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Jay Au-Yeung
Abstract
This paper presents a tailor-made discrete-time simulation model for valuing path-dependent options. In the context of a real-life application that is interest to many students, we illustrate the option pricing by using Quasi Monte Carlo simulation methods. We give an Asian option pricing which relies heavily on the underlying asset path as a case study with the implementation of MATLAB code.
Introduction
The development of financial industry was very fast and innovative derivative related financial instruments which designed for hedging or leverage investment were developed in last decade. Derivative products valuation turns complicated, such as path-dependent option.
Option pricing theory has a very long history since 1973. The well-developed PDE based BlackScholes model presented a revolutionary change to the derivative industry. There are several approaches to the option pricing. A simplified approach is developed by Cox, Ross and Rubintein who applied binomial model for the option valuation. The Monte Carlo approach developed by Phelim (1977) simulating the process, in order to generate the returns on the underlying asset and invokes the risk neutrality assumption to derive the value of the option.
Path-dependent option is a security that payoff at exercise or at expiry depends on the past history of the underlying asset price as well as its spot price at exercise or expiry. There are several types of path-dependent options, such as binaries (or digital options), compounds, choosers, barriers, lookbacks and Asian options. These types of options are well developed for currency and oil exchange in the international financial markets nowadays.
This paper extends the Monte Carlo methods to Quasi Monte Carlo (QMC) method for the pathdependent option valuation. Section 2 illustrates the path-dependent nature of an option and how this property related to the low-discrepancy sequence. There is a brief introduction about the
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Halton and Sobol sequences. In the section 3, there is a case study about QMC approach for Asian option pricing and the implementation of MATLAB code.
The Model
When we are going to value a path-dependent option, the whole underlying asset path is required to be considered. The simulation need to generate a sequence of underlying price at each time instant. For example, 24 underlying monthly price need to be simulated for an option mature in 2 years which t equals to 1 month.
When the number of time instance increases, the dimension for the integration increases. It becomes a high-dimensional problem, which the lattice and PDE method are unable to be applied.
The number of dimensions d is the number of discrete time intervals of one sample path, so d = T/t where T is the time period between current and the maturity. A finer grid can be constructed by using a smaller t. It implies that a good normal distribution of Brownian motion of asset price path is able to be generated.
In this paper, Halton and Sobol sequence, which are low-discrepancy sequences with different deterministic model, will be applied in the QMC for path-dependent option pricing.
= (0. 0 1 2 3 4 ) =
% Halton.m generates low-discrepancy Halton sequence % NSteps = Number of steps (dimensions) between current and maturity % NRepl = Number of simulations per time instant function z_RandMat=Halton(NSteps,NRepl) % % % q
Halton sequences are obtained in multiple dimensions when a Van der Corput generator is associated to each dimension.
(, ) = (+1)
qrandstream is a MATLAB function that constructs quasi-random number stream Parameter Skip and Leap in function qrandstream skip the first 1000 values and then retains every 101st point = qrandstream('halton',NSteps,'Skip',1e3,'Leap',1e2);
% MATLAB function qrand generates quasi-random points from stream RandMat = qrand(q,NRepl); % z_RandMat generates a NReplxNSteps matrix which values are normally % inveresed of the Halton sequence points z_RandMat = norminv(RandMat,0,1); end Figure 1 Halton.m
MATLAB Statistics Toolbox is applied for the Halton sequence generation. Before the option pricing, underlying asset price path need to be constructed. Function Halton.m (Figure 1), qrandstream generates NSteps steps sequence and NRepl number of simulation for each time instant. The result
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matrix is in the interval [0,1]. The function norminv computes the inverse of the normal cumulative distribution function using the corresponding (0,1)at the corresponding Halton sequence value. Sobol Sequence Sobol sequence is complex and MATLAB Statistics Toolbox is applied for the random sequence generation, so the concept covered here is only brief. Let { } be the digital representation in base b=2, which is a binary number, of any integer n. The nth element of the Sobol sequence is defined as, =
=1 +
The ith number of the sequence , , {1, , }, is generated by XOR together the set of . Each Sobol sequence is based on a different primitive polynomial over the integers modulo 2, or a polynomial whose coefficients are either 0 or 1. Suppose p is such a polynomial of degree q, Where p is a polynomial of degree q = + 1 1 + 2 2 + + 1 + 1
1 2
where denotes the XOR operation. The starting values for the recurrence are 1 , , that are odd integers chosen arbitrarily and less than 2, , 2 , respectively. The directional number are given by, where is the maximum number of digits = , = 1, , 2
= 21 1 22 2 2 21 +1 + 1 (2 )
function z_RandMat=Sobol(NSteps,NRepl) q = qrandstream('sobol',NSteps,'Skip',1e3,'Leap',1e2); RandMat = qrand(q,NRepl); z_RandMat = norminv(RandMat,0,1); end Figure 2 Sobol.m
Sobol.m (Figure 2) is similar to Halton.m. The only difference is that the first parameter in function qrandstream is replaced halton by sobol.
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In the next section, there is a case study about the application of an Asian option pricing. Halton, Sobol and Pseudo sequence will be applied for the QMC. Different random sequences yield different pricing approximation results.
where is the discretization step and random variable ~ (0,1), which is generated by simulation. Geometric Brownian motion = +
1 = 2 + 2
Different Asian options may be devised, depending on how the average is computed. Furthermore, the average may be arithmetic or geometric. The discrete arithmetic average is demonstrated in this case study,
Discrete Averaging of the asset underlying [rice generated by Wiener process, = () = (log(0 )+ 1 1 {(1 ) + (2 ) + + ( )}
1 2 , ) 2
= max { , 0}
(log()) 12 2
For the conventional Monte Carlo method, pseudo random number is applied. Here is the MATLAB code, Pseudo.m (Figure 3), for pseudo random number sequence generation.
