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A PDE Approach To Asian Options Analytic
A PDE Approach To Asian Options Analytic
A PDE Approach To Asian Options Analytic
BANKING &
ELSEVIER Journal of Banking & Finance 21 (1997) 613-640 FINANCE
Abstract
We first derive a one-state-variable partial differential equation, easy to implement,
which characterizes the price of a European type Asian option. This result is explained and
related to previous literature. We then derive new results on the hedging of an Asian option
and propose analytical and numerical analysis on the comparison between Asian and
European options. Our methodology which applies to "fixed-strike" Asian options as well
as to "floating-strike" Asian options completes and clarifies various results in the
literature. In this paper we focus on "backward-starting" Asian options. Our approach is
quite general however, and we explain how to adapt our main results to the case of
"forward-starting" Asian options.
1. Introduction
price of an Asian option and we provide quantitative and qualitative new results
on the hedging of an Asian option. One important contribution of our P.D.E.
approach, with respect to the previous literature, is to allow a detailed comparison
between Asian and European options. Moreover our methodology is quite general
and applies to all the various types of Asian options.
Our paper is organized as follows: Section 2 defines the general framework and
specifies the various types of Asian options that we consider. This section ends
with a first result showing the relationship between "fixed-strike" Asian options,
"floating-strike" Asian options and standard European options. Section 3 presents
our P.D.E. approach and its application to the hedging: (i) we derive a one-state-
variable P.D.E. which characterizes the price of an Asian option (this result is
explained and related to the literature); and (ii) we prove general static results as
monotonicity in the various parameters of the pricing model and derive results on
the hedging of Asian options. Section 4 focuses on the comparison between Asian
and European options in an analytical point of view. We deal with the prices as
well as with the delta and the elasticity of Asian and European options. Section 5
is devoted to the numerical implementation of our approach. In particular, we
explain how to adapt the classical finite-difference method to our problem. Section
6 presents the results of the numerical implementation. We focus on the differ-
ences between Asian and European options and propose an analysis of the various
effects which interact in the pricing of an Asian option. Our conclusions are in
Section 7.
d S t = S t r d t + Sto- d W t,
(ii) The price of any option is the discounted expectation of its terminal payoff
(at date T) under Q.
Using this general framework, we consider two different types of Asian options
written on the stock S and exercisable at date T, the time interval over which the
average value of the stock is calculated is defined by the interval [t0,T] with
O<_to <T.
(i) The "fixed-strike" 2 Asian call option which payoff at date T is equal to:
+
( l +
to ]
Thus along the Harrison and Kreps (1979) line, we focus our interest on the
following expectations:
def [ 1
and
where Ele represents the conditional expectation with respect to the filtration 9- t
under the risk neutral probability Q.
Remarks:
(1) These expectations are clearly difficult to evaluate since the distribution,
under Q, of ftroS(u)du is not explicit (as a mix of lognormal random variables).
(2) We consider "European type" Asian options, i.e. options that may only be
exercised at the expiration date.
(3) We distinguish for each of the two types of Asian options two cases.
(i) The time to maturity is less than or equal to the length of the averaging
period (0 < t o < t < T) (these options are sometimes called in the literature
"backward-starting" or "plain-vanilla" Asian options).
2 See, for instance, Vorst (1996) for a review of the literature on Asian options.
3 We use here the terminology of Geman and Yor (1993).
B. Alzia~ et al./Journal of Banking & Finance21 (1997) 613-640 617
(ii) The time to maturity is greater or equal to the length of the averaging period
(0 < t < t o < T) (these options are sometimes called "forward-starting" Asian
options in the literature).
This paper essentially focuses on the case where the time to maturity is less
than or equal to the length of the averaging period (that is the "backward-starting"
Asian option case). Nevertheless we explain in the Appendix how to adapt our
main results to the "forward-starting" Asian option case.
(4) Options considered in this work are Asian call options. The case of Asian
put options is easily deduced from the exact put-call parity. This put-call parity is
derived from the first moment of ffoS(U)du. As a matter of fact, under our
assumptions, using Fubini's theorem, we obtain Proposition l, which is derived in
Bouaziz et al. (1994) for the "floating-strike" Asian option case. To simplify
notation we suppose that t o --- 0 in the following.
