P1: TIX/XYZ JWBK546-fm

P2: ABC JWBK546-Kienitz

August 21, 2012

11:11

Printer: Yet to come

Trim: 244mm 168mm

Introduction 1 2 3 4 5 6 7 8 Introduction and Management Summary Why We Have Written this Book Why You Should Read this Book The Audience The Structure of this Book What this Book Does Not Cover Credits Code

RI TE IG HT ED MA CO PY R
vii

AL
1 1 2 3 3 4 5 6 6 9 9 10 15 17 19 22 22 23 23 24 24 26 26 27 30 31 32

Contents

PART I

FINANCIAL MARKETS AND POPULAR MODELS

1 Financial Markets Data, Basics and Derivatives 1.1 Introduction and Objectives 1.2 Financial Time-Series, Statistical Properties of Market Data and Invariants 1.2.1 Real World Distribution 1.3 Implied Volatility Surfaces and Volatility Dynamics 1.3.1 Is There More than just a Volatility? 1.3.2 Implied Volatility 1.3.3 Time-Dependent Volatility 1.3.4 Stochastic Volatility 1.3.5 Volatility from Jumps 1.3.6 Traders Rule of Thumb 1.3.7 The Risk Neutral Density 1.4 Applications 1.4.1 Asset Allocation 1.4.2 Pricing, Hedging and Risk Management 1.5 General Remarks on Notation 1.6 Summary and Conclusions 1.7 Appendix Quotes

P1: TIX/XYZ JWBK546-fm

P2: ABC JWBK546-Kienitz

August 21, 2012

11:11

Printer: Yet to come

Trim: 244mm 168mm

viii

Contents

2 Diffusion Models 2.1 Introduction and Objectives 2.2 Local Volatility Models 2.2.1 The Bachelier and the BlackScholes Model 2.2.2 The HullWhite Model 2.2.3 The Constant Elasticity of Variance Model 2.2.4 The Displaced Diffusion Model 2.2.5 CEV and DD Models 2.3 Stochastic Volatility Models 2.3.1 Pricing European Options 2.3.2 Risk Neutral Density 2.3.3 The Heston Model (and Extensions) 2.3.4 The SABR Model 2.3.5 SABR Further Remarks 2.4 Stochastic Volatility and Stochastic Rates Models 2.4.1 The HestonHullWhite Model 2.5 Summary and Conclusions 3 Models with Jumps 3.1 Introduction and Objectives 3.2 Poisson Processes and Jump Diffusions 3.2.1 Poisson Processes 3.2.2 The Merton Model 3.2.3 The Bates Model 3.2.4 The BatesHullWhite Model 3.3 Exponential L evy Models 3.3.1 The Variance Gamma Model 3.3.2 The Normal Inverse Gaussian Model 3.4 Other Models 3.4.1 Exponential L evy Models with Stochastic Volatility 3.4.2 Stochastic Clocks 3.5 Martingale Correction 3.6 Summary and Conclusions 4 Multi-Dimensional Models 4.1 Introduction and Objectives 4.2 Multi-Dimensional Diffusions 4.2.1 GBM Baskets 4.2.2 Libor Market Models 4.3 Multi-Dimensional Heston and SABR Models 4.3.1 Stochastic Volatility Models 4.4 Parameter Averaging 4.4.1 Applications to CMS Spread Options 4.5 Markovian Projection 4.5.1 Baskets with Local Volatility 4.5.2 Markovian Projection on Local Volatility and Heston Models 4.5.3 Markovian Projection onto DD SABR Models

35 35 35 37 40 46 50 53 54 55 56 57 67 73 81 81 90 93 93 94 94 95 99 104 105 107 112 118 122 122 129 134 137 137 137 137 139 141 141 143 144 159 162 162 164

