Implied Volatility from Asian Options

via Monte Carlo Methods

Christian-Oliver Ewald
1,1
, Zhaojun Yang
2,2
, Yajun Xiao
33
1
School of Economics and Finance, University of St.Andrews, St. Andrews,
KY16 9AL, UK (e-mail: c.o.ewald@st-andrews.ac.uk)
2 School of Economics and Trade, Hunan University, 410079, Changsha,
China (e-mail: zjyang@hnu.cn)
3 Department of Economics and Finance, Goethe University of Frankfurt,
Merton Str. 17/21, 60054 Frankfurt (e-mail: xiao@nance.uni-frankfurt.de)
Abstract
We discuss how implied volatilities for OTC traded Asian options can
be computed by combining Monte Carlo techniques with the Newton
method in order to solve nonlinear equations. The method relies on ac-
curate and fast computation of the corresponding vegas of the option.
In order to achieve this we propose the use of logarithmic derivatives
instead of the classical approach. Our simulations document that the
proposed method shows far better results than the classical approach.
Furthermore we demonstrate how numerical results can be improved
by localization.
Keywords: implied volatility, Monte Carlo simulation, Asian options, ex-
otic options, calibration, local volatility
Mathematics Subject Classication: 91B28, 60H30, 65H05
JEL Subject Classication: C00, C15, C19, C51, C61
1
The rst author gratefully acknowledges support from BBSRC research grant 28132
as well as the research grant Dependable adaptive systems and mathematical modeling,
Rheinland-Pfalz Excellence Cluster and DFG Grant 529817. Furthermore the rst author
would like to thank Ralf Korn and Olaf Menkens for many suggestions and fruitful discus-
sions as well as an anonymous referee for many suggestions which helped to signicantly
improve the original article.
2
The second author gratefully acknowledges grants from Natural Science Fund ( No.
04JJ3009 ) of Hunan Province/China and Chinese Social Science Fund ( No. 06BJL022 ) as
well as support from the Economic Opening and Trade Development project, Philosophy
and Social Science Innovation Foundation of Hunan University 985 Engineering.
3
The third author gratefully acknowledges a grant from the Graduate Program Fi-
nance and Monetary Economics of the Goethe University Frankfurt
1 Introduction
1.1 Asian options
Asian options are options where the payo depends on the average of the
underlying asset during at least some part of the life time of the option.
The average can be taken in several ways, each leading to a dierent type
of Asian option. According to the Handbook of Exotic Options [13] the
name Asian option was coined by employees of Bankers Trust, which sold
this type of options to Japanese rms that wanted to hedge their foreign
currency exposure. These rms used these options because their annual
reports were also based on average exchange rates over the year. Average
type options are particularly suited to hedge risk at foreign exchange markets
and by reason of the averaging eect, signicantly cheaper than plain vanilla
options. Eectively such options are traded since the mid 1980s and rst
appeared in the form of commodity linked bonds. Specic examples are the
Mexican Petro Bond and the Delaware Gold Index Bond. Asian options are
OTC traded, however market and trading volume appear to grow very fast. A
recent study of CIBC world markets revealed that Asian style options are the
most commonly traded exotic options. Similar statements can be found in the
Handbook of Exotic Options [13]. In the Black-Scholes model, the technically
easiest case to consider is where the average is a geometric average. Since
the product of log-normal distributed random variables is again log-normal
distributed, explicit analytical expressions are available for the price of such
options as well as the derivative of the price with respect to the volatility
parameter, the so called vega. As is shown in this article, vegas can be
used to compute implied volatilities from Asian options, which then in eect
can be used to calibrate local volatility models or interpolate prices of less
traded Asian options from liquid ones by applying the Black-Scholes model
locally. The most eective way to compute vegas in the case where there are
analytical formulas available is obviously to use these formulas. Our paper
is mainly concerned with the case, where no such formulas are available.
Therefore we do not consider the type of geometric average Asian option
1
further. The other type involves the arithmetic average. This average can
be taken either continuously or discretely. An option of continuous average
type is represented by the following example
_
1
T
_
T
0
S
t
dt K
_
+
continuous average price call.
The continuous average type is of particular importance, since the Black-
Scholes partial dierential equation can be easily modied in order to obtain
a Black-Scholes like partial dierential equation for the prices. However, in
contrast to the standard Black-Scholes partial dierential equation, it is not
possible to nd a closed form solutions for this PDE. On the other side it
has to be said, that the continuous average type is neither traded at any
nancial market nor between any two nancial institutions and in a way
only represents an approximation of the discrete average type, which looks
as follows
_
1
n
n

i=1
S
t
i
K
_
+
discrete average price call
where 0 = t
0
< t
1
< t
2
< ... < t
n
= T. More general options are of the
following type g
_
1
n