Proposition 1. (i) let C b (resp. Ptb) denote the price at date t of a "floating-
strike" Asian call option (resp. "floating-strike" Asian put option), then:
(ii) let C~ (resp. P~") denote the price at date t of a "fixed-strike" Asian call
option (resp. the price at date t of a "fixed-strike" Asian put option), then:
Lr
St
Pt~ = C; - -~--(1 - e -r(r o) + e r(T-t)( g - - T1 jot
f S( u) du).
Let us remark that from part (ii) of Proposition 1, it is very easy to deduce the
explicit pricing formula proposed by Kemna and Vorst (1990) [eq. (16), p. 117]. As
a matter of fact, the probability to exercise the Asian call is equal to 1 if and only
if, at the pricing date, the known part of the average is greater than the exercise
price ( K - ( 1 / r ) f d S ( u ) d u ) < 0. In such a case the Asian put is worthless and
part (ii) of Proposition 1 immediately gives the Kemna and Vorst formula:
The P.D.E. approach is the historical way of understanding options (Black and
Scholes, 1973; Merton, 1973). The use of this approach to value Asian options can
be summarized as follows. Kemna and Vorst (1990) establish a P.D.E. with two
state variables (the stock price and the average) which characterize the price of a
"fixed-strike" Asian option. These two state variables complicate the valuation
problem and the hedging analysis. In particular, extra boundary conditions have to
be specified and the numerical methods to solve the P.D.E. are computationally
expensive. We suggest here to use a one-state-variable P.D.E., easy to implement
and giving additional information on the hedging strategy. Our result is based on a
homogeneity property of the price of the Asian call. Such a transformation, based
on a homogeneity property of the price of the option, is very general and well
known in the literature. This argument is first used by Ingersoll (1987) for
studying "floating-strike" Asian options. Ingersoll (1987) derives a two-state-
variable P.D.E., then, using a change of variables, he obtains a one-state-variable
P.D.E. which characterizes the price of a "floating-strike" Asian option. His
result is presented as a boundary value problem (where a full set of boundary
conditions must be specified). Ingersoll (1987) claims without proof that his
P.D.E. has a closed-form solution. We will see later why such an assertion is
clearly difficult to verify. In the framework of the martingale approach, Kramkov
and Mordecki (1993) use a similar homogeneity property to study American type
Asian options with infinite maturity 4. This allows them to reduce an optimal
stopping problem for a two-dimensional Markov process to an optimal stopping
problem for a one-dimensional Markov process. Then, they define implicitly the
optimal stopping time which characterizes the early exercise of an American type
Asian option and propose a quasi explicit pricing formula. Of course, the
assumption of infinite maturity is crucial in order to establish their result. Rogers
and Shi (1995), independently of this work, propose the same approach as ours to
value an Asian option, give a lower bound and an upper bound for the price, and
investigate the computational aspects. However, they do not consider the hedging
problem and the comparison between Asian and European call. Moreover they
only consider the case of "backward-starting fixed-strike" Asian options. In this
paper, using an appropriate change of numeraire, we directly obtain a one-state-
Let us now define the probability associated to a numeraire change under which
we will derive our main result.
C 7 = St E y I/1 )
K - ~ £ r S ( u ) du
Sr
+]
=e-r(r-t)EQ Sr Sr "
dQ s S(T)
dO EQ[S(T)] '
c; = s,e?" -;- []
C~/S t is thus the relative price of an Asian option with respect to the numeraire S.
The probability associated to our change of numeraire is QS. Geman et al. (1995)
propose a general framework to apply change of numeraire to study options. From
Proposition 2, it is easy to remark the homogeneity in (S t, K - (1/T)fdS(u) d u) of
the price of a "fixed-strike" Asian option. Let us recall that for standard European
option the homogeneity is in (St,K). This result enlightens the fact that the
"effective" strike price of our option is K minus the known part of the average.
