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Euler and Milstein Discretization
Euler and Milstein Discretization
t+dt
(Su ; u) du +
t+dt
(Su ; u) dWu :
(2)
Equation (2) is the starting point for any discretization scheme. At time t, the
value of St is known, and we wish to obtain the next value St+dt .
Euler Scheme
The simplest way to discretize the process in Equation (2) is to use Euler discretization. This is equivalent to approximating the integrals using the leftpoint rule. Hence the rst integral is approximated as the product of the
integrand at time t, and the integration range dt
Z
t+dt
(Su ; u) du
(St ; t)
t+dt
du
(St ; t) dt:
We use the left-point rule since at time t the value (St ; t) is known. The
right-hand rule would require that (St+dt ; t + dt) be known at time t. In an
1
t+dt
(Su ; u) dWu
(St ; t)
t+dt
dWu
(St ; t) (Wt+dt
p
(St ; t) dtZ;
Wt )
1.1
The Black-Scholes stock price dynamics under the risk neutral measure are
dSt = rSt dt + St dWt :
(4)
An application of Equation (3) produces Euler discretization for the BlackScholes model
p
St+dt = St + rSt dt + St dtZ:
(5)
Alternatively, we can generate log-stock prices, and exponentiate the result. By
Itos lemma ln St follows the process
d ln St =
1
2
dt + dWt :
(6)
ln St+dt = ln St + r
so that
St+dt = St exp
where dt = ti
1.2
ti
1
2
dt +
dt +
dtZ
dtZ :
(7)
1.
The Heston model is described by the bivariate stochastic process for the stock
price St and its variance vt
dSt
dvt
p
= rSt dt + vt St dW1;t
p
=
(
vt ) dt +
vt dW2;t
(8)
1.2.1
Discretization of vt
vt+dt = vt +
t+dt
vu ) du +
t+dt
vu dW2;u :
(9)
The Euler discretization approximates the integrals using the left-point rule
Z
t+dt
vu ) du
vt ) dt
t+dt
vu dW2;u
vt (Wt+dt
p
vt dtZv
Wt )
where Zv is a standard normal random variable. The right hand side involves
(
vt ) rather than (
vt+dt ) since at time t we dont know the value of vt+dt .
This leaves us with
p
vt+dt = vt + (
vt ) dt +
vt dtZv :
To avoid negative variances, we can replace vt with vt+ = max (0; vt ). This is
the full truncation scheme. The reection scheme replaces vt with its absolute
value jvt j.
1.2.2
Process for St
t+dt
Su du +
t+dt
vu Su dWu :
t+dt
Su du
St dt
t+dt
vu Su dW1;u
vt St (Wt+dt
p
=
vt dtSt Zs
Wt )
with Zv .
1.3
Process for ln St
p
1
vt dt + vt dW1;t
2
or in integral form
ln St+dt = ln St +
1
vu du +
2
vu dW1;u :
ln St + r
ln St + r
p
1
vt dt + vt (W1;t+dt
2
p
1
vt dt + vt dtZs :
2
W1;t )
(10)
p
1
vt dt + vt dtZs :
2
Again, to avoid negative variances we must apply the full truncation or reection
scheme by replacing vt everywhere with vt+ or with jvt j.
1.3.1
Start with the initial values S0 for the stock price and v0 for the variance. Given
a value for vt at time t, we rst obtain vt+dt from
p
vt+dt = vt + (
vt ) dt +
vt dtZv
and we obtain St+dt from
St+dt = St + rSt dt +
or from
St+dt = St exp
p
vt dtSt Zs
p
1
vt dt + vt dtZs :
2
Milstein Scheme
This scheme is described in Glasserman [2] and in Kloeden and Platen [4] for
general processes, and in Kahl and Jackel [3] for stochastic volatility models.
