.04, = 0.2, = 0.25), in this parameter regime the
denominator does not vanish since < 2 (cf. (5.4)). To be consistent with the nal
payo 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 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 diculty reported above with standard payo
conditions is associated with the vanishing of the denominator in (4.1), which will
certainly be the case for standard payo 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
= 0
= 10
S
V
Figure 6.1: Full feedback American put, K = 1, r = 0.04, = 0.2, = 0.25, = 0.15
(smoothed payo), = 0, 1, . . . , 10. Note that we are in the regime < 2 and so
we should expect no singular behaviour.
There is a subtlety with the application of the smoothed payo prole (5.2) to per-
petual options that should be noted and that we shall attempt to outline below. If
we apply the smoothed payo prole to the standard Black-Scholes equation, (3.2),
and evaluate V

at nal 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 specically if V

ever changes sign. For a smoothed put numerical investigation


shows that V

at expiry can be both positive and negative, indicating that there is


an early-exercise region. However for large enough then this is not the case and
V

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 <
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. = 0,
II. 0 <

2
,
III.

2
< <
max
,
IV. >
max
.
For regime I, i.e. kinked payo proles, we have demonstrated in chapter 4, using
a local expansion about = 0, that American options are always early exercised.
Regime IV is of little interest (since we would never optimally exercise the option) and
also gure 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) nite dierence 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 diculties.
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

2
S
2
V
SS
(1 V
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 gure 6.2 for a range of values of the
parameter , with K = 1, = 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 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 1.1).
As a nal 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 nite dierence methods and the so-called body-tted 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 gure 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
= 0
= 1.1
S
V
Figure 6.2: Perpetual full-feedback American put, K = 1, r = 0.04, = 0.2, =
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
_

(6.2)
where =
2r

2
> 0 and S
f
is the (xed) location of the free boundary determined by
S
f
=
K
+ 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
_

, (6.4)
where > 0 is given by
=
1

2
_
_

_
r D
1
2

2
_
+

_
r D
1
2

2
_
2
+ 2r
2
_
_
,
and the free boundary S
f
given by
S
f
=
K
1
.
Interestingly we can see that as D 0, we have 1 and so the free boundary
for the American call tends to innity 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 . It is useful to
rewrite (6.1) as
1
2

2
S
2
V
SS
+ (rSV
S
rV ) (1 V
SS
)
2
= 0 (6.5)
and we proceed by trying a regular expansion of V in powers of , i.e.
V = V
0
+V
1
+
2
V
2
+. . . .
Substituting the above into equation (6.5) and collecting together the powers of
gives the following asymptotic set of equations (cf. sections 1.8 and 4.4)
O(
0
) :
1
2

2
S
2
V
0SS
+rSV
0S
rV
0
= 0, (6.6a)
O(
1
) :
1
2

2
S
2
V
1SS
+rSV
1S
rV
1
= 2V
0SS
(rSV
0S
rV
0
) , (6.6b)
O(
2
) :
1
2

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

,
with as previously dened 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

2
S
2
V
1SS
+rSV
1S
rV
1
= 2r( + 1)
2
B
2
S
22
,
S
2
V
1SS
+SV
1S
V
1
= 2
2
( + 1)
2
B
2
S
22
. (6.7)
The general solution to this equation is thus
V
1
(S) = CS +DS

,
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
22
, where k is to be determined. Substitution into (6.7) gives
(2 + 2) (2 + 3) k (2 + 2) k k = 2
2
( + 1)
2
B
2
,
CHAPTER 6. PERPETUAL OPTIONS 133
which can be solved for k to yield
k =
2
2
( + 1)
2
B
2
(2 + 3) ( + 2)
.
Hence the solution of the rst order correction is
V
1
(S) = CS +DS

2
2
( + 1)
2
B
2
(2 + 3) ( + 2)
S
22
.
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 rst 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
+S
f
1
+. . . .
Along with the perturbation in V (S) the boundary condition (6.8b) thus becomes
V
0
(S
f
0
+S
f
1
+. . .) +V
1
(S
f
0
+S
f
1
+. . .) +. . . = K S
f
0
S
f
1
. . . .
Exploiting the smallness of and recalling Taylors theorem we have
V
0
(S
f
0
+S
f
1
+. . .) = V
0
(S
f
0
) +S
f
1
V
0S
(S
f
0
) +O(
2
),
V
1
(S
f
0
+S
f
1
+. . .) = V
1
(S
f
0
) +S
f
1
V
1S
(S
f
0
) +O(
2
),
hence equating powers of we can see that this boundary condition becomes
O(
0
) : V
0
(S
f
0
) = K S
f
0
, (6.9a)
O(
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 Taylors theorem to the smooth pasting condition (6.8c)
yields
O(
0
) : V
0S
(S
f
0
) = 1, (6.10a)
O(
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 rst-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

, 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

f
0
,
S
f
0
=
K
+ 1
.
The system for the rst order correction V
1
is
_

_
V
1
(S) = CS +DS

2
2
(+1)
2
B
2
(2+3)(+2)
S
22
, 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 innity we have C = 0 and the condition at
the free boundary leads to
D =
2( + 1)
2
S

f
0
(2 + 3)( + 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( + 1)
2 + 3
.
Hence our approximate solution can be written as
V (S) =
S
f
0

_
S
S
f
0
_

+
2( + 1)
2
(2 + 3)( + 2)
_
_
S
S
f
0
_

_
S
S
f
0
_
22
_
+O
_

2
_
,
(6.11)
with the free boundary now located at
S
f
= S
f
0

2( + 1)
2 + 3
+O
_

2
_
.
Figure 6.3 shows the rst order correction term, i.e. V
1
and compares it to the
dierence 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 gure 6.3 but for increasing values of the
parameter , expectedly the agreement with the exact solution worsens for larger
values of .
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

V
1
S
f
0
S
f
Figure 6.3: The rst order correction to the Black-Scholes perpetual American put
option (solid line) compared to the dierence of the fully numerical option value with
the Black-Scholes (dotted line). K = 1, r = 0.04, = 0.2 and = 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

V
1
= 0.1
= 0.5
= 1.0
S
f
0
Figure 6.4: The rst order correction to the Black-Scholes perpetual American put
option (solid line) compared to the dierence of the fully numerical option value with
the Black-Scholes (dotted line) for various values of . K = 1, r = 0.04, = 0.2 and
= 0.1, 0.5, 1.
Chapter 7
Other Models
We have shown that signicant diculties arise when the form of the function (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 (S, t) as was briey discussed in chapter 2. We now discuss some of
these, in particular by investigating their small behaviour, from which we will be
able to ascertain whether or not the diculties outlined in the preceding chapters (for
constant ) 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 (S, ) =

S where

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 (S, ) eectively 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 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