We deduce from this that the appropriate state variable x t to studying our option
is the ratio effective strike price over the price of the underlying (x t
= [ K - ( l / T ) f o ' S ( u ) d u ] / S t ) . As a consequence, the probability QS allows us
to define the relative price of an Asian option with respect to the numeraire S as a
function of the random realisation at date T of our state variable: C~/S, = E°S[ x T ].
The change of numeraire we consider and the previous remarks are quite general
and can be used to study a wide class of derivative securities and in particular
options with random strike. Using the Feyman Kac theorem, we are now in
position to establish the main result of this section: to characterize E°S[x~] (and
thus to characterize the price of an Asian option) by a one-state-variable P.D.E.
Proof From Ito's lemma, the dynamics under the probability QS of the state
variable x t = [ K - ( 1/ T) fdS( u) d u ] / S t is defined by the stochastic differential
equation:
dx,= (')
-~-rx t a t - o - x t d l , V t, (3)
7
S~
d x t= 3/( c ~ - x t ) dt + ~ x tdw t
x0=x>0
Then, Courtadon shows that his process presents two natural boundaries at 0 and
~. Our case is a little more complex since we allow y and ~ and the initial value
x 0 to be negative. The financial meaning of the stochastic differential Eq. (3) is
the following: The state variable that we consider is x t = [ K - ( l / T )
f¢{S(u)du]/S t (with K > 0 ) and thus x o = K / ( S o ) ' is strictly positive. As a
consequence, if there exists t ' > 0 such that ( l / T ) f ~ S ( u ) d u = K then, for all t
greater than t', we have ( 1 / T ) f d S ( u ) d u > K, and finally for all t greater than t'
we have x, < 0. L e m m a 1 captures the fact that if the process x t crosses 0 it stays
Thus, again we find the result derived by Kemna and Vorst (1990) and by Geman
and Yor (1993): In the case K - ( 1 / T ) f d S ( u ) d u <_O, it is easy to obtain a
closed-form expression of the Asian option price. Moreover, Eq. (4) will be useful
in the numerical implementation of our P.D.E. approach (Section 5): Our P.D.E.
will be implemented on R + with Eq. (4) as boundary condition at x t = 0. Finally,
let us remark that, from the proof of Proposition 3, the derivation of a closed-form
solution of our P.D.E. is clearly related to the knowledge of the distribution of the
arithmetic average of a set of lognormal distribution. In the case x < 0, we only
require the first moment of f~S(u)du in order to obtain a closed-form solution of
our P.D.E. In the case x ~ R we need the distribution of foTS(u)du which is not
explicit. This is basically the reason why no one has published a closed-form
solution for this type of P.D.E.
Thus, in this section, we have established a partial differential equation which
characterizes the price of a "fixed-strike" Asian option (an analogous result for a
"floating-strike" Asian option is available). Such a P.D.E. is equivalent to the
P.D.E. derived in Ingersoll (1987)). As far as we know the partial differential Eq.
(2) does not admit explicit solutions. However, the very simple form of Eq. (2)
permits the use of classical numerical techniques such as finite-difference methods
to approximate the price of an Asian option (this is explained in Section 5). The
P.D.E. approach we present here has three main advantages: (i) Firstly, we
approximate the solution of the exact problem of the pricing of an Asian option.
As opposed to an important part of the literature where the approximations consist
of modifying geometric average option prices (see, e.g., Bouaziz et al., 1994), or
to approximate the distribution of an arithmetic average (by Edgeworth series
expansions, see, e.g., Turnbull and Wakeman, 1991). (ii) Secondly, Eq. (2) is a
one-state-variable partial differential equation where the time parameter does not
appear in the coefficients. We are typically in the case where the finite-difference
approach requires in total fewer computations than the Monte Carlo approach in
order to obtain similar accuracy. (iii) Thirdly, contrary to the papers mentioned
above, our P.D.E. approach gives information on the hedging portfolio. This is
discussed in the second part of this section.
Very few results have been derived on the Asian option hedging problem.