n
i=1
S
t
i
_
with a certain payo prole g. A particular
important case is the case of a digital discrete average call, where the payo
prole is the same as in a standard digital call, i.e.
g(x) =
_
1 if x K
0 else.
1.2 Why implied volatility from Asian options ?
The lack of an institutionalized markets for Asian options on one side, and
their growing popularity on the other side make it important to nd appro-
priate methods for the calibration of the models which are used to price them.
Among nancial institutions the most popular models for pricing Asian op-
tions nowadays seem to be local volatility models. A common mistake which
2
is often made by nancial institutions and traders is that for the calibration
of the volatility surfaces implied volatilities from corresponding European
call options are used, while implied volatilities from other related or previ-
ously traded Asian options are left out. The former are easier to compute,
but there is no reason whatsoever, why the implied volatilities from Euro-
pean call options should lead to a good model for pricing Asian options. In
a consistent local volatility model for pricing Asian options, implied volatil-
ities from Asian options must be taken into account. If the objective is to
interpolate less traded Asian options from relatively liquid ones, this aspect
appears even more important. Only when implied volatilities for the liquid
Asian options are used and not those of plain vanilla options, a good approx-
imation can be expected. This paper shows how one can compute implied
volatilities from Asian options in an eective and easy to implement way.
The idea is to combine a standard Newton method in combination with an
ecient method for the computation of vegas of Asian options.
1.3 Relations to other results
Ecient methods to compute certain Greeks by making use of Malliavin cal-
culus have been presented in [8]. In fact, in this reference ecient formulas
for the computation of the vega of a European call as well as the Delta of
a continuous type Asian options under the assumption of either a Wiener
model or a standard Black-Scholes model are given. However an explicit
formula for the vega of a discrete type arithmetic Asian option is missing.
Furthermore we think that for a standard Black-Scholes model based on ge-
ometric Brownian motion, where distribution and density are well known,
the application of Malliavin calculus techniques is not really necessary and
we therefore avoid it entirely in this article. Nevertheless we think that
Malliavin calculus techniques play an important role in advanced models,
such as stochastic volatility models, see [5] and [6]. A signicant amount
of research has been carried out in order to nd eective ways how to com-
pute implied volatilities for the case of standard European call options, see
[12] for an overview of existing techniques and formulas. To our awareness
3
however, nothing has been done so far in addressing the case of Asian op-
tions specically. This article presents in a way a rst step into this direction.
1.4 Outline of the article
The paper is structured in the following way. In section 2 we summarize
some facts about implied volatility and indicate various ways to compute it.
Section 3 covers what we call the logarithmic derivative trick, which basically
shows an alternative way on how to compute the derivative of an expectation
with respect to a parameter in the density function. We apply the idea of the
logarithmic derivative trick in section 4 in order to give an alternative to the
classical method for the computation of the vega of a discrete average Asian
option. In section 5, we discuss how the proposed method can be improved
by means of localization and other variance reduction methods. Section 6
contains a discussion of our numerical results and section 7 summarizes our
conclusions. The appendix contains two technical computations as well as
all the gures.
2 Implied Volatility
2.1 Black-Scholes model
Let us consider the following one dimensional standard Black-Scholes model,
which consists of one stock (S
t
) and one bond (B
t
) satisfying the following
price dynamics
dS
t
= S
t
(bdt + dW
t
) (1)
dB
t
= B
t
rdt.
We assume that the interest rate r, the drift term b and the volatility are
constant. This is the most elementary ( reasonable ) continuous time market
model mathematical nance has to oer. On the other side it is still the
most popular model among traders at real markets, in particular for pricing
4
options with complicated payo proles. It is well known that the unique
arbitrage free price at time t < T for a European call option
h(S
T
) = (S
T
K)
+
= max(S
T
K, 0)
with expiry T and strike K is given by the Black-Scholes formula
C(t) = S
t
(d
1
(t)) K e
r(Tt)
(d
2
(t)) (2)
with the following notation :
d
1
(t) =
ln
_
S
t
K
_
+
_
r +
1
2

2
_
(T t)

T t
, d
2
(t) = d
1
(t)

T t.
For various other options though no explicit solution formulas are known and
one is bound to use techniques such as Monte Carlo simulation in order to
compute approximations of fair prices. Such options include Asian options
which we discussed in the introduction. In any case though, the price will
depend on the parameters r and ( but not on b as is well known ). It will be
useful in the following to consider expression (1), or more general the price of
an arbitrary option, as a function of t,T, and K, i.e. C(t) = C(t, T, , K).
2.2 Implied volatility
A natural assumption is, that the interest rate is observable, so there will
be no problem to determine r. The parameters t, T and K are xed in the
option contract and therefore not up for discussion. But how to determine
the volatility that relates to the prices observed at the market. There are
various ways to do this, one is the following : Let us for example observe the
price C
obs
(t, T, K) of the specied option with expiry T and strike price K
at time t at the market and solve the equation
C(t, T, , K) = C
obs
(t, T, K) (3)
5
for . This is called an implied volatility and often depends on t, T
and K in a non trivial way, contradicting the Black-Scholes assumption of
constant volatility. This eect is well known under the name volatility
smile. Application of the classic Black-Scholes model can be justied in the
way that it is used to interpolate prices for less liquid options and in a sense
is only applied locally. What is often neglected is that also depends on
the type of the option. Whether the option is European, Asian or else has
a signicant eect on the implied volatility. We may use this in order to
compute a price for another option which is not currently listed on a nancial
market but traded OTC and in some sense which we do not specify here is
close to the observed option. As the standard Black-Scholes model can be
seen at least as an approximation of the market, we can expect that the
computed price is the better, the more similar the observed option is to the
new option which is going to be priced. This fact leads us to the conclusion,
that in order to keep mispricing by application of the Black-Scholes model to
a minimum, one has to consider carefully which options one should observe
and use for the computation of implied volatilities. For general Asian options
we postulate to use xed strike Asian options instead of standard European
calls in order to compute implied volatilities and in the following sections we
derive an ecient method how to do this. The technique we are going to
discuss can in fact be used to compute whole volatility surfaces from Asian
options in complete analogy to the case of European calls, which may then
be used in order to setup a local volatility model. However these extensions
are easy to implement and in the following sections we concentrate on the
case of a single implied volatility from one Asian option and omit T and K
in the notation of observed prices, i.e. C
obs
(t) = C
obs
(t, T, K). In the case of
a plain vanilla European call, the derivative of the price C(t, T, , K) with
respect to is given by the following analytical expression