P1: TIX/XYZ JWBK546-fm

P2: ABC JWBK546-Kienitz

August 21, 2012

11:11

Printer: Yet to come

Trim: 244mm 168mm

Contents

ix

4.6 Copulae 4.6.1 Measures of Concordance and Dependency 4.6.2 Examples 4.6.3 Elliptical Copulae 4.6.4 Archimedean Copulae 4.6.5 Building New Copulae from Given Copulae 4.6.6 Asymmetric Copulae 4.6.7 Applying Copulae to Option Pricing 4.6.8 Applying Copulae to Asset Allocation 4.7 Multi-Dimensional Variance Gamma Processes 4.8 Summary and Conclusions PART II NUMERICAL METHODS AND RECIPES 5 Option Pricing by Transform Techniques and Direct Integration 5.1 Introduction and Objectives 5.2 Fourier Transform 5.2.1 Discrete Fourier Transform 5.2.2 Fast Fourier Transform 5.3 The CarrMadan Method 5.3.1 The Optimal 5.4 The Lewis Method 5.4.1 Application to Other Payoffs 5.5 The Attari Method 5.6 The Convolution Method 5.7 The Cosine Method 5.8 Comparison, Stability and Performance 5.8.1 Other Issues 5.9 Extending the Methods to Forward Start Options 5.9.1 Forward Characteristic Function for L evy Processes and CIR Time Change 5.9.2 Forward Characteristic Function for L evy Processes and Gamma-OU Time Change 5.9.3 Results 5.10 Density Recovery 5.11 Summary and Conclusions 6 Advanced Topics Using Transform Techniques 6.1 Introduction and Objectives 6.2 Pricing Non-Standard Vanilla Options 6.2.1 FFT with Lewis Method 6.3 Bermudan and American Options 6.3.1 The Convolution Method 6.3.2 The Cosine Method 6.3.3 Numerical Results 6.3.4 The Fourier Space Time-Stepping

172 174 175 175 177 179 179 180 180 187 193

197 197 197 199 200 202 207 210 214 215 216 220 228 233 235 238 239 242 245 250 253 253 253 254 254 257 258 266 270

P1: TIX/XYZ JWBK546-fm

P2: ABC JWBK546-Kienitz

August 21, 2012

11:11

Printer: Yet to come

Trim: 244mm 168mm

Contents

6.4 The Cosine Method and Barrier Options 6.5 Greeks 6.6 Summary and Conclusions 7 Monte Carlo Simulation and Applications 7.1 Introduction and Objectives 7.2 Sampling Diffusion Processes 7.2.1 The Exact Scheme 7.2.2 The Euler Scheme 7.2.3 The Predictor-Corrector Scheme 7.2.4 The Milstein Scheme 7.2.5 Implementation and Results 7.3 Special Purpose Schemes 7.3.1 Schemes for the Heston Model 7.3.2 Unbiased Scheme for the SABR Model 7.4 Adding Jumps 7.4.1 Jump Models Poisson Processes 7.4.2 Fixed Grid Sampling (FGS) 7.4.3 Stochastic Grid Sampling (SGS) 7.4.4 Simulation L evy Models 7.4.5 Schemes for L evy Models with Stochastic Volatility 7.5 Bridge Sampling 7.6 Libor Market Model 7.7 Multi-Dimensional L evy Models 7.8 Copulae 7.8.1 Distributional Sampling Approach (DSA) 7.8.2 Conditional Sampling Approach (CSA) 7.8.3 Simulation from Other Copulae 7.9 Summary and Conclusions 8 Monte Carlo Simulation Advanced Issues 8.1 Introduction and Objectives 8.2 Monte Carlo and Early Exercise 8.2.1 LongstaffSchwarz Regression 8.2.2 Policy Iteration Methods 8.2.3 Upper Bounds 8.2.4 Problems of the Method 8.2.5 Financial Examples and Numerical Results 8.3 Greeks with Monte Carlo 8.3.1 The Finite Difference Method (FDM) 8.3.2 The Pathwise Method 8.3.3 The Afne Recursion Problem (ARP) 8.3.4 Adjoint Method 8.3.5 Bermudan ARPs 8.4 Euler Schemes and General Greeks 8.4.1 SDE of Diffusions 8.4.2 Approximation by Euler Schemes

277 278 287 289 289 289 290 290 290 291 291 292 294 300 313 313 315 315 322 330 339 346 351 352 353 356 358 359 361 361 361 362 369 374 376 378 382 383 385 389 391 393 396 396 397

P1: TIX/XYZ JWBK546-fm

P2: ABC JWBK546-Kienitz

August 21, 2012

11:11

Printer: Yet to come

Trim: 244mm 168mm

Contents

xi

8.4.3 Approximating General Greeks Using ARP 8.4.4 Greeks 8.5 Application to Trigger Swap 8.5.1 Mathematical Modelling 8.5.2 Numerical Results 8.5.3 The Likelihood Ratio Method (LRM) 8.5.4 Likelihood Ratio for Finite Differences Proxy Simulation 8.5.5 Numerical Results 8.6 Summary and Conclusions 8.7 Appendix Trees 9 Calibration and Optimization 9.1 Introduction and Objectives 9.2 The NelderMead Method 9.2.1 Implementation 9.2.2 Calibration Examples 9.3 The LevenbergMarquardt Method 9.3.1 Implementation 9.3.2 Calibration Examples 9.4 The L-BFGS Method 9.4.1 Implementation 9.4.2 Calibration Examples 9.5 The SQP Method 9.5.1 The Modied and Globally Convergent SQP Iteration 9.5.2 Implementation 9.5.3 Calibration Examples 9.6 Differential Evolution 9.6.1 Implementation 9.6.2 Calibration Examples 9.7 Simulated Annealing 9.7.1 Implementation 9.7.2 Calibration Examples 9.8 Summary and Conclusions 10 Model Risk Calibration, Pricing and Hedging 10.1 Introduction and Objectives 10.2 Calibration 10.2.1 Similarities Heston and Bates Models 10.2.2 Parameter Stability 10.3 Pricing Exotic Options 10.3.1 Exotic Options and Different Models 10.4 Hedging 10.4.1 Hedging The Basics 10.4.2 Hedging in Incomplete Markets 10.4.3 Discrete Time Hedging 10.4.4 Numerical Examples 10.5 Summary and Conclusions