Turnbull and Wakeman (1991) give a rough estimate of the delta based on an
Edgeworth series expansion. Geman and Yor (1993) prove that when K -
B. AlziaD, et al. / Journal of Banking & Finance 21 (1997) 613-640 623
( I / T ) f d S ( u ) d u < 0 then the gamma is 0 while the delta is not constant. The
meaning of this result is clear since in the case K - ( 1 / T ) f d S ( u ) d u < 0 we are
sure to exercise the option. A more constructive result on the hedging problem is
proposed by E1 Karoui and Jeanblanc-Picqu6 (1993). These authors show that the
price of an Asian option on a stock is equal to the price of a European option on a
fictitious asset which has a random volatility. This random volatility admits for the
upper bound the constant volatility o- of the underlying stock. Then they propose a
"super hedging strategy" built on the Black and Scholes formula with volatility
equal to the upper bound o-, Finally, Bouaziz et al. (1994) prove on an approxi-
mate pricing formula that the price of a "forward-starting floating-strike" Asian
option is a linear function in S t. As a consequence, the gamma of the option is just
0. We have proved that their result can be easily extended to the exact pricing
formula. Such a property does not apply to "backward-starting floating strike"
and "forward-starting fixed-strike" Asian options.
In the sequel, we focus on "backward-starting fixed-strike" Asian options. We
give exact formulae easy to implement, for the delta, the gamma and the elasticity
of an Asian option (Proposition 4). Then we derive analytical results as the
monotonicity of the price of the option in the various parameters of the model. In
particular, this allows us to prove some classical intuitive results on the hedging
strategy.
Under the notation of Proposition 3, by straightforward derivation we have:
Proposition 4. (i) The delta, the gamma and the elastici~ of a "fixed-strike"
Asian call option is giuen by:
aef aCf ^a
Aa~- - - = C ( xt,t) - XlCa( xt,t),
aSt
a2 ^
r"= st c " , , ( x t , t ) ,
s, Q(xt,t)
,Q - ~ = 1 -Xt~x,,t)
dQa ftTS(u) du
l fos(u)du)Q(xT<O
- e - r ( r - t ) ( K - -~ ). (5)
Proposition 5 deserves some comment: First notice that, as for the European
call option, the derivative of the price of a "fixed-strike" Asian call with respect
to the exercise price is equal, in absolute value, to the discounted risk neutral
probability to exercise the call. Moreover, we obtain a general expression for the
delta:
1
Aa = --(1 - e--r(r-t))Qa(xT < 0).
Tr
As a consequence:
(i) The probability QO highlights the average nature of Asian options.
(ii) We obtain an upper bound for the delta:
1
~o < T r ( 1 - e - " > ' ~ ) .
(iii) When the known part of the average is greater than K, we have
Q(x r < 0 ) - 1 (we are sure from the valuation date t to exercise the option).
Thus, we meet again the Geman and Yor (1993) formula for the delta of an Asian
option with a probability of exercise equal to one:
1
Aa-- - - ( 1 --e-r(T-t)).
Tr
B. AIziary et aL / Journal of Banking & Finance 21 (1997) 613-640 625
(iv) When t tends to T, the delta tends to 0. Therefore we have proved a very
simple result which is intuitively explained in Hull (1992): Near the exercise date
T, the change in the average value with respect to the stock asset price is small
and the option becomes progressively easier to hedge.
(v) Finally, notice that Eq. (5) has the same structure as the Black and Scholes
formula: We have proved that the price of an Asian option, as the price of a
standard European option, is equal to the price of the underlying asset times the
delta of the considered option minus the discounted effective strike price times the
risk neutral probability to exercise the option. The same analysis holds for a
"floating-strike" Asian option (the analogous formula is given in Appendix B).
Of course, Eq. (5) is not explicit, however our P.D.E. approach allows us to
compute numerically the probabilities Q a ( x T < 0) and Q ( x r < 0) and thus to
investigate the various effect which interact in the pricing of an Asian option.
Moreover such an analysis allows us, as we will see in the following sections, to
obtain new results on the comparison between Asian and European options.
K
C;=StCe(y~,t) with Yt=--,
St
626 B. Alziary et al, / Journal of Banking & Finance 21 (1997) 613-640
Ce(y,T)=(1-y) +
which holds in the domain D = {(y,t): 0 _< y < 0% 0 _< t _< T}.
Proposition 7. The delta, the gamma and the elasticity of a European call option
are given by."