C(t, T, , K) = S
t

T t

(d
1
). (4)
This expression, the vega of a plain vanilla European call option, is always
strictly positive and therefore Equation (3) has at most one solution for .
6
It can be shown, that there exists a solution of equation (3) whenever C
obs
(t)
is contained in the open interval
_
(S
t
Ke
r(Tt)
_
+
, S
t
) ( see [3], page 8
). In this case the solution is called the implied volatility for this option
and is denoted
impl
. For the case of an Asian option existence and unique-
ness of a solution of Equation (3) is not obvious. The uniqueness follows
from Lemma 8.1 in the technical appendix. We are particular thankful to
Peter Carr who suggested the maximum principle in order to prove this re-
sult. Note that the result in Lemma 8.1 is not obvious and that the naive
argument, which goes uncertainty increases with the volatility parameter
and as the payo is bounded from below, but has unlimited upward po-
tential, the price of an arithmetic average Asian call option increases is
in general wrong, see Carr [2], pages 19-21 for a counter example. Exis-
tence of a solution to equation (3) however follows in analogy with the case
of a European call option, as long as the observed price is in the interval
_
(S
t

1
n

n
i=1
e
r(Tt
i
)
Ke
r(Tt)
)
+
, S
t

1
n

n
i=1
e
r(Tt
i
)
_
.
2.3 Newton method and alternatives
How to compute implied volatilities ? Even in the case of a European call op-
tion, where an analytic formula for the option price exists, no analytical form
for the solution of Equation (3) can be obtained. However we can compute
its zeros numerically by applying the Newton method which guarantees local
convergence. This means that we dene an iterative sequence
k
starting
with
0
> 0 some positive value and

k+1
=
k

C(t, T,
k
, K) C
obs
(t)

C(t, T,
k
, K)
(5)
In the case of a European call, all expressions in this iteration scheme are in
analytical form and the scheme is ( neglecting rounding or machine errors )
essentially deterministic. Nevertheless, even in this case care must be taken
with regard to the choice of the starting value as the convergence of the
scheme is only local. The function C(t, T, , K) has a saddle point at
_
2
T

S
t
e
r(Tt)
K

and is convex to the left of this saddle point and concave to

7
the right. The Newton scheme converges to the implied volatility as long
as the starting value has been chosen on this side of the saddle point which
contains the implied volatility. In the case of an Asian option it is not known
in which regions we nd concavity and in which regions we nd convexity.
In this case nding a sucient close starting value is very important. We
propose the following: As starting value of the iteration (5) for an Asian
arithmetic average call, use the implied volatility from a related geometric
average Asian option, for which closed form solutions for price and vega exist,
see for example Wilmott [17], page 442. If the price of such an option is not
available, the implied volatility of a plain vanilla European call may serve
as an initial value. In the case of an Asian option the expressions in the
iteration scheme (5) need to be computed by Monte Carlo simulations. We
show how this can be done eectively in the following sections. Unfortunately,
the inaccuracy of the Monte Carlo method causes errors, which theoretically
can cause the iterative scheme (5) to leave the convergence range, even if the
starting value has been chosen within the range of convergence of the scheme.
In our numerical experiments we havent experienced this, if the scheme was
divergent it was mainly because the starting point was chosen to far from
the implied volatility. Figures 13 to 16 show, that the Monte Carlo error
is actually rather small, consistently throughout a range of volatilities. On
the other side we think that the problems related to Monte Carlo inaccuracy
cant be avoided. There are three obvious alternatives to the Newton method,
which are the classical bisection method, the secant method and the Brent
method, which is eectively a combination of the rst two, see [1]. These
methods have slower convergence rates but do not depend on the computation
of vegas. However they naturally depend on the evaluation of the objective
function. In the case of an Asian call option this evaluation can only be
done by Monte Carlo simulation. In the case of the secant method, the
Monte Carlo error is signicantly increased by the error which is made by
approximating the tangent with the secant. In case of the bisection method a
wrong interval may be chosen due to the Monte Carlo error and the method
may converge against the wrong value or not at all. Monte Carlo errors
therefore eect all the known schemes more or less in the same way, while
8
the advantageous of the classical Newton method, quadratic convergence if
no errors are present, remain.
3 The logarithmic derivative trick
3.1 Logarithmic derivative
Let us consider a family of R
n
-valued square integrable random variables
X

where is a parameter chosen from a parameter set R and let h :

R
n
R be a function. For reasons which will become clear in the following
section, we are interested in the derivative of the expectation E(h(X

)) with
respect to . Obviously, such a derivative will only exist under appropriate
assumptions on the laws of X

for and the function h. The following

proposition shows how the derivative

E(h(X

)) can be computed without

dierentiating h.
Proposition 3.1. Denote the law of X

with respect to the Lebesgue measure

on R
n
with P

and assume that for all the measure P

has a density
f(, ) with respect to satisfying the following conditions :
1. f(x, ) has full support for all , i.e. f(x, ) > 0 for all x R
n
and
2. f(x, ) is a continuous function in x and and continuously dieren-
tiable with respect to
3. h(X