2


2
K
2

2
_
1

_
2
+rKH() = 0,
and for a call


2


2
K
2

2
_
1

_
2
rKH() = 0.
It is clear that this model will exhibit the same behaviour as the model discussed
previously, since the addition of S is not sucient to alter the qualitative behaviour
of the solution - it merely leads to a rescaling of . 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
dierence in the model of Frey (1998, 2000) is when we consider rst-order feedback.
When considering the location of the vanishing of the denominator similar to the
analysis in section 3.3 the denominator of the rst-order Frey (1998, 2000) model
vanishes when
1
e

1
2
d
1
(S

,)
2

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

2
_

,
and S

() 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

() = Ke
(r+
1
2

2
)
exp
_

log
_

2
2
2

_
_
, (7.2)
Figure 7.1 shows these locations for the same parameters as gure 3.7. Again it can
be seen that there exists no solution past a critical value of . This can be seen
directly from equation (7.2) since there exists no real solution when

2
2
2

< 1,
hence when >
crit
where

crit
=

2
2
2
.
CHAPTER 7. OTHER MODELS 139
For the parameters used in gure 3.7, i.e. = 0.1 and = 0.2, then we have

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

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 = 0.1,
K = 1, r = 0.04 and = 0.2.
7.2 Frey and Patie (2002)
Here an asset dependent liquidity is introduced in order to reproduce the volatility
smile with
(S, t) =

_
1 + (S S
0
)
2
_
a
1
I
{SS
0
}
+a
2
I
{SS
0
}
__
, (7.3)
where I denotes the indicator function and

, 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 (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
(S, ) =

_
1 + (
0
)
2
_
a
1
I
{
0
}
+a
2
I
{
0
}
__
,
which as 0 reduces to

, 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


1
2

2
S
2
_
1

V
S
1

V
S

SV
SS
_
2
V
SS
rSV
S
+rV = 0, (7.4)
where again

R. With a little rearranging we can see that this equates to (2.10)
with
(S, ; V
S
) =

S
1

V
S
.
The authors state that there will be diculties with the PDE when the denominator
passes through zero (as has been outlined in chapter 5 of the present study). To
circumvent this diculty, Sircar and Papanicolaou set the value of the option close
to expiry to be equal to the Black-Scholes analytical value. More specically this is
done in the region 0 < < , where is chosen such that for > the denominator
of (7.4) remains positive. This is eectively introducing a smoothing in the payo
function and, indeed, is switching o the eect of the price impact close to expiry.
They do, however, oer the nancial 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 analysis considered earlier is quite similar to (7.4), in
particular using the scaling (4.7) leads to the following small- equation for a put:


2


2
K
2

2
_
1
_

K
1+

H()
_

_
2
+rKH() = 0, (7.5)
and, similarly, for a call


2


2
K
2

2
_
1
_

K
1

H()
_

_
2
rKH() = 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 ) at S = K ( = 0). Another interesting point to note is that
the symmetry seen in the full-feedback model of section 4.6 has now been broken,

call
() ,=
put
() + rK; this is as a consequence of the inclusion of V
S
into the
function (S, ).
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

in gures 7.2 and 7.3 respectively, with K = 1, = 0.2, r = 0.04. Although in
both cases there appears to be very little variation with

, 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

= 0

= 0.2
Figure 7.2: Local ( 0) call solution of the Sircar and Papanicolaou (1998) model
K = 1, r = 0.04, = 0.2, and

= 0, 0.05, . . . , 0.2.
7.4 Bakstein and Howison (2003)
Bakstein and Howison (2003) developed a model for liquidity eects 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

= 0

= 0.3
Figure 7.3: Local ( 0) put solution of the Sircar and Papanicolaou (1998) model
K = 1, r = 0.04, = 0.2, and

= 0 0.05, . . ., 0.3.
the following PDE,
V


1
2

2
S
2
V
SS

2
S
3
V
2
SS

1
2

2
(1 )
2

2
S
4
V
3
SS
rSV
S
+rV = 0, (7.7)
where

R is a measure of the markets liquidity and is a measure of the price
slippage impact of a trade felt by all market participants, = 1 corresponding to no
slippage. The rst point to note is that this equation looks uncannily like a small

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 aect 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 dierent 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 payo proles) can be found in
the class of smooth functions. The following outlines the procedure adopted to nd
such a scaling.
For the standard payo prole (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 nd an appropriate
scaling we require a balancing between this cubic term and the time derivative, i.e.
V


1
2

2
(1 )
2

2
S
4
V
3
SS
. (7.8)
We seek a solution of the form
V (S, ) =

1
f() where =
S K

2
where we require
1
=
2
= in order to obtain an O(1) inner solution and correctly
match with the standard payo proles (cf. section 3.1). Substituting this into
equation (7.8) we have

1
(f f

)
1
2

2
(1 )
2

2
K
4
f
3

3
we can see that in order to obtain an appropriate balance of terms (for all ) we are
forced to set
1 = 3 =
1
4
.
Hence applying this scaling to the full equation (7.7) it can be shown that in the limit
0 the equation for the inner solution becomes the cubically nonlinear ODE
1
f
3

+
1
(f

f) = 0 (7.9)
where
1
=
_
2

2
(1 )
2

2
K
4
_
1
. The boundary conditions arise from an asymp-
totic match which is the same as for the corresponding Black-Scholes (

= 0) case,
1
Note that
1
can be scaled out by setting f() =

1

f() but we will not do so as this would
place the constant
1
into the boundary conditions.
CHAPTER 7. OTHER MODELS 144
i.e.
f 0 as , f as for calls, (7.10a)
f as , f 0 as for puts. (7.10b)
The system (7.9) and (7.10) can be solved using standard nite-dierence techniques.
Figure 7.4 shows sample results for the inner put solution with = 0.2, r = 0.04,
K = 1, = 1.5 and with = 0.01, 0.5, 1, 5. Note that as is decreased (i.e. the
parameter
1
increased) the solution appears to collapse down onto the standard put
option payo prole, with the solution becoming increasingly focused around = 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
(

,
1

Figure 7.4: Solution to equation (7.9) for a put option with = 0.01, 0.5, 1, . . ., 5,
= 0.2, r = 0.04, K = 1, and = 1.5.
However there is another subtlety that arises with the above scaling in the limit
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 1. In this limit, the smallness of 1
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
, suggesting that an asymptotic breakdown occurs when = O
_
(1 )
8
_
, this can
be seen by balancing the quadratic and cubic V
SS
terms in equation (7.7). Therefore
the limit 1 is not a trivial one. When = 1 however, the cubic term in equation
CHAPTER 7. OTHER MODELS 145
(7.7) disappears and the equation is reduced to
2
V


1
2

2
S
2
V
SS

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 = 1 is
given by
V (S, ) =
1
3
g() where =
S K

1
3
,
leading to the equation (in the limit 0)
3
g
2

+
2
(g

g) = 0 (7.12)
where
2
=
_
3

2
K
3
_
1
and it is once again coupled with the boundary conditions
(7.10). Note that if we dierentiate equation (7.12) then we obtain
g

(2g

+
2
) = 0
which suggests two solutions to equation (7.12)
g() =

4
48
+
C
1

2
2
+C
2
+
C
2
1

2
,
g() = D
1
,
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 ineective. The results were not consistent with grid renement
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) payo prole. 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
2
can be scaled out by setting g() =
2
g() 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