Aedef OCte
= - OSt
- =~e(yt,t) ^e ( Yt ,t) = N ( d l ) ,
__ ytCy
def 22 C e y2 1 1 1
--=-..f_t ^e Yt,t ) =
F e= ~S 2 St Cyy( s, r~U~-t 2q~ e- U ~,
def St Cy(yt,t) SN( d, )
1"2e = A ~ - - = 1
C[ Y' d e ( y, ,t) SN( d, ) - K e - r ( r - t W ( d, - ~ ) "
8 Notice that Proposition 6 allow us to explain how to adapt our P.D.E. approach to the case of
"forward-starting" Asian option. This is done in Appendix C.
B. Alziar), et al. / Journal of Banking & Finance 21 (1997) 613-640 627
We remark that the two state variables we consider for studying Asian and
European options ( x t and yt ) are equal at the time t = 0 (x 0 = Y0 = K/So). Thus,
for our comparison to be relevant, we consider in the sequel the pricing date t = 0.
Therefore, comparing the prices and the hedging tools between Asian and Euro-
pean options is equivalent to comparing the functions Ca(x,0), C'~(x,0) and
C e (x,O), C~(x,O).
^e
In the following, we first clarify and complete a result due to Geman and Yor
(1993) (Proposition 8). Then we extend our analysis to the comparison of the delta
between Asian and European options (Proposition 9). Proposition 10 focuses on
elasticities.
Geman and Yor (1993) prove that, ceteris paribus, for all values of the exercise
price K in a neighborhood of 0, if r is negative 9, the Asian option price is greater
than the standard European option price. We extend their result in two ways.
Firstly, we prove that their result holds when x 0 = ( K ) / ( S o) is in the neighbor-
hood of 0 (part (i) of Proposition 8). Secondly, we prove that for "small negative"
value of r, the previous result cannot be extended to all x 0 = ( K ) / ( S o) (part (ii)
of Proposition 8).
Now, part (i) of Proposition 8 comes from the continuity of da and d e in the
variable x.
Let us prove part (ii) of the proposition. From Geman and Yor (1993), if r = 0,
then:
d°(o,o) = d2o,o).
9 As Geman and Yor (1993) notice it, the sign of r can be negative for currency Asian options or
Asian options on oil spreads. When r is positive (and the time to maturity equal to to the length of the
averaging period, which is here t = 0), the Asian call option price is smaller than the standard
European call price (Geman and Yor (1993)).
628 B. A lziary et al. / Journal of Banking & Finance 21 (1997) 613-640
therefore,
~C a aC e
VK>0 VSo>_0 TE ( s°'0)=-gE ( s°'0)'
From Proposition 5, this can be written:
Now, let us apply Proposition 8 to compare the delta and the elasticity between
Asian and European options. We deduce a result analogous to Proposition 8: if r
is negative for all x 0 = ( K ) / ( S o) in the neighborhood of 0, the delta of the Asian
call is greater than the delta of the European call. The result is reversed when r is
positive. More precisely, we have:
Let us now make a more precise comparison between the elasticity of the Asian
and European options. From Propositions 4 and 7, we have for x = 0 ( K = 0), for
all values of r, Oa = ~ ' ~ e = 1. Using the previous result we can propose a little
more.
Proof. From Propositions 4 and 7, let us first remark that for x different from 0,
a C°(x,t)
,Q, < ~Qe <=~ >0.
ax de(x,t)
Now, for r = 0, x = 0 we have C a ( 0 , 0 ) / c e ( 0 , 0 ) = 1 and, from Proposition 7,
there exists x * such that C " ( x * , O ) / C e ( x *,0) < 1. As a consequence, there exists
x* * ~ [0, x* ] such that, for r = 0, (a/Ox)(Ca(x * * , 0 ) ) / ( C ' ( x * *,0)) < 0. From
the initial remark, this is equivalent to O a > D e. The standard continuity argu-
ment ends the proof. []
Of course, we just obtain locally analytical results. However, they prove the
existence of interesting features. For instance, the elasticity of an Asian option can
be greater than the elasticity of a European option. As a consequence, in such a
case, it is costless to hedge a stock with an Asian option rather than with a
European option. In the following section we focus on the numerical implementa-
tion of our P.D.E. approach. This allows us in Section 6, to make precise from a
numerical point of view, the analytical results established in this section.