) L
1
().
Dene the following random variable w

: R as w

log(f(X

, )).
Then

E(h(X

)) = E(h(X

) w

).
Proof. It follows from assumptions 1 and 2, that the expression

log(f(x, ))
is well dened and satises

f(x, ) =

log(f(x, )) f(x, ). We conclude

from our assumptions that
9

E(h(X

)) =

h(x)f(x, )d(x) =
_

h(x)

f(x, )d(x)
=
_

h(x)

(log(f(x, ))f(x, )d(x) = E(h(X

) w

).
3.2 Application to European options
Let us now demonstrate this technique at the example of a stock in the
standard Black-Scholes model as discussed in section 2.1 and a European
style contingent claim g(S
T
) with expiry time T, satisfying g(S
T
) L
1
. This
serves only as an illustration, we will later consider the general case of a
discrete type Asian option. The special case of a European call will allow
us however to compare our technique with formulas presented in [8] which
are based on the application of Malliavin calculus. We assume that we are
already in the risk neutral setting and that the stock-price is given by
S
t
= S
0
exp
_
W
t
+
_
r
1
2

2
_
t
_
.
We consider a European style contingent claim g(S
T
) with expiry time T,
satisfying g(S
T
) L
1
. If we want to make the dependence of S
t
on the
volatility parameter explicit, we write S

t
. In most cases however we omit
in the notation. Let us dene the function h : R
+
R
+
via h(x) :=
g(S
0
exp(x)) and the family of random variables X

for R
+
via
X

= W
T
+
_
r
1
2

2
_
T.
Clearly X

N
__
r

2
2
_
T,
2
T
_
for all , i.e. X

is standard normal
distributed with mean
_
r

2
2
_
T and variance
2
T. In this case the family
of densities in the previous proposition is given as
10
f(x, ) =
1

2T
exp
_

_
x
_
r
1
2

2
_
T
_
2
2
2
T
_
.
Taking the logarithm and dierentiating with respect to yields

ln f(x, ) =
_
x
_
r
1
2

2
_
T
_
2

3
T

_
x
_
r
1
2

2
_
T
_

.
Furthermore by substituting X

for x we obtain

ln f(X

, ) =
W
2
T
T
W
T

1

=: w

.
This is exactly the same weight function as derived in [8], page 405, by
means of Malliavin calculus. Applying Proposition 3.1. therefore leads to
the following result :

E(g(S

T
)) =

E(h(X

)) = E(g(S

T
)w

) = E
_
g(S

T
)
_
W
2
T
T
W
T

1

__
.
As is well known, the arbitrage free price at time t = 0 of a European option
g(S
T
) in the model from section 2 can be computed by taking the discounted
expectation E
_
e
rT
g(S

T
)
_
where the drift term b of the stock is replaced by
the interest rate r ( as in this section ). This gives the following alternative
expression for the term in equation (4) :

C(0, T, , K) = e
rT
E((S

T
K)
+
w

) (6)
The expression in equation (6) can then be computed by running Monte Carlo
method. Corresponding formulas for the case t > 0 are derived similarly,
using conditional expectations instead of unconditional ones.
11
4 Computing vegas from Asian options
4.1 Classical approach
Let us now consider an Asian option which is of the type g
_
1
n

n
i=1
S
t
i
_
,
where g : R R is a measurable function, satisfying g
_
1
n

n
i=1
S
t
i
_
L
1
().
We assume that the stock price dynamic is given by equation (1). The
classical approach to compute the vega in this case where no closed form
solutions are available and where one has to rely on Monte Carlo method
instead is as follows : Without loss of generality we assume that the interest
rate is equal to zero and that the time point we are considering is t = 0.
Otherwise we just have to include an appropriate discount factor, similar as
in (6), and use conditional expectations instead of unconditional ones. The
price of the option is then given by E
_
g
_
1
n

n
i=1
S
t
i
__
. We have to compute
the expression

E
_
g
_
1
n

n
i=1
S
t
i
__
. We assume for the moment that the
payo function g is continuously dierentiable with bounded derivative. This
restriction will later be lifted. In this case however we have

S
t
i
=

_
S
0
exp
_
W
t
i
+
_
r
1
2

2
_
t
i
__
= S
t
i
(W
t
i
t
i
). (7)
and therefore by interchanging dierentiation and expectation

E
_
g
_
1
n
n

i=1
S
t
i
__
= E
_
g

_
1
n
n

i=1
S
t
i
_

1
n
n

i=1
S
t
i
(W
t
i
t
i
)
_
. (8)
For technicalities on the justication of interchanging dierentiation and ex-
pectation see [5] or [6]. Formally this approach works only if the payo
function is dierentiable. For most payo proles of options traded on mar-
kets the condition for the payo function g to be continuously dierentiable
is not satised. However formula (8) still holds in the case when g is a payo
function like that of a European call. The derivative is then understood as a
12
left derivative. Taking g(x) = (x K)
+
one obtains the following formula :

