Pricing and Hedging

Asian Options
Julien GAUBERT David RUSO
Under the direction of Emmanuel GOBET
Ecole Polytechnique
Fall 2004
Contents
1 Introduction 3
2 The Problem 5
2.1 Scope of the study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2.2 A path-dependent option . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2.3 Project goals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
3 PDE Evaluation 7
3.1 The two-variable PDE . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
3.1.1 Search of the equation . . . . . . . . . . . . . . . . . . . . . . . . 7
3.1.2 Commentaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
3.2 The one-variable PDE . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
3.2.1 The equation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
4 Pricing and hedging by Monte Carlo methods 11
4.1 The problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
4.2 Lemmas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
4.2.1 The brownian bridge . . . . . . . . . . . . . . . . . . . . . . . . . 12
4.2.2 Probabiliy law of some integrals . . . . . . . . . . . . . . . . . . . 13
4.2.3 Black - Scholes formula for variance reduction . . . . . . . . . . . 15
4.3 Dierent schemes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
4.3.1 Time discretisation . . . . . . . . . . . . . . . . . . . . . . . . . . 17
4.3.2 Riemann scheme . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
4.3.3 First gaussian scheme . . . . . . . . . . . . . . . . . . . . . . . . . 17
4.3.4 Second gaussian scheme . . . . . . . . . . . . . . . . . . . . . . . 19
4.3.5 Schemes convergence . . . . . . . . . . . . . . . . . . . . . . . . . 19
4.4 Variance Reduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
4.4.1 Principle and implementation . . . . . . . . . . . . . . . . . . . . 20
4.4.2 The oating strike case . . . . . . . . . . . . . . . . . . . . . . . . 21
4.5 The hedging problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
1
4.6 Hedging by resimulation . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
4.7 Hedging by Pathwise method . . . . . . . . . . . . . . . . . . . . . . . . 25
4.8 Numerical results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
4.8.1 The zero strike case . . . . . . . . . . . . . . . . . . . . . . . . . . 26
4.8.2 Trust intervals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
4.8.3 Numerical results . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
5 Pricing and hedging with determinist methods 36
5.1 Problem and context . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
5.2 Forward Shooting Grid . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
5.2.1 Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
5.2.2 Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
5.2.3 Algorithm complexity . . . . . . . . . . . . . . . . . . . . . . . . . 38
5.3 Numerical results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
5.3.1 Zero strike case . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
5.3.2 Numerical results . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
6 Extensions 42
6.1 Improvement of the determinist method . . . . . . . . . . . . . . . . . . 42
6.2 Sensibilities computation . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
6.3 Eciency comparison of the pricing methods . . . . . . . . . . . . . . . . 43
2
Chapter 1
Introduction
Financial needs of companies trading gas and oil are not single and periodic but on
the contrary, they are frequent and steady. Actors on energy markets seek protection
against variations of market prices during a specied period of time. European options
do not provide this protection. Therefore options whose pay-o depends on the average
value of the underlier over a given period, and not on the value itself, become necessary.
These contracts, named Average Options, have been introduced for the rst time in
1987 by David Spaughton and Mark Standish, two traders who were then working with
Bankers Trust in Tokyo. Their creators called them Asian Options.
In the case of gas trading, the contracts are settled during the last week of each
month. The Asian Options are based on the last days of this Bid Week, thus avoiding
potential manipulations of the prices by the various actors of the market. It is actually
more dicult to manipulate the average price of an asset by acting only on the price at
maturity.
In the case of oil trading, Asian options are based on the prices over the last calendar
month. The volatility is smaller and the Gamma decreases during this month. Therefore
the contract price is lower.
Asian Options are adapted to the energy market where there are
daily needs. Their success is due to the protection they provide
against price manipulation at maturity and to their low price.
3
The Average Option concept can be applied to all kinds of options. In most cases
the value used is the arithmetic average. The following table gives the payo for the
various types of Asian Options including the oating strike options.
Call Put Straddle
Fixed strike (
1
T
_
T
0
S
u
du K)
+
(K
1
T
_
T
0
S
u
du)
+
|
1
T
_
T
0
S
u
du K|
Floating strike (S
T