2
S
2
V
SS
2
_
1

SV
SS
_
2
rSV
S
+rV = 0. (7.13)
Making the assumption that

is small and further that

SV
SS
1 then we can
make the approximation
(1

SV
SS
)
2
1 + 2

SV
SS
+. . .
and hence equation (7.13) can be approximated by
V


1
2

2
S
2
V
SS

2
S
3
V
2
SS
rSV
S
+rV = 0,
which coincides with the Bakstein and Howison (2003) model for = 1, i.e. equation
(7.11). Clearly the assumption that

SV
SS
1 prohibits the denominator of the
equation (7.13) vanishing, but also leads to a regime in which standard put and call
payo proles are not permitted due to their innite 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


2

1
2

2
K
2

2
K
3
(

)
2

2
2
(1 )
2

2
K
4
(

)
3
+rKH() = 0,
(7.14)
and


2

1
2

2
K
2

2
K
3
(

)
2

2
2
(1 )
2

2
K
4
(

)
3
rKH() = 0,
(7.15)
for a call, with the boundary conditions described in section 4.6.
The cubic nonlinearity in the second-order derivative

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 and
1
=

, thereby resulting in two rst-order equations. Second-order


nite dierencing, coupled with Newton iteration was then employed. Sample results
are shown in gures 7.5 and 7.6 for puts and calls respectively, with = 0.2, r = 0.04,
K = 1, = 1.5, and with

= 5, -4.75, . . . , 5. Bakstein and Howison (2003) do
discuss possible values for these latter two parameters (it appears that [

[ is likely
very small). Other computations performed suggested that although the variation
of option values with is generally quite small (with xed

), 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

= 0

= 5

= 5
Figure 7.5: Local ( 0) put solution of the Bakstein and Howison (2003) model
K = 1, r = 0.04, = 0.2, = 1.5, and

= 5, -4.75, . . ., 5.
7.4.2 New non-smooth solutions to the Black-Scholes equa-
tion
It should be noted that when

= 0, the Bakstein and Howison model degenerates
to the standard Black-Scholes equation and, somewhat intriguingly, gures 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

= 0

= 5

= 5
Figure 7.6: Local ( 0) call solution of the Bakstein and Howison (2003) model
K = 1, r = 0.04, = 0.2, = 1.5, and

= 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
=
1
2
H() +
BS
().
Doing so we arrive at the equation for the inner solution of a put

BS

BS


1
2

2
K
2

BS

+rKH() = 0,
i.e. equation (7.15) with

= 0. To illustrate the non-smooth behaviour of these
solutions gure 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 rst 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 innitely many smooth solutions to the Black-Scholes equation
but ones which do not satisfy the required growth conditions on the coecients 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
= .25
= 1
Figure 7.7: Non-smooth solution of the Black-Scholes equation. K = 1, r = 0.04,
= 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 eectively switching o
the eect of liquidity as we approach it. This is achieved by adding a time dependency
to the function (S, ) of the form
(S, ) =

(1 e

) (7.16)
where

, 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 0, leading to

2
K
2
f

+f

f = 0.
Note that this has the same structure as the standard Black-Scholes model as 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 (S, ) 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 rst-order feedback case, i.e. equation (3.1) with (S, ) dened
by (7.16). To determine if the denominator vanishes in this simple case reduces to
determining whether there exists a real solution S

() to the equation
1

(1 e

)
S

2
e

1
2
d
1
(S

,)
2
= 0,
where d
1
(S, ) has been dened previously. The rst point to note is that the Liu
and Yong (2005) model reduces to the Sch onbucher and Wilmott (2000) model in
the limit ; as such the location of the vanishing denominator in this limit was
shown in gure 3.7. Conversely when considering the limit 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 , hence we can
see that the denominator does still vanish for suciently large values of . This will
not cause any problems in the rst-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 = 0 the denominator
never vanishes because the denominator reduces to 1 at = 0. However, it is of
interest to check to see if the denominator vanishes for > 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

S
increasing
Figure 7.8: Location of the vanishing of the denominator for the Liu and Yong (2005)
model for various value of . K = 1, r = 0.04, = 0.2, = 0.1, and = 1 10
5
,
2 10
5
, . . ., 1 10
6
.
is investigate the region close to strike and expiry, i.e. 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

(SK)
2
2
2
K
2
K

2
,
valid for both puts and calls. Using this, and the knowledge that in this region
e

1 the denominator will thus vanish if and when


1

K
_

2
e

(SK)
2
2
2
K
2
= 0.
The exponential is bounded above by one and so the denominator will not vanish
provided
<
K

_
2

,
in other words there is a potential for model failure (breakdown) in the region
= O(
2
),
if this is also in the region 1, hence if is suciently large. Liu and Yong (2005)
use the value = 100 in the numerics giving = O(10
5
) which is within the region
where 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 payo
proles, is the Jonsson and Keppo (2002) model. Here the price observed in the
market, S, is dependent on an exogenous Brownian motion (ds = sdt +sdW
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
eect parameter. This leads to a very dierent nonlinear pricing PDE, namely
V


1
2

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

2
K
2
e
2af
f

+f

f = 0, (7.19)
subject to
f

1 as , f 0 as ,
for a call and
f

1 as , f 0 as ,
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
diculties if we have discontinuous payo proles, such as binary options. The above
system was solved using a straightforward fourth-order shooting scheme; results for
calls and puts are shown in gures 7.9 and 7.10 respectively, with = 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

f
a = 1
a = 1
Figure 7.9: Local ( 0) call solution of the Jonsson and Keppo (2002) model
K = 1, = 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

f
a = 1
a = 1
Figure 7.10: Local ( 0) put solution of the Jonsson and Keppo (2002) model
K = 1, = 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 eect parameter g, or more
specically 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
= dt +dW
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
= (S, t)
df(S, t)
S
,
in other words the liquidity function (S, t) can be chosen such that
(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 dene 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 to be
(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 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 dened 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 specically 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 signicant impact, despite understandable interest from market pro-
fessionals. Ni et al. (2005) suggested that this pinning eect 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 (dened 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 modied to
dS
S
=
_
nE

t
_
dt +dW
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, dened 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
+(S, t)
P
S
+
1
2

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 (S, t) is the drift of the process and (S, t) the volatility. For the model of
(8.1) this corresponds to solving the system
P
t
+
_
S nE

t
_
P
S
+
1
2

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

2
_
(T t)
2(T t)
3
2

2
_
exp
_

_
log(S/K) +
_
r +
1
2

2
_
(T t)
_
2
2
2
(T t)
_
.
(8.4)
Avellaneda and Lipkin (2003) showed that, for the special case = 0 and r+
1
2

2
= 0,
the system (8.3) admits an exact solution given by
P(S, t) = 1 exp
_

nE

_
2(T t)
exp
_

_
log(S/K)
_
2
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 ,= 0, and
more importantly r +
1
2