E
__
1
n
n

i=1
S
t
i
K
_
+
_
= E
_
1
{
1
n

n
i=1
S
t
i
>K}

1
n
n

i=1
S
t
i
(W
t
i
t
i
)
_
.
This expression can now be calculated by Monte Carlo method. The re-
sults obtained for the case where g corresponds to the payo of a standard
European call are quite satisfying, see Figure 7 in the Appendix.
4.2 Problems with the classical approach
The singularity at the strike price of the payo function however can lead
us into trouble, if the slope of the payo function at the strike price is very
large. In the following we illustrate this problem. Let us consider an option
with payo prole
g(x) =
_

_
0 if x K
x(K)
2
if K < x K +
1 if K + < x
Figure 1 in the appendix illustrates this payo prole for the choice of = 2.
The series of gures ( Figure 2-5 ) documents that the classical approach
becomes very problematic if the is chosen to be small. The blue crosses
indicate the results for the vegas depending on the value of the volatility
obtained with the classical approach. The red line shows the exact values,
which in this case can be obtained since the option can be implemented
by holding a portfolio consisting of a combination of European call options,
and the green dots show the results of the method based on the logarithmic
derivative trick which we introduced in section 3.1. In the extreme case where
we choose = 0 the payo function g corresponds to a digital call and the
derivative g

of g has to be replaced with a Dirac functional. In a Monte Carlo

simulation the Dirac functional can not be used. Instead one has to use an
approximation of the payo prole as discussed above. Our numerical results
show however that this approximation is indeed numerically very unstable if
13
combined with the classical approach to compute the vega.
4.3 Vegas for Asian options via logarithmic derivative
The approach using the logarithmic derivative appears to produce much bet-
ter results. Adapting the discussion in section 3.1 to the case of an Asian
option leads to the following formula for its vega:

E
_
g
_
1
n
n

i=1
S
t
i
__
= E
_
g
_
1
n
n

i=1
S
t
i
_
w

_
(9)
with the weight function
w

= (t
1
, .., t
n
)
1
(W
t
1
, .., W
t
n
)

+
1

(W
t
1
, .., W
t
n
)
1
(W
t
1
, .., W
t
n
)

.
where = (
ij
) denotes the matrix with entries
ij
= min(t
i
, t
j
). For a
derivation of the formula we refer to the technical Appendix. Of particular
importance is the case, where the evaluation times t
i
are equidistant, i.e.
t
i
=
iT
n
. With =
T
n
the matrix is then given by
=
_
_
_
_
_
_
_
_
_
_
_
_
_
1 1 1 1
1 2 2 2
1 2 3 3



1 2 3 4 n
_
_
_
_
_
_
_
_
_
_
_
_
_
and the inverse
1
is given by
14

1
=
1

_
_
_
_
_
_
_
_
_
_
_
_
_
_
_
_
2 1 0 0 0
1 2 1 0 0
0 1 2 1 0 0



0 0 0 0 1 2 1
0 0 0 0 0 1 1
_
_
_
_
_
_
_
_
_
_
_
_
_
_
_
_
i.e.
1
=
1

1
with

1
being a tridiagonal matrix with the upper
and lower diagonal only consisting of 1s and the diagonal consisting of 2s
except of the last diagonal entry which is 1. This special structure of the
matrix
1
signicantly simplies the computation of the expression w

.
5 Localization and variance reduction
5.1 Mixing logarithmic derivative with the classical
approach
We showed in the last section, that in the case where the payo function g is
continuously dierentiable, there are at least two possibilities to compute the
derivative

E
_
g
_
1
n

n
i=1
S
t
i
__
. The numerical experiments indicate, that in
the case when the payo function is smooth, the classical method ( formula
(8) ) shows better results, whereas the logarithmic derivative method ( for-
mula (9) ) proves to be better, when the payo function g is highly irregular.
Similar observations have been made in [8]. An intuitive explanation for this
is the following : On the right hand side of equation (9) the weight func-
tion w

which includes powers of order one and two of the Brownian motion
produces additional variance and in this way slows down the Monte Carlo
simulation. On the right hand side of equation (8) we only observe powers
of order one, resulting in less variance and eectively faster Monte Carlo
convergence. If the function g is very regular, its derivative g

has good an-

alytical properties and formula (8) should be preferred to formula (9). This
15
advantage however is more than oset, if the payo function g is irregular
and its derivative has to be replaced by a box approximation of a Dirac-type
functional or something similar. In this case formula (9) is the better choice.
In order to get optimal results, one should therefore split the payo function
g into a regular part g
reg
, which is continuously dierentiable with bounded
derivatives and a singular part g
sing
, which contains all the singularities of g,
i.e. g(x) = g
reg
(x) + g
sing
(x). We assume that g
sing
satises the conditions
in Proposition 3.1. In this case we can write

E
_
g
_
1
n
n

i=1
S
t
i
__
=

E
_
g
reg
_
1
n
n

i=1
S
t
i
__
+

E
_
g
sing
_
1
n
n

i=1
S
t
i
__
= E
_
g

reg
_
1
n
n

i=1
S
t
i
_

1
n
n

i=1
S
t
i
(W
t
i
t
i
)
_
+ E
_
g
sing
_
1
n
n

i=1
S
t
i
_
w

_
using formulas (8) and (9) respectively for the regular and singular part of
g. The decomposition of g into g
reg
and g
sing
is obviously not unique and
one can therefore experiment which decomposition gives the best results.
Analytical methods how to nd the best decomposition are work in progress.
In a way, the logarithmic derivative method is only locally applied, where the
function g behaves badly. One therefore speaks of localization of the method.
We will illustrate the method of localization at two examples. In the rst
one the payo function g corresponds to that of a European call option, i.e.
g(x) = (x K)
+
. For > 0 we dene
g
reg
(x) =
_

