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Finite Difference Methods: Autumn 2 0 0 9
Finite Difference Methods: Autumn 2 0 0 9
Lecture Objectives
Introduction to Finite Difference Methods
Forward - Explicit Finite
Backward - Implicit
Central – Crank-Nicolson
Hedge Sensitivities
COMPUTATIONAL FINANCE
MSc
©Finbarr Murphy 2007
Agenda
Page
1
Explicit Finite Difference Methods 2
2
Implicit Finite Difference Methods 18
3
Crank-Nicholson 25
Hedge Sensitivities 29
COMPUTATIONAL FINANCE
MSc
3
©Finbarr Murphy 2007
4
©Finbarr Murphy 2007
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©Finbarr Murphy 2007
∂C ∂C 1 2 2 ∂ 2C
+ rS + σ S − rC = 0
∂t ∂S 2 ∂S 2
∂C 1 2 2 ∂ 2C ∂C
− = σ S +v − rC
∂t 2 ∂x 2
∂x
COMPUTATIONAL FINANCE
6
©Finbarr Murphy 2007
f(x+h)
COMPUTATIONAL FINANCE
f(x)
f(x-h)
MSc
7
©Finbarr Murphy 2007
∂C/∂t = ΔC/Δt
j+2
COMPUTATIONAL FINANCE
j+1
Ci+1,j+1
j
Ci,j Ci+1,j
j-1
Ci+1,j-1
MSc
j-2 8
i-1 i i+1 i+2 i+3
©Finbarr Murphy 2007
j+2
COMPUTATIONAL FINANCE
j+1
Ci+1,j+1
j
Ci,j Ci+1,j
j-1
Ci+1,j-1
MSc
j-2 9
i-1 i i+1 i+2 i+3
©Finbarr Murphy 2007
σ 2
Pm = 1 − ∆t 2 − r∆t
COMPUTATIONAL FINANCE
∆x
σ 2
v
pd = ∆t −
2∆x 2∆x
2
MSc
10
©Finbarr Murphy 2007
Number of steps, N = 3
Timestep, Δt = T/N = 1/3
Space step, Δx = 0.2
MSc
11
©Finbarr Murphy 2007
v = r - δ - ½σ2 = 0.01
pu = 0.1750
pd = 0.6467
pd = 0.1583
COMPUTATIONAL FINANCE
MSc
12
©Finbarr Murphy 2007
j+1 Ci+1,j+1
Si+3,j+1 = 122.14 Ci+3,j+1 = 22.14
j
COMPUTATIONAL FINANCE
Ci,j Ci+1,j
Si+3,j = 100.00 Ci+3,j = 0.00
Ci+1,j-1
Si+3,j-1 = 81.87 Ci+3,j-1 = 0.00
100e(-2x 0.2 )
= 67.03
j-2 Si+3,j-2 = Se(-N. Δx)
14
©Finbarr Murphy 2007
15
©Finbarr Murphy 2007
16
©Finbarr Murphy 2007
∆x = 6σ T / 100 = 0.015
COMPUTATIONAL FINANCE
17
©Finbarr Murphy 2007
18
©Finbarr Murphy 2007
Agenda
Page
1
Explicit Finite Difference Methods 2
2
Implicit Finite Difference Methods 18
3
Crank-Nicholson 25
Hedge Sensitivities 29
COMPUTATIONAL FINANCE
MSc
19
©Finbarr Murphy 2007
j+2
COMPUTATIONAL FINANCE
j+1
Ci+1,j+1
j
Ci,j Ci+1,j
j-1
Ci+1,j-1
MSc
j-2 20
i-1 i i+1 i+2 i+3
©Finbarr Murphy 2007
Ci +1, j − Ci , j 1 2 Ci , j +1 − 2Ci , j + Ci , j −1 Ci , j +1 − Ci , j −1
− = σ +v − rC i , j
∆t 2 ∆x 2
2∆x
j+2
j+1
Ci,j+1
COMPUTATIONAL FINANCE
j
Ci,j Ci+1,j
j-1
Ci,j-1
j-2
i-1 i i+1 i+2 i+3
MSc
21
©Finbarr Murphy 2007
1 σ v
2
pu = − ∆t 2 +
2 ∆x ∆x
σ 2
Pm = 1 + ∆t 2 + r∆t
∆x
COMPUTATIONAL FINANCE
1 σ 2
v
pd = − ∆t 2 −
2 ∆x ∆x
MSc
22
©Finbarr Murphy 2007
Ci , N j − Ci , N j −1 = λU
Ci , − N j +1 − Ci , − N j = λL
COMPUTATIONAL FINANCE
23
©Finbarr Murphy 2007
λU = Si , N j − Si , N j −1
λL = 0
To see this more clearly, consider a 1-step
calculator
COMPUTATIONAL FINANCE
MSc
24
©Finbarr Murphy 2007
j+2
C0,1
j=1
λU = { C1,0
COMPUTATIONAL FINANCE
C0.0
j=0
j=-1
λL = {
C0,-1
i-1 i=0 i=1 i+2
MSc
25
©Finbarr Murphy 2007
Agenda
Page
1
Explicit Finite Difference Methods 2
2
Implicit Finite Difference Methods 18
3
Crank-Nicholson 25
Hedge Sensitivities 29
COMPUTATIONAL FINANCE
MSc
26
©Finbarr Murphy 2007
27
©Finbarr Murphy 2007
j+2
j+1
Ci,j+1 Ci+1,j+1
j
Ci,j Ci+1,j
COMPUTATIONAL FINANCE
j-1
Ci,j-1 Ci+1,j-1
j-2
i-1 i i+1 i+2 i+3
MSc
28
©Finbarr Murphy 2007
Ci , N j − Ci , N j −1 = λU
COMPUTATIONAL FINANCE
Ci , − N j +1 − Ci , − N j = λL
MSc
29
©Finbarr Murphy 2007
Agenda
Page
1
Explicit Finite Difference Methods 2
2
Implicit Finite Difference Methods 18
3
Crank-Nicholson 25
Hedge Sensitivities 29
COMPUTATIONAL FINANCE
MSc
30
©Finbarr Murphy 2007
Hedge Sensitivities
Computing the hedge sensitivities is as important
as the calculation of the option price
31
©Finbarr Murphy 2007
Hedge Sensitivities
As an example, sensitivity to the underlying stock
price, delta can be approximated by the equation
∂C C0 , j +1 − C0, j −1
∆= ≈
∂S S 0 , j +1 − S 0, j −1
COMPUTATIONAL FINANCE
MSc
32
©Finbarr Murphy 2007
Recommended Texts
Required/Recommended
Clewlow, L. and Strickland, C. (1996) Implementing derivative
models, 1st ed., John Wiley and Sons Ltd.
— Chapter 3
Additional/Useful
Brandimarte, P. (2006) Numerical methods in finance and
economics: A matlab-based introduction, 2nd Revised ed.,
John Wiley & Sons Inc.
— Chapter 9, P475-85
COMPUTATIONAL FINANCE
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