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 eects 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 = 0.2.
the following
dS
S
= dt +dW
t
nEd(S, t)
= dt +dW
t
nE
_

t
dt +

S
dS +
1
2

S
2
(dS)
2
_
=
1
1 +nES

S
_
nE
_

t
+

2
S
2
2
_
1 +nES

S
_
2

S
2
__
dt +
dW
t
1 +nES

S
,

dS
S
= (S, t)dt + (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 aect the drift of
the process it also aects 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 eect is that the drift pushes the underlying towards the strike and the
reduced volatility eectively 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, = 0.2, and r +
1
2

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 aect 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 ow and the resulting
average order book, nding 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, articial nancial markets have been
constructed; see LeBaron (2000) for a review of work in the eld. These agent-based
models aim to reproduce the main stylized facts observed in real nancial 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 eect 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 rst introduced in Avellaneda
and Lipkin (2003). They do so by assuming a price impact of the form
dS
S
sgn
_

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
=
_
nE sgn
_

t
_

p
_
dt +dW
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
+
_
S nE sgn
_

t
_

p
_
P
S
+
1
2

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 ve 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, = 0.2
and r +
1
2

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

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( ) [ [
p
1
dt + sgn( ) [ [
p
2
dW
t
where (S, t) and (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( ) [ [
p
1
P
S
+
1
2
sgn( ) [ [
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 aect 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 eectively assuming that the change of the log price with respect to time and
the Brownian motion is given by
d log S
dt
sgn( ) | |
p1
,
d log S
dW
t
sgn( ) | |
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, = 0.2, and r +
1
2

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)
Theorie Analytique des Probabilites (1812)
In this chapter we aim to investigate the mathematical properties and nancial 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 eects 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 rst 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
writers 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 prot given his view on the market. Peskir and Samee
(2008b) dene 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 , and that it diers 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 buyers rational exercise boundary would be given by the free
boundary of the following optimal stopping problem
1
V (S, t; ) = sup
tT
E
P
S,t
_
e
r(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 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 dicult 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 buyers
beliefs on the future price movements not transpire. More specically, at any time
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 payo (K S
T
)
+
(given
all the information up to the stopping time ) under the assumption that the drift
of the underlying is
c
, the so-called contract drift, for the remaining term of the
contract. Hence the (now time-dependent) payo prole of the early-exercise British
put option is given by
G(S, ;
c
) = E
R
_
(K S
T
)
+
[T

,
where the expectation is taken with respect to a new probability measure R, under
which the stock price evolves according to
dS
t
= (
c
D)S
t
dt +S
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
c
corresponds to a lower level of protection.
CHAPTER 9. THE BRITISH OPTION 167
9.2 The no-arbitrage price
Let us x a probability space (, T, Q), where describes a nancial market with a
ltration (T
t
)
t0
, which represents the information structure of the nancial 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 dened in subsection 1.3.5, the no-arbitrage
price of the British put option is given by the supremum over all stopping times
(adapted to the ltration T
t
generated by the process S
t
) of the expected discounted
future payo. In contrast with an American option, the future payo is now itself an
expectation, i.e.
V (S, t) = sup
tT
E
Q
S,t
_
e
r(t)
E
R
_
(K S
T
)
+
[T

.
Recall that the future payo is dened as the best prediction of the European payo,
conditional on all the information available up to the stopping time . 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

=
_

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

_
log
_
z
S
_

c
D
1
2

2
_
(T )
_
2
2
2
(T )
_
.
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 , i.e.
E
R
_
(K S
T
)
+
[T

=
_

(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

),
where the probability is now conditional on the ltration of information up to the
stopping time . Further simplication gives
_
K
0
(K z)R(z dz[T

).
In order to evaluate this integral we rewrite the function Kz as an integral to give
_
K
z=0
_
Kz
y=0
dyR(dz) =
_
K
y=0
_
Ky
z=0
R(dz)dy,
where we have also changed the order of integration. We can now exploit the fact
that (see appendix C)
_
Ky
0
R(z dz[T

) = P
R
[z K y[T

] ,
=
_
_
log
_
Ky
S
_

c
D
1
2

2
_
(T )

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

2
_
z

1
2
y
2
dy.
Finally we have our expression for the conditional expectation
E
R
_
(K S
T
)
+
[T

=
_
K
0

_
_
log
_
Ky
S
_

c
D
1
2

2
_
(T )

T
_
_
dy
= S

_ K
S
0

_
log u
_

c
D
1
2

2
_
(T )

T
_
du,
where at the nal step we have made the substitution u =
Ky
S
. The British option
value is thus given by
V (S, t) = sup
tT
E
Q
S,t
_
e
r(t)
S

_ K
S
0

_
log z
_

c
D
1
2

2
_
(T )

T
_
dz
_
.
CHAPTER 9. THE BRITISH OPTION 169
Dening the function
G(S, t) = S
_ K
S
0

_
log z
_

c
D
1
2

2
_
(T t)

T t
_
dz,
we have that the problem now reads
V (S, t) = sup
tT
E
Q
S,t
_
e
r(t)
G(S, )

.
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
nd an analytical expression for G(S, t) which can be done easily with integration by
parts to give
G(S, t) = K
_
log
_
K
S
_

c
D
1
2

2
_
(T t)

T t
_
Se
(cD)(Tt)

_
log
_
K
S
_

c
D +
1
2

2
_
(T t)

T t
_
.
Alternatively this can be written as
G(S, t) = K
_
d
1
(S, t;
c
)
_
Se
(cD)(Tt)

_
d
2
(S, t;
c
)
_
, (9.1)
where
d
1
(S, t;
c
) =
log
_
K
S
_

c
D
1
2

2
_
(T t)

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

c
D +
1
2

2
_
(T t)

T t
= d
1
(S, t;
c
)

T t. (9.2b)
Note that the dependency on the contract drift rate
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 dened as

= inft [0, T] : S
t
T,
3
For the standard American put option the gain function is simply the (time homogeneous)
payo prole i.e. G
A
(S, t) = (K S)
+
.
CHAPTER 9. THE BRITISH OPTION 170
i.e. the rst 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

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 t),
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
rst take a closer look at the gain function.
9.2.1 The gain function
This section briey 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(Tt)

_
d
1
(S, t; r)
_
Se
D(Tt)

_
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
c
= r. Note that this looks very much like the gain function
and indeed if
c
= r, then it is clear that
G(S, t)[
c=r
= e
r(Tt)
V
P
E
(S, t).
This is intuitive as the payo 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 (d
2
) (d
1
) 0 for S > K and conversely (d
2
) (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 payo condition, namely
G(S, T) = (K S)
+
,
which is consistent with the fact that at t = T clearly the best prediction of the put
payo will be the payo 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 dierent measures, resulting in non-trivial solutions.
9.3 Numerical treatment
The (nonlinear) system (9.3) can be solved numerically via a number of dierent
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
=

T t, (9.4)
which has the eect 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