The scheme works for SDEs for which the coe cients (St ) and (St ) depend
only on S, and do not depend on t directly. Hence we assume that the stock
price St is driven by the SDE
dSt
=
=
(11)
In integral form
Z
St+dt = St +
t+dt
s ds
t+dt
s dWs :
(12)
The key to the Milstein scheme is that the accuracy of the discretization is
increased by considering expansions of the coe cients t = (St ) and t =
(St ) via Itos lemma. This is sensible since the coe cients are functions of
S. Indeed, we can apply Itos Lemma to the functions t and t as we would
for any dierentiable function of S. By Itos lemma, then, the SDEs for the
coe cients are
1
2
1
t+
2
0
t t
0
t
00 2
t t
dt + (
0
t t ) dWt
00 2
t t
dt + (
0
t t ) dWt
where the prime refers to dierentiation in S and where the derivatives in t are
zero because we assume that t and t have no direct dependence on t. The
integral form of the coe cients at time s (with t < s < t + dt)
Z s
Z s
1 00 2
0
=
+
+
du
+
( 0u u ) dWu
s
t
u u
u u
2
t
t
Z s
Z s
1 00 2
0
( 0u u ) dWu :
=
s
t+
u u du +
u u+
2
t
t
Substitute for
St+dt
and
= St +
+
in (12) to produce
t+dt
t
t
t+dt
t
+
Z
s
0
u u
0
u u
1
+
2
1
2
00 2
u u
00 2
u u
du +
du +
0
u u ) dWu
ds
0
u u ) dWu
dWs
3=2
The terms higher than order one are dsdu = O (dt) and dsdWu = O (dt)
and are ignored. The term involving dWu dWs is retained since dWu dWs =
5
t+dt
ds +
t+dt
dWs +
t+dt
s
0
u u ) dWu dWs :
(13)
t+dt
s
0
u u dWu dWs
0
t t
t+dt
dWu dWs
(14)
0
t t
t+dt
(Ws
Wt ) dWs
0
t t
t+dt
Ws dWs
Wt Wt+dt +
Wt2
Now dene dYt = Wt dWt . Using Itos Lemma, it is easy to show1 that Yt has
solution Yt = 21 Wt2 12 t so that
Z
t+dt
Ws dWs = Yt+dt
Yt =
1 2
W
2 t+dt
1 2
W
2 t
1
dt:
2
(15)
t+dt
s
0
u u dWu dWs
1
2
1
= :
2
0
u u
0
u u
(Wt+dt
Wt )
2
( Wt )
i
dt :
i
dt
p
where Wt = Wt+dt Wt , which is equal in distribution to dtZ with Z
distributed as standard normal. Combining Equations (13) and (15) the general
form of Milstein discretization is therefore
St+dt = St +
2.1
t dt
dtZ +
1
2
0
t t dt
Z2
1 :
(16)
dt Z 2
(St ) = St
= W , and
@2Y
@W 2
= 1, so that dYt =
1
2
+0+
1
2
1 1 dt +
r 12 2 and
therefore
(St ) =
so that
0
t
0
t
1
2
ln St+dt = ln St + r
dt +
dtZ
which is identical to the Euler scheme in (7). Hence, while the Milstein scheme
improves the discretization of St in the Black-Scholes model, it does not improve
the discretization of ln St .
2.2
2.3
p
= rSt dt + vt St dW1;t
p
vt dW2;t
=
(
vt ) dt +
Process for vt
p
1
vt dtZv +
4
vt ) dt +
vt +
vt ) and
dt Zv2
1 p
dtZv
2
+ (
vt ) dt
1
4
(vt ) =
vt
(17)
dt:
This last equation is also Equation (2.18) of Gatheral [1]. Milstein discretization
of the variance process produces far fewer negative values for the variance than
Euler discretization. Nevertheless, the full truncation scheme or the reection
scheme must be applied to (17) as well.
2.3.1
p
1
vt dtSt Zs + St2 dt Zs2
4
1 :
(St ) =
vt St
(18)
We can also discretize the log-stock process, which by Itos lemma follows the
process
p
1
d ln St = r
vt dt + vt dW1;t :
2
p
1
The coe cients are (St ) = r 2 vt and (St ) = vt so that 0t = 0t = 0.
Since vt is known at time t, we can treat it as a constant in the coe cients. An
ln St+dt = ln St + r
2.4
p
1
vt dtZv +
4
vt ) dt +
dt Zv2
p
1
vt dtSt Zs + St2 dt Zs2
4
r
1 :
p
1
vt dt + vt dtZs :
2
References
[1] Gatheral, J. (2006) The Volatility Surface: A Practitioners Guide. New
York, NY: John Wiley & Sons.
[2] Glasserman, P. (2003). Monte Carlo Methods in Financial Engineering.
New York, NY: Springer.
[3] Kahl, C., and P. Jackel (2006). Fast Strong Approximation Monte-Carlo
Schemes for Stochastic Volatility Models. Quantitative Finance, Vol. 6, No.
6.
[4] Kloeden, P.E., and E. Platen (1992). Numerical Solution of Stochastic Differential Equations. New York, NY: Springer.