Basic Numerical Procedures

Chapter 19

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Approaches to Derivatives
Valuation

Trees
Monte Carlo simulation
Finite difference methods

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 Binomial Trees
Binomial trees are frequently used to
approximate the movements in the price
of a stock or other asset
In each small interval of time the stock
price is assumed to move up by a
proportional amount u or to move down by
a proportional amount d

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Movements in Time t
(Figure 19.1, page 408)

p Su

S
1–p
Sd

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Tree Parameters for asset
paying a dividend yield of q

Parameters p, u, and d are chosen so that the

tree gives correct values for the mean &
variance of the stock price changes in a risk-
neutral world

Mean: e(r-q)t = pu + (1– p )d

Variance:2t = pu2 + (1– p )d 2 – e2(r-q)t

A further condition often imposed is u = 1/ d

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Tree Parameters for asset
paying a dividend yield of q
(continued)

When t is small a solution to the equations is

 t
u e
d e   t

a d
p
u d
a e ( r  q ) t

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The Complete Tree
(Figure 19.2, page 410)
S0u 4
S0u 3
S0u 2
S0u S0u S0u 2

S0
S0 S0
S0d S0d
S0d 2

S0d 3 S0d 2

S0d 4
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 Backwards Induction
We know the value of the option at the
final nodes
We work back through the tree using
risk-neutral valuation to calculate the
value of the option at each node, testing
for early exercise when appropriate

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Example: Put Option
(Example 19.1, page 410)

S0 = 50; K = 50; r =10%;  = 40%;

T = 5 months = 0.4167;
t = 1 month = 0.0833
The parameters imply
u = 1.1224; d = 0.8909;
a = 1.0084; p = 0.5073

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Example (continued)
Figure 19.3, page 411
89.07
0.00
79.35
0.00
70.70 70.70
0.00 0.00
62.99 62.99
0.64 0.00
56.12 56.12 56.12
2.16 1.30 0.00
50.00 50.00 50.00
4.49 3.77 2.66
44.55 44.55 44.55
6.96 6.38 5.45
39.69 39.69
10.36 10.31
35.36 35.36
14.64 14.64
31.50
18.50
28.07
21.93

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Calculation of Delta
Delta is calculated from the nodes at time t

2.16  6.96
Delta   0.41
.  44.55
5612

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Calculation of Gamma
Gamma is calculated from the nodes at
time 2t

0.64  3.77 3.77  10.36

1   0.24;  2   0.64
62.99  50 50  39.69
1   2
Gamma = 0.03
11.65

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Calculation of Theta
Theta is calculated from the central nodes
at times 0 and 2t

3.77  4.49
Theta =  4.3 per year
01667
.
or - 0.012 per calendar day

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Calculation of Vega
We can proceed as follows
Construct a new tree with a volatility of 41%
instead of 40%.
Value of option is 4.62
Vega is

4.62  4.49 013

.
per 1% change in volatility

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Trees for Options on Indices,
Currencies and Futures
Contracts
As with Black-Scholes:
◦ For options on stock indices, q equals the
dividend yield on the index
◦ For options on a foreign currency, q equals the
foreign risk-free rate
◦ For options on futures contracts q = r

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Binomial Tree for Stock Paying
Known Dividends
Procedure:
◦ Draw the tree for the stock price less the
present value of the dividends
◦ Create a new tree by adding the present value
of the dividends at each node
This ensures that the tree recombines and
makes assumptions similar to those when
the Black-Scholes model is used

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Extensions of Tree Approach
Time dependent interest rates
The control variate technique

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Alternative Binomial Tree
(Section 19.4, page 422)

Instead of setting u = 1/d we can set each

of the 2 probabilities to 0.5 and

( r  q   2 / 2 ) t  t
u e
( r  q   2 / 2 ) t   t
d e

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 Trinomial Tree (Page 424)
Su
u e  3 t
d 1 / u
pu
t    1 2
pu  r 
2 
 
12  2  6 pm
2
S S
pm 
3
t   2  1
r   
pd
pd  2 
12  2  6
Sd
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Time Dependent Parameters in a
Binomial Tree (page 425)
Making r or q a function of time does not
affect the geometry of the tree. The
probabilities on the tree become functions
of time.
We can make  a function of time by
making the lengths of the time steps
inversely proportional to the variance rate.

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Monte Carlo Simulation and 
How could you calculate by randomly
sampling points in the square?