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 nancial intuition, in what follows
we choose to retain the dimensional form.
Despite the PSOR algorithms 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-tted coordinate system, was employed for the
results given in the present chapter. Body-tted coordinates where rst proposed
by Landau (1950) and later applied to nite-dierence 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)),

S =
S
b()
. (9.5)
This eectively maps the continuation region S [b(), ) onto the xed domain

S [1, ), where the free boundary now becomes an additional variable in the prob-
lem. Making these changes of variables yields the following modied xed boundary
problem
_

_
1
2
V


1
2

2

S
2
V

S

S

_
r +
1
2b()
b()

_

SV

S
+rV = 0 for

S [1, ),
V (

S, t) = G(

S, t) on

S = 1,
V

S
(

S, t) = G

S
(

S, t) on S = 1 (smooth t),
V > G for

S (1, ),
V = G for

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 xed domain and standard nite-dierence 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

c
increasing
Figure 9.1: The British put option free boundary for varying values of the contract
drift. T = 1, K = 1, = 0.4, r = 0.1, D = 0, and
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
increasing
Figure 9.2: The British put option free boundary for varying volatilities. T = 1,
K = 1,
c
= 0.125, r = 0.1, D = 0, and = 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
c
and in addition gure 9.2 the variation with the volatility
CHAPTER 9. THE BRITISH OPTION 174
(for a xed
c
). Note that some parameters (such as volatility) have been chosen
articially 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 signicant
inuence on the shape of the free boundary.
The most striking dierence 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 diculties 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
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
c
but keeping the dierence
between
c
and interest rate r constant resulted in distinct free boundaries. Further-
more, varying
c
and keeping the ratio of the contract drift to interest rate constant,
i.e.
r
c
= const., also resulted in diering 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 (eectively the perpetual limit), the numerical
results showed in gure 9.1 suggest that the free boundary for the British put option
either tends to innity or tends to zero in this limit, dependent on the choice of the
parameter
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

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 It os formula to the discounted gain function and
taking expectations to obtain
E
Q
_
e
r(
B
t)
G(S

B
,
B
)

= G(S, t) +E
Q
__

B
t
0
e
ru
H(S
t+u
, t +u)du
_
, (9.8)
where
B
is dened as

B
= inft [t, T] : (S
t
, t) / B,
i.e. the rst exit time of the process from the domain B dened 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,

(d
2
) =
K
S
e
(cD)(Tt)

(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
=
Ke

1
2
d
2
1
2
_
2(T t)
+ (
c
D)Se
(cD)(Tt)
(d
2
), (9.10)
G
S
= e
(cD)(Tt)
(d
2
),
G
SS
=
Ke

1
2
d
2
1
S
2
_
2(T t)
,
which after substitution into (9.7) yields
5
H(S, t) =
c
Se
(cD)(Tt)
(d
2
) rK(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

c
S
h
e
(cD)(Tt)

_
d
2
(S
h
, t)
_
rK
_
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 rst point to note is that S
h
is not
monotonic for some values of the contract drift
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
c
which separates two distinct regions of asymptotic
behaviour of S
h
(t), namely tending to innity 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 dierentiation 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

c
increasing
Figure 9.3: The zero of the H-function, i.e. S
h
(t), for varying values of the contract
drift.
c
= 0.102, 0.104, . . . , 1. T = 50, K = 1, r = 0.1, D = 0, and = 0.4.
of T t takes on an exponential form, i.e.
S
h
(t) Ae
(Tt)
as T t . (9.13)
Therefore making this ansatz we can see that
d
1,2
(S
h
, t) =
log
_
K
A
_

c
D
1
2

2
+
_
(T t)

T t
,
which as T t the second term dominates giving
lim
Tt
d
1,2
(S
h
, t) =
1

c
D
1
2

2
+
_

T t.
The equation for S
h
(t) in the limit T t thus becomes

c
Ae
(cD+)(Tt)

(
c
D +
1
2

2
+)

T t
_
= rK
_

(
c
D
1
2

2
+)

T t
_
.
(9.14)
For convenience in what follows we shall dene

c
D
1
2

2
+

.
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

. 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

> 0, i.e. if
>
1
2

c
+D >
1
2

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 (z) has the following asymptotic expansion
(z) =
e

1
2
z
2
z

2
_
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

T t
_
=
e

1
2

(Tt)

_
2(T t)
+. . . ,
therefore equation (9.14) becomes

c
Ae
(cD+)(Tt)

+
_
2(T t)
e

1
2

2
+
(Tt)
=
rK

_
2(T t)
e

1
2

(Tt)
+. . . . (9.17)
Finally considering the exponent of the exponentials on the left-hand-side we can see
that

c
D +
1
2

2
+
=
c
D +
(
c
D +
1
2

2
+)
2
2
2
=
(
c
D
1
2

2
+)
2
2
2
=
1
2

,
which remarkably allows us to cancel through all exponential terms leaving the much
simpler equation

c
A

+
=
rK

. (9.18)
This, however, only provides us with one equation for two unknown constants A and
. In order to determine their value uniquely we can obtain another equation by
dierentiating (9.12), noting that S
h
is a function of t, to obtain

c
e
(cD)(Tt)
_
dS
h
dt
(
c
D)S
h
_
(d
2
) +K

(d
1
)
_
(
c
r)
d
1
t
+

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

> 0

+
(
c
D +) A =
K
2
_
(
c
r)

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

+
c

,
2r (
c
D +) = (
c
r)
_

c
D
1
2

2
+
_
2
+
c
_

c
D
1
2

2
+
_
.
(9.20)
Finally solving the (quadratic) equation (9.20) for yields
=
1
2

2
_

c
+r

c
r
_

c
+D (9.21)
where we have taken the positive root in order not to violate the assumption (9.15).
Also note that since
c+r
cr
> 1 for
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
c
r the free boundary
appears to be tending to innity 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 gure 9.2) that the volatility appears to greatly aect the
behaviour of the free boundary. Finally, substitution of the found value for , (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
(Tt)
where is given by equation (9.21).
The more useful corollary of this result however is that clearly if > 0 then S
h
(t)
for large values of T t and conversely if < 0 then S
h
0. The critical value of
the parameter
c
which separates these two distinct regimes is given by the solution
to the equation
=
1
2

2
_

c
+r

c
r
_

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

c
=
1
2

2
_

c
+r

c
r
_
+D,
or

c
=
1
2
_
r +D +
1
2

2
_
+
1
2
_
_
r +D +
1
2

2
_
2
+ 4r
_
1
2

2
D
_
_1
2
. (9.22)
If D <
1
2

2
then we are required to take the positive square root in order to obtain
a positive

c
. If D >
1
2

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 dierent regimes of behaviour of the free boundary, but can also
be used to improve the eciency 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 innity of the free boundary for large T t. We have shown that in the limit
S
h
(t) takes on the form Ke
(Tt)
, suggesting that the transformation

S = Se
(Tt)
(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 (

S, t)-
space, all free boundaries, regardless of the value of the contract drift
c
, will tend
to nite or zero values. Furthermore any numerical treatment of the free-boundary
problem in (