% Pseudo.m generates pseudorandom number sequence % NSteps = Number of steps (number of dimensions) between current and maturity % NRepl = Number of simulations per time instant function z_RandMat=Pseudo(NSteps,NRepl) % z_RandMat generates a NReplxNSteps matrix which values are normally % inveresed of the pseudorandom number z_RandMat = norminv(rand(NRepl,NSteps),0,1); end Figure 3 Pseudo.m
can be priced by analytic approximation by applying Edgeworth series expansion, however, we are not going to discuss this method in this paper, QMC as a case study instead.
Once the random sequence is generated, they can be inputted into the Wiener process. AsianC.m (Figure 4) firstly generates the underlying asset price path based on the geometric Brownian motion. The increment of underlying asset price changes with the random value. Then, it calculates the Asian option price by taking the arithmetic average for each time instant for each simulated path and discounts it back into the present value.
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In this case study, an option with $50.00 strike and matures in 2 years. The current price is $50.00, risk-free rate equals to 1.00%, and standard deviation is 40.00%. 50,000 underlying asset price paths will be generated by simulation.
% % % % % % % % % % AsianC.m approximates the Arithmetic Average Asian Call option price based on the Brownian motion of the underlying asset price with random sequence that generated by Pseudo.m , Halton.m or Sobol.m S0 = Current underlying asset price K = Strike Price mu = Risk-free rate T = Time between current and the maturity sigma = Square root of variance NSteps = Number of steps (dimensions) between current and maturity NRepl = Number of simulations per time instant
function P=AsianC(S0,K,mu,T,sigma,NSteps,NRepl) dt = T/NSteps; drift = (mu-0.5*sigma^2)*dt; vari = sigma*sqrt(dt); Increments = drift + vari*Halton(NSteps,NRepl); LogPaths = cumsum([log(S0)*ones(NRepl,1) , Increments] , 2); % Underlying asset price path SPaths = exp(LogPaths); Payoff = zeros(NRepl,1); Payoff = max(0, mean(SPaths(:,2:(NSteps+1)),2) - K); P = mean(exp(-mu*T) * Payoff); end Figure 4 AsianC.m
>> AsianC(50,50,0.01,2,0.4,24,50000)
8.5
7.5
Option Price
6.5
5.5
4.5
5,000
10,000
15,000
20,000
25,000
30,000
35,000
40,000
45,000
50,000
Number of Simulation
Figure 5
8.5
Option Price
7.5
6.5
5.5
5,000
10,000
15,000
20,000
25,000
30,000
35,000
40,000
45,000
50,000
Number of Simulation
Figure 6
The overall standard deviation of Halton sequence is lower than the Sobol sequence, but the variation is very small after 50,000 simulations. The result implies that the adoption of Halton or Sobol sequence in QMC is make-sense for the path-dependent option pricing, by comparing with pseudo random Monte Carlo method. Also, more simulations yield lower standard deviation and higher pricing approximation accuracy.
Standard deviation decreases across the range of number of simulation for the 3 random sequences (Figure 7). Their standard deviation drop continuously when the number of simulation increases. Obviously, the standard deviation of Halon and Sobol sequence are smaller that the pseudo random sequence. This statistical result explains the large frustration in pricing approximation by using conventional Monte Carlo method.
The option prices approximated by the three sequences are close together. The prices generated by the Halton and Sobol sequence tend to be stable after 50,000 times simulation. However, the frustration of price is very large by using pseudo random number, which is the default random sequence in Monte Carlo method (Figure 5, 6). It implies that exact solution is not available after mass simulation.
0.4
0.35
0.3
Standard Deviation
0.25
0.2
0.15
0.1
0.05
0 0-5,000
5,000-10,000
Figure 7
Conclusion
The application of Asian option pricing is just a small sample of possible problems for which QMC can provide more precise approximation for path-dependent option than conventional Monte Carlo methods with pseudo random number sequence in computational finance. It shows that QMC is a tailor-made method for path-dependent option pricing. It focuses on the particular path-dependent property. Other path-dependent options, like binaries (or digital options), compounds, choosers, barriers or lookbacks, can be priced by using QMC method. The implementation by using MATLAB provides an efficient way for random sequence generation, mass simulation and calculation.
References
Black, Fischer; Myron Scholes (1973). The Pricing of Options and Corporate Liabilities, Journal of Political Economy Boyle, Phelim P., (1977). Options: A Monte Carlo approach, Journal of Financial Economics, Elsevier, vol. 4(3) Cox, John C. & Ross, Stephen A. & Rubinstein, Mark, (1979). Option pricing: A simplified approach, Journal of Financial Economics, Elsevier, vol. 7(3)
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Kemna, A. G. Z. & Vorst, A. C. F., (1990). A pricing method for options based on average asset values, Journal of Banking & Finance, Elsevier, vol. 14(1) Morokoff, W. J. and Caflisch, R. E. (1994). Quasi-random sequences and their discrepancies, SIAM J. Sci. Comput. 15, 6 Rogers, L.C.G.; Shi, Z. (1995), The Value of an Asian Option, Journal of Applied Probability 32 (4) Niederreiter, Harald (1992), Random number generation and quasi-Monte Carlo methods, SIAM, p. 29
Harald G. Niederreiter (1978), Quasi-Monte Carlo methods and pseudo-random numbers, Bull. Amer. Math. Soc. 84, no. 6
Turnbull, Stuart M. & Wakeman, Lee Macdonald, (1991). A Quick Algorithm for Pricing European Average Options, Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 26(03), pages 377-389
Smith, Clifford Jr., (1976). Option Pricing: A review, Journal of Financial Economics, Elsevier, vol. 3(1-2)
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