_
0 if x K
1
4
x
2

K
2
x +
(K)
2
4
if K x K +
x K if K + x
and g
sing
(x) = g(x) g
reg
(x). Figure 6 in the appendix shows this function
for the case where K = 10 and = 2. In our numerical simulation the
improvement due to localization in the case of an arithmetic average Asian
16
option with European call type of payo has only been minor. The eect
of localization is more signicant, if the slope of the payo increases near
the singularity. Figure 7 in the appendix shows the numerical results for the
computation of the vega with the three methods discussed. The number of
time steps in the average has been chosen n = 1 in order to compare the
results of the various methods with the analytically formula which is known
in this case.
5.2 Example: Digital call
In order to show that localization really has a major eect on the quality
of the computation let us now consider the case where the payo function g
corresponds to the payo of a digital call. Figure 8 in the appendix shows a
localization function for this case. The function g
reg
(x) for this case is given
explicitly by
g
reg
(x) =
_

_
0 if x <

1
4
3
x
3
+
3
4
x +
1
2
if x < +
1 if x
In gure 8 the parameter has been chosen to be 2. The eect of this
localization with dierent parameters for is documented in Figures 9 and
10.Next to localization there are further possibilities in order to improve the
method. These rely on standard variance reduction methods in order to
speed up Monte Carlo methods.
6 Numerical Results
6.1 Algorithm
Let us now put things together and combine the discussed techniques for the
computation of the vega with the Newton method in equation (5) in the case
of a discrete arithmetic average Asian option. Depending on which choice
we make for the computation of the vegas, we obtain dierent methods for
17
the computation of the implied volatilities. We call the method obtained by
using the classical approach for the vega (4.1) the classical method, while we
refer to the other ones as logarithmic derivative or log-trick method (4.3) and
combined or decomposition method (5.1). For all Monte Carlo simulations we
used antithetic variates, control variates and importance sampling for vari-
ance reduction. For the antithetic variate case we used mirrored Brownian
paths ( see [10] page 223 ) while for the control variate we used a geometric
average Asian option, for which analytical expressions for the vega are avail-
able. We did not use specic exit conditions but simply let the iteration run
for a xed period, in the following example about 6300 times. The Monte
Carlo simulations have been done with a xed number of generated prices
M = 10000.
6.2 Data and Result
Figure 11 in the appendix shows the result of two simulations in the case of
an arithmetic average Asian option on a stock whose dynamic is given by
equation (1), with initial value S
0
= 100, strike price K = 100, interest rate
r = 0.1 and maturity time T = 0.0833 which corresponds to one month.
The number of time steps in the average is chosen to be 30, corresponding to
one daily value. In both simulations the Newton method ( see equation (5)
) is used to compute the implied volatility. The observed prices have been
created articially using a high accuracy Monte Carlo simulation with an
exact volatility of = 0.43. In the rst simulation the computation of the
vega is based on the logarithmic derivative method ( Equation (9) ) without
localization while in the second simulation it is based on the classical method
( Equation (8) ). The x-scale shows the number of steps in the iteration of
Equation (5), while the y-scale shows the volatility level
k
after k steps ob-
tained from the iteration (5). The solid black line shows the exact volatility
which in the ideal case should be reobtained. It can be seen that both graphs
converge toward the right value of but a certain degree of uctuation re-
mains due to the stochasticity of the Monte Carlo term. The starting value
has been chosen as
0
= 0.7 in both cases. Note however that the rst 300
18
steps of the iteration are not displayed in the gures. The simulation doc-
uments that our new method based on the logarithmic utility trick delivers
much better results in terms of speed of convergence and accuracy. These
results can still be improved by using the localization method discussed in
the previous section. However one has to be very careful in the choice of the
localization parameter as the accuracy of the simulation crucially depends
on this choice. Figure 12 in the appendix shows the eect of the choice of
dierent localization parameters . The results in this case indicate that a
choice of 0.4 leads to optimal results. General criteria how to choose an
optimal are work in progress. As indicated before, we did not use any xed
exit condition. A closer inspection of the numerical results appears to show
that that once a certain accuracy has been reached, the implied volatility
k
obtained in step k simply uctuates around the true implied volatility . The
size of these uctuations is determined by the variance of the Monte Carlo
estimator which therefore puts an upper limit on the maximum accuracy
that can be reached. As indicated in section 2.3 however, the same implies
to the bisection and secant method. Variance reduction and localization as
discussed in section 5.1 are therefore very important.
7 Conclusion
Asian options are becoming more and more popular and are traded actively
on OTC markets around the world. For the calibration of pricing models for
Asian options implied volatilities are needed. It is a major mistake to use
implied volatilities from corresponding standard European call options for
this, as this leads to major inconsistencies and misprizing. We propose to
compute the implied volatilities directly from Asian options. This is compu-
tational more dicult as no closed form solutions are available. However we
propose a method based on the logarithmic derivative for the computation
of the corresponding vegas and the Newton method for solving non linear
equations which shows very promising results. It is faster and more accurate
than the classical method ( section 4.1 ). We indicate how this method can be
optimized by using variance reduction techniques, such as localization, anti-
19
thetic variates, control variates and importance sampling. We hope that our
results make a contribution to better understand Asian options and enable
actively engaged traders of Asian options to improve their pricing models.
8 Appendix
8.1 Technical computations
Let us rst derive formula (9) for the vega of an arithmetic average Asian
option.
Proof. We dene the function h as
h : R
n
R
(x
1
, ..., x
n
)

g
_
S
0
_
1
n
n

i=1
exp(x
i
)
__
.
Then, by dening the family of random variables X

= (X

1
, ..., X

n
)

via
X

i
= W
t
i
+
_
r
1
2

2
_
t
i
where denotes the volatility parameter within our Black-Scholes model, we
obtain
g
_
1
n
n

i=1
S
t
i
_
= h(X

1
, ..., X

n
) = h(X

). (10)
Let

= (

ij
) denote the covariance matrix of X

, i.e.

