Small Dimension PDE for

Discrete Asian Options

Eric BenHamou (LSE, UK)

& Alexandre Duguet (LSE, UK)

CEF2000 Conference (Barcelona)

 Plan
• Introduction
• How to reduce the dimension
• Homogeneous case
• Extension to non Homogeneous case
• Numerical results
• Conclusion

6-8 July 2000 CEF 2000 Conference Slide N°2

Introduction to the Asian Option
• Origin and motivation
– spot manipulation
– periodic cash flows
• Definition:
– type of averaging
– fixed or floating strike
• Pricing problem?

6-8 July 2000 CEF 2000 Conference Slide N°3

 Different methods
• Closed forms solutions
– Geometric approximations (Vorst 92 96)
– density distributions assumptions (Turnbull Wakeman 91,
Levy 92 Jacques 95, Milevsky Posner 97)
– Laplace Transform (Geman Yor 93) (Madan Yu 95)
• Numerical methods
– Monte Carlo (Kemma Vorst 90 96)
– Fast Fourier Transform PDE (Caverhill Clewlow 92
Benhamou 2000)
– PDE (Roger Shi 95 He and Takashi 96 Alziary et al. 97 Forsyth et
al. 98)

6-8 July 2000 CEF 2000 Conference Slide N°4

 Motivations

• Find a numerical method consistent with:

– Smile model: (Dupire 93 Derman Kani 94)
– Discrete non proportional dividend
• Use PDE method to solve this problem:
– determination of the PDE
– dimension reduction problem

6-8 July 2000 CEF 2000 Conference Slide N°5

 Notations and Assumptions
• Continuous time trading economy with an infinite
horizon. Complete market with absence of
arbitrage
• St underlying modelled by a diffusion equation:
dSt  rt St dt  S t  t , St  dWt
Wt  tR one dimensional Brownian motion
• Discrete non proportional dividends D

6-8 July 2000 CEF 2000 Conference Slide N°6

 Different PDEs
• Traditional PDEs (Ingersoll 87 Forsyth Vetzal Zvan 98)
1 2
C t  σ  t, S S2 CSS  rSt CS  St C I  rC  0
2
• Change of Variable: (adaptation of Roger an Shi 95)
g t  Ag  0
 1 2 2 2
 y
2 y 2

  t  i 1 i ti  ry
n
  

y 
 
1
   2  t, s s  2
  2

 2  rt  y 2

 s 2
s s  y 
6-8 July 2000 CEF 2000 Conference Slide N°7
 Change of variable
 T 

T

• Payoff: e t 
   S s   ds   K  | t 
 rs ds

 0  

• “Homogenised” Payoff
 T S 


f  t , k , S t      s   ds   k  | t 
 t S t  
T

g  t , y, s   e t f  t , y, s 
 rs ds

6-8 July 2000 CEF 2000 Conference Slide N°8

 Rewriting of the Payoff
 T 

T

e t    S s   ds   K  | t 
 rs ds

 0  
T
  rs ds
 T S  t S  


 e t St    s   ds    K   s   ds    | t 
 t St  0 S
 
 t

 
T
t S
 e t St f  t , K     ds  , St , St 
 rs ds
s
0 S
 t 

• Ideal case: Homogeneity!!!

6-8 July 2000 CEF 2000 Conference Slide N°9

 Black Scholes case (1/2)
• Crucial property of Homogeneity!!!
C BS  S , K   C  S , K 
K  K0 
C BS  S , K   C S , K0 
K0  K 
S1  S 2
• So method for an Asian option on
S2 2
– Calculate a call on with strike S1
2 K
– Payoff  rT2  S1  S 2  
 2
e E  K 
 2  
6-8 July 2000 CEF 2000 Conference Slide N°10
 Black Scholes case (2/2)
• if S1  2 K call exercised for any value at date 2
S1e  r  T2 T1   S1  r  T2 T1 
value at time 1  Ke
2
 S1 S1 
• if S1  2 K call is equal to C  T2  T1 , , K  
 2 2
obtained because we calculate for any S

C  T2  T1 , S , K 

6-8 July 2000 CEF 2000 Conference Slide N°11

 Numerical Scheme
• Θ-Schema for PDE Crank Nicholson
Scheme on the Log of the underlying
• Linear interpolation   50% r  5%
• Good Results T2  2 y T1  1 y
Strike 100% 110%
PDE 24.47 20.81
MC 24.46 20.81

6-8 July 2000 CEF 2000 Conference Slide N°12

 Extension
to non-homogeneous Case (1)
• Smile (Dupire model 93)   t, St 
– Non homogeneous model
– form of implied vol
 K  F  K  S
2
T  

  t , St    0 1  S m F  Cu  K  
BS BS  T

 T 
• vega correction
C  S , K ,  S , K  

  C  S , K ,    Vega BS   S , K     
6-8 July 2000 CEF 2000 Conference Slide N°13
 Extension
to non-homogeneous Case (2)
• Numerical Results
30
K  110 %
4
K  180%
3.5
25
3
20 2.5 With smile

180%call price
With smile 2 Without smile
110%call price

15
Without smile Vega correction
1.5
10
1
5 0.5

0 0
50 100 150 50 100 150
Spot
Spot

6-8 July 2000 CEF 2000 Conference Slide N°14

 Dividend case
• Same sort of correction
C  S , K , D     C  S , K , D   1     C  S , K , D   C  S , K ,0  
40
35
30
25 With dividend
Call price

20 Without dividends

15 Dividend correction

10
5
0
50 100 150
Spot

6-8 July 2000 CEF 2000 Conference Slide N°15

 Conclusion
• Method efficient for these more realistic cases
– smile
– non proportional discrete dividends

• Extensions
– to other options like Ratchet and path dependent
options
– control of the error

6-8 July 2000 CEF 2000 Conference Slide N°16