5. Numerical implementation
First, using the fact that the solution is known in the case x < 0, we consider
the P.D.E. (2) only for x > 0 with the following boundary conditions:
1
6a(0,t) = ~r(1 - e-r(T-,)),
lira 6 ~ ( x , t ) = O.
The boundary condition at infinity comes obviously from the definition of the
Asian call.
Then we define a new state variable y = e -x, so that, for x ~ [0,~], y ~ [0,1].
Finally, the P.D.E. (2) becomes:
t
0 -2
0= C~(y,t) + - ~ - y 2 ( l n y ) 2 C-ar y ( y , t )
__ __ 2 ~a
+ T rlny y+--~--y(lny) C,(y,t)
(a)
d~( y,T) = 0
1
C a ( l , / ) = -~r(1 - e - r ( r - o )
(~(0,t) = 0
and so the new P.D.E. holds on a bounded domain.
Ci,j t- I,j
(11)
Ot At
Substituting Eqs. (9)-(1 I) into Eq. (8) gives:
(~,'[,,~ =0 VO<j<ny
ca,-I,j __
- P j j - I C i . j -a
-I _1_ pj.j ~iaj +Pj4+lCi,j+J
~a
(12)
& i - 1,0 = 0
1
C"i_ ,,.. = ~r(1 _ e-r(r (i-I)At))
where
1 At
PJ4-' = ~0-2(YJ)2( In yj)Z × --,(A y) 2
At
PJ4 = 1 - ~r2( yj)2(ln yj)2 (AY) 2
--
[(1 ~, rln yj yj + ~o-~-yj(lnyj) 2 S-yy'
At
]
1 At
ej,j+l = ~0-2(yj)2( In yj)Z ( A y)"
Proposition 11. Let 0- and r be such that o-z < r. The solution of the difference
equation (12) approaches the solution of the P.D.E. (8) as A y ~ 0 and At--* O,
if..
0-2 At 1 At
1 e2 (Ay) 2 T A~ > 0 (13)
Proof First, let us note that the explicit finite-difference approximation (12) is
obviously consistent with the P.D.E. (8) and that Eq. (13) insures the stability.
632 B. Alziary et al, / Journal of Banking & Finance 21 (1997) 613-640
[The proof based on a theorem in Ames (1977), p.75, is available upon request.]
Then, for this type of parabolic equation, consistency and stability imply conver-
gence as it is shown in Lamberton and Lapeyre (1991). []
To check the accuracy our method, we test it on the European call option
equation, since it is very similar to the Asian one, and since we can compare the
computed solution and the exact one.
Computations were carried out on a Alpha 800 Digital Workstation with
FORTRAN, and a quite acceptable accuracy was obtained. Of course, for a fixed
increment Ay, the maximum increment At required by the stability condition
decreases as the volatility increases. But P.D.E. results improve as the volatility
increases. Moreover, it is important to emphasize that with P.D.E. methods, we
obtain with one computation the price at t = 0 for any strike. That is why we are
able to approximate the derivative of the price function and so A and /2.
60,00 F
50,00 F
40,00 F
~iiiiiii.
-~az- .. -.. _ European
30,00 F
"%.", -. . . ____ Asian
20,00 F
10,00 F
o,ooF I. . . . .
Table i
Relative price difference D in percent between European and Asian option with respect to the
European option price:
o = [(c; - c 7 ) / c , ] x 10o
Current price of the underlying asset: SO= 10O. Riskless interest rate: r = 0.09. Time to maturity:
T = 1 year.
This section ends with two features of our approach: Firstly, our approach allows
to explain and to precise from a numerical point of view when the price of a
European option is lower than the price of an Asian option. Secondly, our
approach applies to " b a c k w a r d - s t a r t i n g " Asian options as well as to " f o r w a r d -
starting" Asian options.