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 eciency of numerical schemes used in determining the free boundary.
For example when using the body-tted coordinate system described in section 9.3,
providing the correct location of the free boundary at expiry can be crucial in the
schemes 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 Greens 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
dierential 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 dened 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) =
c
S rK.
Hence we have that
S
h
(T) =
rK

c
,
and that the H-function is positive in the region S >
rK
c
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
c
. 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

c
. (9.24)
Note that the inclusion of dividends does not aect the location to which the free
boundary asymptotes as one might expect; this fact is easily conrmed numerically.
The above result can be shown using a dierent approach which we shall briey
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 options European
counterpart (i.e. with no early exercise) lies below the payo 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 specically
if the quantity

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

t
_
V (S, T t) G(S, T t)
_
V (S, T) G(S, T) +t
_
V
t
(S, T)
G
t
(S, T)
_
.
By denition 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 t) G(S, T t)
_
t(rK
c
S)
for S < K and trivially zero otherwise. Hence there exists a (possible) early-exercise
region when
rK
c
S > 0 S <
rK

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

S = Se
(cD)(Tt)
, (9.25)
then the governing PDE becomes
V
t
+
1
2

2

S
2
V

S

S
+ (r
c
)

SV

S
rV = 0,
and the gain function is transformed to
G(

S, t) = K
_
d
1
(

S, t)
_


S
_
d
2
(

S, t)
_
,
with
d
1
(

S, t) =
log
_
K

S
_
+
1
2

2
(T t)

T t
,
d
2
(

S, t) = d
1
(

S, t)

T t.
Notice that the parameter
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
aect 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 rst point to note is that in this limit
d
2
d
1
and so it will suce to determine the behaviour of d
1
in this limit. It is clear
that as T t 0 (i.e. t T) the rst term in d
1
(

S, t) will dominate giving


lim
tT
d
1
(

S, t) = lim
tT
1

T t
log
_
K

S
_
.
CHAPTER 9. THE BRITISH OPTION 184
Since log
_
K

S
_
< 0 for

S > K, then in this region it is clear that d
1
as t T
and conversely for

S < K then d
1
+as t T. In the region

S > K if d
1

then we can exploit the asymptotic expansion of the cumulative normal distribution
function (9.16) to give
(d
1
) =
e

1
2
d
2
1
d
1

2
+. . . ,
(d
1
) =
_
T t
2
_
log
_
K

S
__
1
exp
_

1
2
2
(T t)
_
log
_
K

S
__
2
_
+. . . .
Similarly for the region

S < K where d
1
+ we can use the symmetry of () to
obtain
(d
1
) = 1
e

1
2
d
2
1
d
1

2
+. . . ,
(d
1
) = 1
_
T t
2
_
log
_
K

S
__
1
exp
_

1
2
2
(T t)
_
log
_
K

S
__
2
_
+. . . .
Using the above and further the fact that (d
1
) (d
2
) as t T, the gain function
can be approximated by
G(

S, t) = (K

S)
+

_
T t
2
_
log
_
K

S
__
1
exp
_

1
2
2
(T t)
_
log
_
K

S
__
2
_
(K

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
Tt
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(

S, t) =
_
K

S
_
+
,
i.e. the standard put option payo.
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

Tt
or S > Ke
+B

Tt
, 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
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

D
_
1
0
_
2(T t)
_
for constant dividend yield

D > r, where the constant
0
is the solution to the
transcendental equation

3
0
e

2
0
_

0
e
u
2
du =
1
4
_
2
2
0
1
_
,
which can be calculated to give
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

c
_
1
0
_
2(T t)
_
e
(cD)(Tt)
, (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 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
dier 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
dierent functional form for dierent values of the dividend parameter, i.e. for

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, = 0.4, r = 0.1,
c
= 0.125, and D = 0.
or

D < r, however for the British put option we have the natural restriction that

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 specically 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 prots 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,
dened 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 payo (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 payo 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 dene 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 investors 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. (KS
T
)
+
, but that the initial price paid for the option
will have varied, more specically 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 dierence 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
c
= 0.125. This surface indicates the dierences 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 gure 9.7
compares the return of the British put to the European put and nally for reference
gure 9.8 compares the American and European put option. For comparison the
rational exercise boundaries can be found in gure 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

c
= 0.125

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 gures 9.6, 9.7 and 9.8. T = 1, K = 1,
= 0.4, r = 0.1,
c
= 0.125, and D = 0.
The most striking feature of gure 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 dierence 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 dierence 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, = 0.4, r = 0.1, D = 0, and
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 dierence 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,
= 0.4, r = 0.1, D = 0, and
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 dierence 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,
= 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 prole seen in gure 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
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 (gure
9.7) the return dierentials 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, = 0.4, r = 0.1 and D = 0.
location) for the British, American and European put option are dierent.
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-fths of the way to maturity.
This also highlights what could be described as an unexpected additional benet 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 gures 9.6, 9.7, and 9.8 obtained
for the parameter value
c
= 0.125, although the same qualitative behaviour is seen for other values.
CHAPTER 9. THE BRITISH OPTION 193
the contracts 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, gure 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 gure 9.10(a). It should be noted that for the
majority of the values of S
0
/K presented in gure 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 nal 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, = 0.4, r = 0.1 and D = 0.
boundary for all
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

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 t)
V > G in (
V = G in T
(9.28)
where now the gain function is given by
G
C
(S, t) = K
_

_
d
1
(S, t;
c
)
_
1

Se
(cD)(Tt)
_

_
d
2
(S, t;
c
)
_
1

(9.29)
where all of the notation is as previously dened. Note the relationship between the
call and put option gain functions
G
C
(S, t) = Se
(cD)(Tt)
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 payo
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(Tt)
Ke
r(Tt)
+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
c
showing again a monotonic collapse of the free boundary as
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 , 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

c
increasing
Figure 9.11: The British call option free boundary for varying values of the contract
drift. T = 1, K = 1, = 0.4, r = 0.1, D = 0, and
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
increasing
Figure 9.12: The British call option free boundary for varying volatilities. T = 1,
K = 1,
c
= 0.08, r = 0.1, D = 0, and = 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) =
c
Se
(cD)(Tt)
[(d
2
) 1] rK [(d
1
) 1] , (9.30)
and hence we are interested in the large Tt behaviour of the solution to H(S
h
, t) = 0,
hence

c
S
h
e
(cD)(Tt)
_

_
d
2
(S
h
, t)
_
1

rK
_

_
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

(Tt)
as t T we wish to solve for the constants

A and

. Substitution into the equation
(9.30) yields

c

Ae
(cD+

)(Tt)
_

_

+

T t
_
1
_
= rK
_

T t
_
1
_
,
where we have dened

c
D
1
2

2
+

for convenience of algebra. We wish to look at the asymptotic behaviour as T t


and it transpires that there are three dierent regimes in which the solution is
quantitatively dierent. If