397 404 407 408 410 413 416 419 433 434 435 435 437 442 444 449 453 455 460 463 464 468 473 475 477 482 487 488 493 497 500 505 507 507 508 508 511 521 528 528 531 533 541 544 550

P1: TIX/XYZ JWBK546-fm

P2: ABC JWBK546-Kienitz

August 21, 2012

11:11

Printer: Yet to come

Trim: 244mm 168mm

xii

Contents

PART III IMPLEMENTATION, SOFTWARE DESIGN AND MATHEMATICS 11 Matlab Basics 11.1 Introduction and Objectives 11.2 General Remarks 11.3 Matrices, Vectors and Cell Arrays 11.3.1 Matrices and Vectors 11.3.2 Cell Arrays 11.4 Functions and Function Handles 11.4.1 Functions 11.4.2 Function Handles 11.5 Toolboxes 11.5.1 Financial 11.5.2 Financial Derivatives 11.5.3 Fixed-Income 11.5.4 Optimization 11.5.5 Global Optimization 11.5.6 Statistics 11.5.7 Portfolio Optimization 11.6 Useful Functions and Methods 11.6.1 FFT 11.6.2 Solving Equations and ODE 11.6.3 Useful Functions 11.7 Plotting 11.7.1 Two-Dimensional Plots 11.7.2 Three-Dimensional Plots Surfaces 11.8 Summary and Conclusions 553 553 553 556 556 562 564 564 567 570 570 571 571 573 577 578 581 589 589 589 591 593 593 595 597

12 Matlab Object Oriented Development 12.1 Introduction and Objectives 12.2 The Matlab OO Model 12.2.1 Classes 12.2.2 Handling Classes in Matlab 12.2.3 Inheritance, Base Classes and Superclasses 12.2.4 Handle and Value Classes 12.2.5 Overloading 12.3 A Model Class Hierarchy 12.4 A Pricer Class Hierarchy 12.5 An Optimizer Class Hierarchy 12.6 Design Patterns 12.6.1 The Builder Pattern 12.6.2 The Visitor Pattern 12.6.3 The Strategy Pattern 12.7 Example Calibration Engine 12.7.1 Calibrating a Data Set or a History

599 599 599 599 606 607 609 610 611 613 618 620 621 624 626 629 631

P1: TIX/XYZ JWBK546-fm

P2: ABC JWBK546-Kienitz

August 21, 2012

11:11

Printer: Yet to come

Trim: 244mm 168mm

Contents

xiii

12.8 Example The Libor Market Model and Greeks 12.8.1 An Abstract Class for LMM Derivatives 12.8.2 A Class for Bermudan Swaptions 12.8.3 A Class for Trigger Swaps 12.9 Summary and Conclusions 13 Math Fundamentals 13.1 Introduction and Objectives 13.2 Probability Theory and Stochastic Processes 13.2.1 Probability Spaces 13.2.2 Random Variables 13.2.3 Important Results 13.2.4 Distributions 13.2.5 Stochastic Processes 13.2.6 L evy Processes 13.2.7 Stochastic Differential Equations 13.3 Numerical Methods for Stochastic Processes 13.3.1 Random Number Generation 13.3.2 Methods for Computing Variates 13.4 Basics on Complex Analysis 13.4.1 Complex Numbers 13.4.2 Complex Differentiation and Integration along Paths 13.4.3 The Complex Exponential and Logarithm 13.4.4 The Residual Theorem 13.5 The Characteristic Function and Fourier Transform 13.6 Summary and Conclusions List of Figures List of Tables Bibliography Index

634 634 637 639 641 643 643 643 644 644 645 649 654 655 660 665 665 670 671 671 672 673 674 675 679 681 691 695 705

P1: TIX/XYZ JWBK546-fm

P2: ABC JWBK546-Kienitz

August 21, 2012

11:11

Printer: Yet to come

Trim: 244mm 168mm

xiv