Fig. 1 gives the prices of Asian and European options as a function of the
exercise price K for various volatilities o- and for a given riskless interest rate r
equal to 0.09. Asian and E u r o p e a n option prices are both decreasing convex
functions in the exercise price K. Notice that these curves illustrate the property
analytically proved by K e m n a and Vorst (1990) and G e m a n and Yor 11993):
W h e n the time to maturity is equal to the length of the averaging period European
option prices are greater than Asian option prices. More interesting are the
observations of the behavior of Asian options as a function of the volatility (since
until n o w no analytical result has been derived on this subject). The price of an
Asian option is a decreasing function in the volatility of the u n d e r l y i n g stock.
Moreover, A s i a n options are less sensitive to an increase in volatility than
European options. The third c o l u m n of Table 1 specifies this point and focuses on
634 B. Alziary et al. / Journal of Banking & Finance 21 (1997) 613-640
the relative price difference D between the two types of options with respect to
the European option price. Our numerical results are the following: For a given
volatility, the relative price difference D is increasing in the strike K. Moreover,
the higher the given volatility, the smaller the increase of D. Notice that for
options out of the money (S o < K), the relative price difference D is "rapidly"
decreasing in ~r. For options in the money (S o > K), D is "slowly" increasing in
o- and for options at the money (S o = K), D is "slowly" decreasing in tr.
Let us now focus on the comparison of the deltas and the elasticities between
Asian and European options. By implementing the formulas of Propositions 4 and
7 we obtain Table 1. Let us first remark that the numerical results given in Table 1
seem to generalize the analytical results of Section 4: for values of parameters
currently observed the value of European delta is greater than the value of the
Asian one. The Asian elasticity is greater than the European one. More precisely,
Table 1 indicates that, as in the case for European options, in the money Asian
options have higher delta than out of the money Asian options. The behaviour of
the elasticities are the same for Asian and European options. In particular, out of
the money Asian options have higher elasticities than in the money Asian options.
However, due to the average nature of Asian options, the difference in risk is
smaller for Asian options than for European options. Moreover Table 1 indicates
that the difference between the elasticities of Asian and European options is
increasing in K. The higher the volatility the smaller the increase. Notice that the
difference between the elasticities is decreasing in the volatility. The following
proposition, easily deduced from assertion (iii) of Proposition 5, enlightens two
effects which interact in these numerical results:
Proposition 12. The difference between the deltas and the elasticities of standard
European and Asian options are given by:
1
Ae-- Aa= -~o(( C e - C a) -[- K e - r r [ Q ( y r < 1 ) - Q ( x r < 0)1),
Two effects interact in these differences: (i) a price effect and (ii) a probability
effect. The probability effect is easy to quantify. Using our P.D.E. approach, the
implementation to exercise the risk neutral probability to exercise the Asian option
comes from Proposition 5, part (ii). Our numerical implementation indicates, for
instance, that Asian and European options have the same probability of exercise
for value of the strike around the money. As a consequence for options around the
B. Alziary et al. / Journal of Banking & Finance 21 (1997) 613-640 635
money the difference in prices between Asian and European options is approxi-
mated by the value of the underlying asset times the difference of the delta.
Let us now summarize how sensitive the Asian call is with respect to the
riskless interest rate: We find that, as for European options, the risk neutral
probability to exercise the Asian call is increasing in the riskless interest rate r. In
the same manner, the price of an Asian call is increasing in the riskless interest
rate. Moreover, the smaller the riskless interest rate the greater the relative price
difference between Asian and European options.