> 0 then both the cumulative normal distributions


tend to zero in this limit and the leading order terms become

c

Ae
(cD+

)(Tt)
= rK +. . . ,
and since in this regime

>
1
2

2

c
+ D, the exponent of the exponential term
must be positive, indicating that there can be no solution to this equation for

in the
limit, hence our ansatz for the form of the solution does not permit

>
1
2

c
+D.
The second regime corresponds to a situation when
+
> 0 and

< 0, i.e. when

1
2

c
+D <

<
1
2

c
+D
1
2

2
<

<
1
2

2
;
CHAPTER 9. THE BRITISH OPTION 197
in this regime the rst cumulative normal distribution function tends to zero but the
second tends to unity in the limit, hence the leading-order terms become

c

Ae
(cD+

)(Tt)
=
rKe

1
2

2

(Tt)

_
2(T t)
+. . . ,
where we have used the approximations for () 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

. Finally we have that

< 0, in this regime the leading-order terms


become

c

Ae
(cD+

)(Tt)

+
_
2(T t)
e

1
2

2
+
(Tt)
=
rK

_
2(T t)
e

1
2

2

(Tt)
+. . . ,
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

< 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

will be given by

=
1
2

2
_

c
+r

c
r
_

c
+D,
i.e. the same behaviour as for the British put. Recall that for a British call we must
have that
c
< r and all parameters must be positive so we have that

c
+r

c
r
< 1,
which conrms our original assumption

<
1
2

c
+D, i.e. that

< 0.
An interesting corollary to this result is that when the dividend yield D is zero, we
have that

< 0 for all possible values of
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 innity (and so must the free boundary) provided that the dividend is greater
than some critical value, i.e.
D > D
crit
=
c
+
1
2

2
_
r +
c
r
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 specically if the contract drift is less
than the critical value

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

D
_
1 +
0
_
2(T t)
_
,
where
0
is as before. Hence the British call free boundary behaves as
b(t)
rK

c
_
1 +
0
_
2(T t)
_
e
(cD)(Tt)
. (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, = 0.4, r = 0.1,
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(Tt)
G(S
T
, T)

+rK
_
Tt
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) = (KS
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 rst 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
_
Tt
0
e
ru

_
_
log
_
b(t+u)
S
_

_
r
1
2

2
_
u

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 denition) 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
_
Tt
0
e
ru

_
_
log
_
b(t+u)
b(t)
_

_
r
1
2

2
_
u

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
Tt
log
_
b(t +u)
b(t)
_
= 0
This is eectively 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

_
(
2
2r)

u
2
_
du.
This integral can be solved (with a little work) by rstly setting s = k
1

u where
k
1
=

2
2r
2
leading to
K b(t) =
2rK
k
2
1
_

0
se

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

2
_

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
_

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
_

2
+ 2r

2
2r
_
2
,
and so substitution gives the location of the free boundary as
b(t) =
2rK
2r +
2
=
K
+ 1
,
where =
2r

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 It os 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 innitesimal generator of the process dened
by
L
St
=

u
+
1
2

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 dierential 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(Tt)
V (S
T
, T)

_
Tt
0
e
ru
E
Q
_
L
_
V (S
t+u
, t +u)
_
du.
Now by denition 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 modies the expression to
V (S, t) = E
Q
_
e
r(Tt)
G(S
T
, T)

_
Tt
0
e
ru
E
Q
_
L
_
G(S
t+u
, t +u)
_
I
_
S
t+u
b(t +u)
_
du
= E
Q
_
e
r(Tt)
G(S
T
, T)

_
Tt
0
e
ru
E
Q
_
H(S
t+u
, t +u)I
_
S
t+u
b(t +u)
_
du,
where we have used the denition 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 nishing at position z at time t +u given by
10
f(S, t; z, t +u) =
1
z

2u
exp
_

_
log
_
z
S
_

_
r D
1
2

2
_
u
_
2
2
2
u
_
.
Hence we have the following representation of the British put option value,
V (S, t) = J(S, t)
_
Tt
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 dened
J(S, t) = E
Q
S,t
_
e
r(Tt)
G(S
T
, T)

,
= E
Q
S,t
_
e
r(Tt)
(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 dened 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)
_
Tt
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 nite 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 payo conditions are
approached). The upshot of this is that models of this general class cannot exhibit
fully dierentiable 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 insucient nancial 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 nite liquidity without
the undesirable features observed in a number of the existing models. Several models
in the past have circumvented these diculties close to expiry but generally using
ad hoc, rather than intuitively justiable arguments. The hope is that the analysis
presented in this thesis will help in this respect; in addition, below we discuss briey
some preliminary ideas about how this may be achieved in future research.
One problem with the modelling framework introduced in chapter 2, from a nancial
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 payo
proles, 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 diculties. We could choose
to incorporate such nonlinearity into our denition 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 aects the price, but rather its
innitesimal change df, hence it is the term df which we require to remain bounded
(irrespective of the trading strategy ). Furthermore, when considering option pric-
ing, the only term in df that lters 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) =

n
x
n
+
n1
x
n1
+. . . +
0

n
x
n
+
n1
x
n1
+. . . +
0
,
which in the limit x is bounded above by the ratio
n
/
n
. If the aim is to
prevent the denominator from vanishing then we require this ratio to be 1/ or below,
hence the function
g(x) =
x
x +
would suce, where 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 x to the diculties
associated with the vanishing of the denominator. It is possible, however, that the
ideas presented above could be suciently 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 Hookes 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 Hookes 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 aect on the price must be bounded, since there are
only a nite number of shares (and hence a nite 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 dened 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 payo prole. Such a face-lifted
payo prole corresponds ostensibly to a suciently smoothed payo prole. It is
thought that applying the constraint V
SS
< 1/ 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 suciently dierent
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 x
the problem with the denominator vanishing, resulting in well-posed problems for
standard payo proles, and (if possible) (ii) to incorporate the empirical evidence of
nonlinear price impact. Criteria such as consistency with empirical data, exibility
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 eects of a nitely 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 nance have an opinion on the direction
of future research in the eld, 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 suciently 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
eects. 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 dierential 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

,=1
b

+
n

i=1
a
i
V
S
i
+
m

=1
b

.
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

+a
1
V
S
+b
1
V

,
and hence we can apply the maximum principles to equations of the form
AV
SS
+BV

+aV
S
+bV

+cV = D(S, ). (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 dierential operator L to be elliptic in the S-
variables and parabolic in the -variables. Therefore we require
n

i,j=1
a
ij

j
> 0,
hence positive denite and
m

,=1
b

0
hence positive semi-denite for any real vectors , ,= 0. In the case m = n = 1 this
reduces to
a
11

2
1
> 0 a
11
> 0 A > 0
and also
b
11

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
(diusion) equation of the form
AV
SS
+aV
S
V

+cV = D(S, ), A > 0. (A.2)


Furthermore we make the assumption that c = 0 in the above. This last simplication
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
c
u to arrive at an equation of the form
L(u) = Au
SS
+au
S
u