ij
= cov(X

i
, X

j
) =
2
min(t
i
, t
j
). (11)
Furthermore let = (
ij
) be the matrix with entries
ij
= min(t
i
, t
j
). Then
clearly =
2
. The density of the law of X

with respect to the standard

Lebesgue measure on R
n
is given by
20
f(x, ) =
1

_
(2)
n
det()
exp
_

1
2
2
(x ())

1
(x ())
_
with () =
__
r
1
2

2
_
t
1
, ...,
_
r
1
2

2
_
t
n
_

R
n
. Taking derivatives of
log(f(x, )) with respect to yields

log(f(x, )) =
1

(t
1
, .., t
n
)
1
(x ()) +
1

3
(x ())

1
(x ())
n

.
Substituting X

for x then gives

w

= (t
1
, .., t
n
)
1
(W
t
1
, .., W
t
n
)

+
1

(W
t
1
, .., W
t
n
)
1
(W
t
1
, .., W
t
n
)

.
With the weight function w

it follows from Proposition 3.1 that

E
_
g
_
1
n
n

i=1
S
t
i
__
= E
_
g
_
1
n
n

i=1
S
t
i
_
w

_
(12)
It is not clear from expression (12) whether the vega is in general positive
or negative. However we have the the following Lemma.
Lemma 8.1. Assume that stock and bond follow the dynamics (1) and as-
sume that g(x) is a continuous convex function, which is piecewise C
1
with
bounded derivatives and at most nitely many singularities. Then the price
of a continuous type arithmetic Asian option g
_
1
T
_
T
0
S
t
dt
_
as well as the
price of a discrete type arithmetic Asian option g
_
1
n

n
i=1
S
t
i
_
are strictly
increasing functions of the volatility parameter > 0.
Proof. Let us rst consider the case of the continuous type Asian option.
W.l.o.g. we assume that the interest rate satises r = 0. The partial dif-
ferential equation for the value function v(t, x, y, ) where x represents the
21
price of the stock and y the cumulative stock price is then given by ( see for
example Shreve [14] page 322 )
v
t
+ xv
y
+
1
2

2
x
2
v
xx
= 0 (13)
with boundary conditions
v(t, 0, y, ) = g(y), 0 t < T, y R, > 0 (14)
lim
y
v(t, x, y, ) = 0, 0 t < T, x 0, > 0
v(T, x, y, ) = g(y), x 0, y R, > 0
Dierentiating (13) with respect to gives
v
t
+ xv
y
+
1
2

2
x
2
v
xx
+ x
2
v
xx
= 0 (15)
Denoting the vega v

(t, x, y, ) of the option with V shows that

V
t
+ L
AS
t
V = x
2
v
xx
(16)
where L
AS
t
is the corresponding dierential operator. Dierentiating the
boundary conditions (14) with respect to we obtain that V vanishes on
the whole of the boundary. As was assumed to be positive, the maximum
principle for parabolic PDEs ( see for example Theorem 3.11, page 66 in [15]
) therefore implies that V is positive, given that the right hand side of (16)
is negative. the latter is true if v
xx
is positive. It therefore suces to show
that the gamma v
xx
of the Asian option is positive. In order to do this, it
suces to show that

2
x
2
E
_
g
_
x
T
_
T
0

S
t
dt
__
> 0 (17)
where x = S
0
and

S
t
:= exp
_
W
t

1
2

2
t
_
denotes the normalized stock
price. Let us rst assume that g is two times continuously dierentiable. As
22

S
t
does not depend on x taking the second derivative in (17) gives

2
x
2
E
_
g
_
x
T
_
T
0

S
t
dt
__
= E
_
g

_
x
T
_
T
0

S
t
dt
__
1
T
_
T
0

S
t
dt
_
2
_
(18)
It follows from the convexity of g that the expression on the right hand side
of (18) is clearly positive. If g is not two times continuously dierentiable, an
approximations such as in [8] ( proof of Proposition 3.2. page 23 ) enables us
to get the same result. The result for the case of a continuous type arithmetic
Asian option is therefore obtained. For the case of a discrete type arithmetic
Asian option we refer to Vecer (2005) for a single partial dierential equation
for the price of a discrete type arithmetic Asian option ( equation (3.9) in
[16] with q
t
chosen in (3.5) ). Positivity of the coecient in front of the
second order term guarantees that the methodology presented above using
the maximum principle works in this case as well, positivity of the gamma
follows in exactly the same way as before.
8.2 Numerical results and graphical output
0 2 4 6 8 10 12 14 16 18 20
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
An Option Payoff
x
g
(
x
)
K=10, =2
Figure 1:
23
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4
10
9
8
7
6
5
4
3
2
1
0