Our P.D.E. approach also specifies when the price of an Asian call is greater
than the European one. As Turnbull and Wakeman (1991) and Geman and Yor
(1993) notice, if the maturity of the option is less than the averaging period, the
price of an Asian option may be greater than the price of a European option
(priced at the same date with the same maturity and the same strike K). Such a
result happens when the known part of the average at the pricing date is
sufficiently high. Our numerical approach allows us to catch this point. As a
matter of fact, we compute in a single step the prices of Asian or European calls
for all positive strikes. Therefore, we are able to give the required amount of the
known part of the average at the pricing date such that the price of an Asian call is
Table 2
Relative price difference D in percent between European Asian option with respect to the European
option price:
D = [(C; - Cf)/C~] × lOO
tr K D A" Ae /2" .Q~ 1 2 " - 12e
(%)
0.05 95 16.84 0.9552 0.9987 8.1470 6.2040 1.9430
0.05 100 25.35 0.9257 0.9840 12.5800 8.4000 4.1800
0.05 105 41.60 0.7327 0.9054 21.1200 12.0200 9.1000
0.1 95 17.02 0.9002 0.9397 7.5440 5.7250 1.8190
0.1 100 23.70 0.7966 0.8678 9.8840 6.9410 2.9430
0.1 105 33.01 0.6262 0.7582 12.8500 8.3850 4.4650
0.2 95 17.59 0.7672 0.8063 5.6220 4.2610 1.3610
0.2 100 21.98 0.6775 0.7409 6.4190 4.6770 1.7420
0.2 105 27.05 0.5767 0.6695 7.2640 5.1100 2.1540
0.3 95 17.96 0.7052 0.7499 4.3760 3.3400 1.0360
0.3 100 21.15 0.6386 0.7015 4.7580 3.5410 1.2170
00.3 105 24.62 0.5695 0.6518 5.1460 3.7430 1.4030
0.4 95 18.16 0.6769 0.7285 3.5970 2.7720 0.8250
0.4 100 20.65 0.6254 0.6912 3.8180 2.8890 0.9290
0.4 105 23.26 0.5733 0.6537 4.0380 3.0050 1.0330
0.5 95 18.22 0.6650 0.7232 3.0770 2.3950 0.6820
0.5 100 20.26 0.6232 0.6933 3.2190 2.4710 0.7480
0.5 105 22.40 0.5816 0.6635 3.3600 2.5450 0.8150
Current price of the underlying asset: SO= 100. Risldess interest rate: r = 0.09. Time to maturity:
T = l year. to = 0.5 (i.e. the pricing date is 26 weeks prior to the averaging period).
636 B. AIziary et al./ Journal of Banking & Finance 21 (1997) 613-640
greater than the price of a European call. For instance, our numerical results
indicate that for a riskless rate equal to 0.09, a volatility cr equal to 0.1 and a
strike equal to 100 francs, if the known part of the average is greater than 6 francs
then the price of the Asian call is greater than the price of the European call.
Moreover, the higher the volatility the higher the required amount of the known
part of the average.
Finally, using Appendix C, we have computed in Table 2 the prices of a
"forward-starting" Asian call characterized by a length of average equal to 1 year
and a pricing date which is 26 weeks prior to the averaging period. The behavior
of the relative price difference D between "forward-starting" call and standard
European call is qualitatively the same that the relative price difference between
"backward-starting" Asian call and standard European call. We notice neverthe-
less that this relative price difference is lower in the case of "forward-starting"
Asian call. The intuition is clear: When the length of the averaging period tends to
0, the price of "forward-starting" Asian option tends to the price of a standard
European option. Here again our P.D.E. methodology allows to quantify this point.
Appendix A
dxt= (') T rx t d t - o - x l d W t
x o = x. (14)
where t ~ [0,~[, W t is a B r o w n i a n motion. T, r and o" are constants and T > O.
Then the stochastic differential equation (14) has a unique solution x t in [O,T].
Moreover, this solution ( xl) o ~_t ~_r verifies:
Vt ~ R + P ( x t < O / x o = O) = 1,
P( x, > O/x o <_O) = O,
P ( x, = O/xo < O) = O.
Proof The proof is a direct application of Karatzas and Shreve's (1988) theorem
2.9, p.289. From Ito's lemma, the solution of Eq. (2) is given by the expression:
0"2 1 1 0"2
x t =Xoe(2 --r)'-¢wO)- _ f e~T-r×t-s)-¢~w,-W,)ds.
T Jo
Appendix B
8C~ 1
Ab - = Q S ( e ) -- - - ( 1 - - e - r ( T - t ) ) Q a ( E ) .
OS Tr
Appendix C
c, =
and
1 ) ^a 1 2 2^o ^
rx C (x,t) + x =0
T- to 2
(°(x,v)
1
Ca(O,t) (1 -- e - r ( T - ' / )
(r-to)r
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