= e
c
D(S, ) =

D(S, ), (A.3)
which we now wish to apply the maximum principle to. Before we state the maximum
principle we can formally dene the solution domain as R
+
and assume that it
is open, connected and bounded. Let

T
= (0, T],
where T > 0 and also dene

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

T
corresponds to the boundaries
= 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

D(S, ) 0 and A > 0 everywhere in the
closure of the domain,
T
, and furthermore that the coecients of equation (A.3)
are bounded in
T
, then the maximum of the solution (which is assumed to be C
2,1
in the interior of
T
) must occur on the boundary

T
, i.e.
sup

T
u = max

T
u = max

T
u.
By analogy we can nd the minimum principle by making the substitution u = u
to obtain
L( u) = A u
SS
a u
S
+ u

=

D(S, ),
A u
SS
+a u
S
u

= L( u) =

D(S, ).
Hence the maximum principle states that if

D 0 or

D 0 then u has its maximum
on the boundary and hence u = u has its minimum on the boundary. To summarise,
applying the maximum (minimum) principle to the equation
L(u) =

D(S, ),
we have that, provided A > 0, then if

D 0 then the maximum occurs on the
boundary

T
, and alternatively if

D 0 then the minimum must occur on the
boundary. Furthermore if

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

.
Suppose that u(S, ) satises the inequality L(u) > 0 in the domain
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

= 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

) M,
where

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

) [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, ) will satisfy a forwards
parabolic PDE and the solution to this dierential equation must have its maximum
on the boundary T =

.
A.1 Nonlinear equations
The maximum principles outlined above also hold for any nonlinear equation that
can be expressed in the form
L(u) =

D(S, ),
where the coecients of the derivatives in the operator can now be functions of the
solution and its derivatives, in other words
L(u) = A(S, , u, u
S
, u
SS
)u
SS
+a(S, , u, u
S
)u
S
u

.
APPENDIX A. MAXIMUM PRINCIPLES 227
As an example, consider a general nonlinear PDE of the form
u

= F(S, , 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
T
. In other words in general form
n

l,q=1
F(S
i
, , p, p
i
, p
ij
)
p
lq

q
> 0,
i.e. positive denite. For the one dimensional case (n = m = 1) we have
F(S, , p, p
1
, p
11
)
p
11

2
1
> 0
F(S, , 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

= F(S, , 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

V
2

= F(S, , V
1
, V
1
S
, V
1
SS
) F(S, , 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 rst and second derivatives with
respect to S. Doing so we obtain
(V
1
V
2
)

=
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, ), (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
c
(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 coecients remain bounded, then the
maximum principle will ensure that
u 0 V
1
V
2
0
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 coecient of the diusion term will become degenerate at S = 0.
Fortunately we can make the change of variable x = log S which reduces the equation
to
V

=
1
2

2
V
xx
+rV
x
rV = F(x, V, V
x
, V
xx
),
hence a constant coecient linear PDE, which exhibits no such degeneracy. Evalu-
ating the derivatives of F, equation (A.5) becomes
1
2

2
(V
1
V
2
)
xx
+r(V
1
V
2
)
x
(V
1
V
2
)

r(V
1
V
2
) = 0.
APPENDIX A. MAXIMUM PRINCIPLES 229
and letting u = e
r
(V
1
V
2
) leads to
1
2

2
u
xx
+ru
x
u

= 0.
Hence we can identify A =
1
2

2
> 0 and

D(S, ) = 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 diusion coecient 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
xr
and V = ue
r
, which reduces equation (4.1) to
u

=

2
(u
xx
u
x
)
2
_
1 e
2x+r
(u
xx
u
x
)
_
2
= F (x, , 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.
Dierentiating F with respect to the second derivative gives
F
u
xx
=

2
_
1 +e
2x+r
(u
xx
u
x
)
_
2
_
1 e
2x+r
(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
2xr


T
.
Transforming the above back to the original variables it is clear that this corresponds
to [V
SS
[ < 1/ for all (S, ), 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 coecients 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/ 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

2
(1 +e
2x+r
(u
xx
u
x
))
2
_
1 e
2x+r
(u
xx
u
x
)
_
3
(u
1
u
2
)
xx
(u
1
u
2
)

= 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
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
(S, ), provide we do not allow the denominator to vanish.
A.3 Monotonicity in
Having proved uniqueness we now wish to determine the dependence of the solution to
equation (4.1) on the liquidity parameter . We can do so by dierentiating (directly)
the transformed equation (A.6) with respect to . Doing so and setting w =
u

leads
to the following second order (linear) PDE for w

2
(1 +e
2x+r
(u
xx
u
x
))
2
_
1 e
2x+r
(u
xx
u
x
)
_
3
(w
xx
w
x
) w

=

2
e
2x+r
(u
xx
u
x
)
2
_
1 e
2x+r
(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
2x2r
u
SS
= e
2xr
V
SS
= e
2xr
,
APPENDIX A. MAXIMUM PRINCIPLES 231
where we have dened := V
SS
, and thus equation (A.8) becomes

2
(1 +)
2 (1 )
3
w
xx


2
(1 +)
2 (1 )
3
w
x
w

2
e
2xr

2
(1 )
3
. (A.9)
Since the initial condition of any option contract will be independent of the liquidity
parameter , we must have
w(x, 0) = 0
and more generally w = 0 on the boundary

T
. Now applying the maximum
principle, or more specically 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
T
, in other words
u

0
V

0
T
,
hence the solution is an increasing function of . It should be emphasised that this
result only holds in the regime [V
SS
[ < 1/, 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(cD)(Tt)
,
t = T
2

2
,
V (S, t) = K
_
e

2r

v(x, ) + 1 e
x
_
.
The resulting non-dimensional system becomes
v

v
xx
+ (1
1
+
2
)v
x
= e

(
2
e
x

1
) ,
v(x, ) = e
x+
1

_
x +

2
_
e

_
x

2
_
on x = x
f
,
v
x
(x, ) = e
x+
1

_
x +

2
_
on x = x
f
,
v(x, ) = (e
x
1) e

as x ,
v(x, 0) = (e
x
1)
+
,
where
1
=
2r

2
and
2
=
2(c+D)

2
. In addition we have the condition that
x
f
(0) = log
_
r

c
_
if
c
r, which it trivially must satisfy due to the species 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 +S
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
_
(W
t+u
W
t
) +
_
r D
1
2

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
_
(W
t+u
W
t
) +
_
r D
1
2

2
_
u
_
z
_
= P
Q
_
exp
_
(W
t+u
W
t
) +
_
r D
1
2

2
_
u
_

z
S
t
_
= P
Q
_
(W
t+u
W
t
) +
_
r D
1
2

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

2
_
u

_
_
.
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

2
_
u

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

_
r D
1
2

2
_
u

u
_
_
. (C.2)
where we have used the standard result that P[W
1
y] = (y). The transitional
probability density function is given by the derivative of the above with respect to z,
this can be seen from the denition,
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
z

2u
exp
_

_
log
_
z
S
_

_
r D
1
2

2
_
u
_
2
2
2
u
_
under the measure Q.