Comparison Between Methods of Log Trick and Classical Method for Bull Spread


Standard Errors Compared with the Explicit Solution:
Simulation=100,000 =1
r = 0.05 S = 5760 K=5780 T = 4/12 = T

C(0, 4/12, , 5760, 5780)

Log Trick=0.0264, Classical Method=0.1207
Explicit Vega
Log Trick
Classical Method
Figure 2:
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4
10
9
8
7
6
5
4
3
2
1
0

Comparison Between Methods of Log Trick and Classical Method for Bull Spread


Standard Errors Compared with the Explicit Solution:
Simulation=100,000 =0.1
r = 0.05 S = 5760 K=5780 T = 4/12 = T

C(0, 4/12, , 5760, 5780)

Log Trick=0.0225, Classical Method=0.2525
Explicit Vega
Log Trick
Classical Method
Figure 3:
24
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4
14
12
10
8
6
4
2
0

Comparison Between Methods of Log Trick and Classical Method for Bull Spread


Standard Errors Compared with the Explicit Solution:
Simulation=100,000 =0.01
r = 0.05 S = 5760 K=5780 T = 4/12 = T

C(0, 4/12, , 5760, 5780)

Log Trick=0.0310, Classical Method=1.0678
Explicit Vega
Log Trick
Classical Method
Figure 4:
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4
10
9
8
7
6
5
4
3
2
1
0

Comparison Between Methods of Log Trick and Classical Method for Bull Spread


Standard Errors Compared with the Explicit Solution:
Simulation=1,000,000 =0.001
r = 0.05 S = 5760 K=5780 T = 4/12 = T

C(0, 4/12, , 5760, 5780)

Log Trick=0.0114, Classical Method=1.3760
Explicit Vega
Log Trick
Classical Method
Figure 5:
25
6 7 8 9 10 11 12 13 14
0.5
0
0.5
1
1.5
2
2.5
3
3.5
4
An Option Payoff
x
g
(
x
)


K=10, =2
Regular Part
(x10)
+
Singular Part
Figure 6:
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4
700
800
900
1000
1100
1200
1300
1400
Comparison among Log Trick, Classical Method and Decomposition for European Call Option

Simulation=100,000 =100
r = 0.05 S = 5760 K=5770 T = 4/12 = T
Standard errors compared with the explicit solution:

C(0, 4/12, , 5770)

Log trick=15.9032, Classical method=7.4596 and Decomposition=7.1853
Explicit Vega
Log Trick
Classical Method
Decomposition
Figure 7:
26
6 4 2 0 2 4 6
0.5
0
0.5
1
An Option Payoff
x
g
(
x
)


Regular Part
Original Function
Singular Part
Figure 8:
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4
900
800
700
600
500
400
300
200
100
0
Comparison between Log Trick and Decomposition for Digital Call Option

Simulation=100,000 =10
r = 0.05 S = 5760 K=5800 Q=100;T = 4/12 = T
Standard Errors Compared with the Explicit Solution:

C(0, 4/12, , 5800)

Log Trick=3.9221, Decompositionn=1.7226
Explicit Vega
Log Trick
Decomposition
Figure 9:
27
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4
900
800
700
600
500
400
300
200
100
0
Comparison between Log Trick and Decomposition for Digital Call Option

Simulation=100,000 =100
r = 0.05 S = 5760 K=5800 Q=100;T = 4/12 = T
Standard Errors Compared with the Explicit Solution:

C(0, 4/12, , 5800)

Log Trick=7.2896, Decompositionn=0.9147
Explicit Vega
Log Trick
Decomposition
Figure 10:
0 1000 2000 3000 4000 5000 6000 7000
0.36
0.38
0.4
0.42
0.44
0.46
0.48
Newton method based on logarithmic derivative
I
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y
0 1000 2000 3000 4000 5000 6000 7000
0.36
0.38
0.4
0.42
0.44
0.46
0.48
Newton method based on classical approach
I
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y
Figure 11:
28
0 1000 2000 3000 4000 5000 6000 7000
0.38
0.4
0.42
0.44
0.46
Combined Method, epsilon=0.2
I
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y
0 1000 2000 3000 4000 5000 6000 7000
0.38
0.4
0.42
0.44
0.46
Combined Method, epsilon=0.4
I
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y
0 1000 2000 3000 4000 5000 6000 7000
0.38
0.4
0.42
0.44
0.46
Combined Method, epsilon=0.8
I
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y
Figure 12:
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4
0.6
0.5
0.4
0.3
0.2
0.1
0
0.1
0.2
0.3

e
r
r
o
r
Errors of Trick and Classical ( =0.1)
Log Trick
Classical Method
Figure 13:
29
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4
1
0.8
0.6
0.4
0.2
0
0.2
0.4
0.6
0.8

e
r
r
o
r
Errors of Trick and Classical ( =0.01)
Log Trick
Classical Method
Figure 14:
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4
0.6
0.4
0.2
0
0.2
0.4
0.6
0.8
1

R
e
l
a
t
i
v
e

E
r
r
o
r
s
Relative Errors of Trick and Classical ( =0.1)
Log Trick
Classical Method
Figure 15:
30
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4
1
0.5
0
0.5
1
1.5
2
2.5
3
3.5
4

R
e
l
a
t
i
v
e

E
r
r
o
r
s
Relative Errors of Trick and Classical ( =0.01)
Log Trick
Classical Method
Figure 16:
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