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Monte Carlo Simulation and
Options

When used to value European stock options, Monte

Carlo simulation involves the following steps:
1. Simulate 1 path for the stock price in a risk neutral
world
2. Calculate the payoff from the stock option
3. Repeat steps 1 and 2 many times to get many
sample payoff
4. Calculate mean payoff
5. Discount mean payoff at risk free rate to get an
estimate of the value of the option

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Sampling Stock Price
Movements
(Equations 19.13 and 19.14, page 427)
In a risk neutral world the process for a
stock price is
 S dt  S dz
dS 
We can simulate a path by choosing time
steps of length t and using the discrete
version of this
ˆ S t  S  t
S 
where  is a random sample from (0,1)

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A More Accurate Approach
(Equation 19.15, page 428)

Use
 
d ln S  ˆ   2 / 2 dt   dz
The discrete version of this is
 
ln S (t  t )  ln S (t )  ˆ   2 / 2 t   t
or
S (t  t ) S (t ) e ˆ   / 2 t 
2
t

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Extensions
When a derivative depends on several
underlying variables we can simulate
paths for each of them in a risk-neutral
world to calculate the values for the
derivative

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Sampling from Normal
Distribution (Page 414)

One simple way to obtain a sample

from (0,1) is to generate 12 random
numbers between 0.0 & 1.0, take the
sum, and subtract 6.0
In Excel =NORMSINV(RAND()) gives a
random sample from (0,1)

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 To Obtain 2 Correlated
Normal Samples
Obtain independent normal samples x1
and x2 and set
1  x1
 2 x1  x2 1   2

Use a procedure known as Cholesky’s

decomposition when samples are
required from more than two normal
variables (see page 430)

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Standard Errors in Monte Carlo
Simulation

The standard error of the estimate of the

option price is the standard deviation of the
discounted payoffs given by the simulation
trials divided by the square root of the
number of observations.

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 Application of Monte Carlo
Simulation
Monte Carlo simulation can deal with path
dependent options, options dependent on
several underlying state variables, and
options with complex payoffs
It cannot easily deal with American-style
options

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Determining Greek Letters
For 
1. Make a small change to asset price
2. Carry out the simulation again using the
same random number streams
3. Estimate  as the change in the option
price divided by the change in the asset
price

Proceed in a similar manner for other Greek

letters
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Variance Reduction Techniques

Antithetic variable technique

Control variate technique
Importance sampling
Stratified sampling
Moment matching
Using quasi-random sequences

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Sampling Through the Tree
Instead of sampling from the stochastic
process we can sample paths randomly
through a binomial or trinomial tree to value
a derivative

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Finite Difference Methods
Finite difference methods aim to
represent the differential equation in
the form of a difference equation
We form a grid by considering
equally spaced time values and stock
price values
Define ƒi,j as the value of ƒ at time
it when the stock price is jS

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Finite Difference Methods
(continued)

ƒ ƒ 1 2 2  2 ƒ
In  rS  σ S 2
rƒ
t S 2 S
ƒ ƒi,j 1  ƒi,j  1
we set 
S 2 ΔS
 2 ƒ  ƒi,j 1  ƒi,j ƒi,j  ƒi,j  1 
2
   ΔS or
S  ΔS ΔS 
 2 ƒ ƒi,j 1  ƒi,j  1  2 ƒi,j
2

S ΔS 2
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Implicit Finite Difference Method
(Equation 19.25, page 437)

ƒ ƒi 1,j  ƒi,j
If we also set 
t Δt
we obtain the implicit finite difference method.
This involves solving simultaneo us equations
of the form :
a j ƒi,j  1  b j ƒi,j  c j ƒi,j 1 ƒi 1,j

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Explicit Finite Difference Method
(page 439-444)

If f S and 2 f S 2 are assumed to be the same

at the (i  1, j ) point as they are at the (i, j ) point
we obtain the explicit finite difference method
This involves solving equations of the form :
ƒi,j a*j ƒi 1,j  1  b*j ƒi 1,j  c*j ƒi 1,j 1

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Implicit vs Explicit Finite
Difference Method

The explicit finite difference method is

equivalent to the trinomial tree approach
The implicit finite difference method is
equivalent to a multinomial tree approach

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Implicit vs Explicit
Finite Difference Methods (Figure 19.16,
page 441)

ƒi , j +1 ƒi +1, j +1

ƒi , j ƒi +1, j ƒi , j ƒi +1, j
ƒi , j –1
ƒi +1, j –1
Implicit Explicit
Method Method
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Other Points on Finite Difference
Methods
Itis better to have ln S rather than S as the
underlying variable
Improvements over the basic implicit and
explicit methods:
◦ Hopscotch method
◦ Crank-Nicolson method

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