1
T
_
T
0
S
u
du)
+
(
1
T
_
T
0
S
u
du S
T
)
+
|
1
T
_
T
0
S
u
du S
T
|
Asian options can be structured as european options for which the contract holder
can exercise at maturity only or as american options which can be exercised at any
moment up to maturity.
The present study proposes various pricing and hedging methods for the european
Asian Options.
4
Chapter 2
The Problem
2.1 Scope of the study
For this study we have selected the case of an european asian call with a xed strike
based on the average value on the period going from the date of the contract to the
maturity date. The payo is:
(
1
T
_
T
0
S
u
du K)
+
However any additional theoritical diculty raised by other european asian option
will be covered. Furthermore, the methods we have implemented for this study have all
been applied to these dierent types of strikes.
2.2 A path-dependent option
These options are path-dependent i.e. the pay-o depends on all the history of the asset
value from the sale of the contract and not only on the asset value at maturity date.
The Black-Scholes formula does not necessarily apply to these options. In the case of
Asian Options, Black-Scholes formulas are not available anymore, because the payo
integral law is not log-normal.
For standard european options the option price is given by a 1-dimensional PDE for
which an analytical solution can be found leading to the Black-Scholes formula. This is
no longer true for the Asian Options whose price is a solution of a 2-dimensional PDE
involving partial derivatives with respect to the current value and the average value of
the underlier. Therefore there exists neither analytical expression for the option price
nor for the hedging.
5
2.3 Project goals
The aim of the project is to review dierent numerical methods for pricing and hedg-
ing Asian Options. Our objective is to describe accurately methods which have been
published, to implement them and to present their respective results. The added value
of our paper will lie in the clarity and the exactness of explanations as well as in the
relevance of results.
We will especially pay attention to the results connection and to the process legit-
imacy and interpretation, particularly concerning the dierent integral discretisation
schemes and concerning the determinist method.
We will focus successively on the following methods:
Numerical solution of the option price PDE
Simulation using Monte Carlo methods
Determinist methods (Forward Shooting Grid method)
6
Chapter 3
PDE Evaluation
Our knowledge in non-standard PDE solution approximation methods does not permit
us to carry out the numerical solving of the equation which governs the price of an
Asian Option. However, we can lay down this equation, comment it and describe some
approximations and solutions which have been published.
3.1 The two-variable PDE
3.1.1 Search of the equation
The self-nancing condition of the portfolio V
t
is :
dV
t
= r(V
t

t
S
t
)dt +
t
dS
t
We dene Itos vectorial function :
X
t
=
_
_
t
S
t
I
t
_
_
This process veries :
dX
t
=
_
_
dt
dS
t
dI
t
_
_
=
_
_
1
S
t
S
t
_
_
. .
(t)
dt +
_
_
0
S
t
0
_
_
. .
(t)
dW
t
7
v being a C
1,2
([0, T] R
2
, {f(t, X
t
); t [0, T]}) function, Itos formula gives :
dv(X
t
) =
3

i=1
v
x
i
(X
t
)dX
i
t
+
1
2
3

i,j=1

2
v
x
i
x
j
(X
t
)d < X
i
, X
j
>
t
dv(X
t
) =
v
t
(X
t
)dt +
v
S
t
(X
t
)dS
t
+
v
I
t
(X
t
)S
t
dt +
1
2
3

i,j=1

2
v
x
i
x
j
(X
t
)d < X
i
, X
j
>
t
Of all nine terms of the last sum only the following is not equal to 0 :

2
v
S
2
t
(X
t
)d < S, S >
t
=

2
v
S
2
t
(X
t
)
2
S
2
t
dt
Finally we have :
dv(X
t
) =
_
v
t
(X
t
) +
v
I
t
(X
t
)S
t
+
1
2

2
S
2
t

2
v
S
2
t
(X
t
)
_
dt +
v
S
t
(X
t
)dS
t
Assuming that a regular function v satisfying v(t, S
t
, I
t
) = V
t
exists we obtain:
_
v
t
(X
t
) +
v
I
t
(X
t
)S
t
+
1
2

2
S
2
t

2
v
S
2
t
(X
t
) = r(V
t

t
S
t
)
v
S
t
(X
t
) =
t
so we can now consider that the price of an Asian Option is the solution of the following
two-variable PDE:
V
t
+S
V
I
+
1
2

2
S
2

2
V
S
2
rV +rS
V
S
= 0
3.1.2 Commentaries
This PDE shows an additional term to the Black - Scholes equation:
V
t
+
1
2

2
S
2

2
V
S
2
rV +rS
V
S
= 0
which represents the dependancy of the payo on the asset average value.
8
This PDE can be broken down into the following terms:
a time dependency term [
V
t
]
a convection term with respect to S [rS
V
S
]
a diusion term with respect to S [
1
2

2
S
2
2
V
S
2
]
a convection term with respect to I [S
V
I
]
The lack of diusion term with respect to I makes the PDE dissymmetrical over the
two space variables, this makes the numerical solving dicult.
3.2 The one-variable PDE
3.2.1 The equation
Rogers and Shi
[3]
have proved that the two-variable equation above can be reduced to
the following one-variable equation by changing variables:
u
t
+ (rx +
1
T
)
u
x

1
2

2
x
2

2
u
x
2
= 0
This PED has only one space variable and nally we are left with the following terms:
a time dependency term [
u
t
]
a convection term [(rx +
1
T
)
u
x
]
a diusion term [
1
2

2
x
2
2
u
x
2
]
Francois Dubois
[7]
has proposed a solving method based on tranforming this advection-
diusion equation into a pure diusion equation by an appropriate change of variable.
9
As the convection factor [(rx+
1
T
)
u
x
] is linear, the characteristic method can be applied
and it leads to the diusion equation:
v

1
2

2
(y e
r
)
2

2
v
y
2
= 0
Time and space discretisation is then possible and a relevant choice in nite dier-
ences grid nally gives an accurate result for the price.
10
Chapter 4
Pricing and hedging by Monte
Carlo methods
4.1 The problem
Under the neutral-risk probability an option price is the discounted terminal pay-o
expected value i.e.:
V
0
= e
rT
E(f(S
T
))
where f(S
T
) is the option pay-o.
This formula remains applicable to path-dependent options. Thus we get:
V
0
= e
rT
E(f(S
t
, 0 t T))
Monte-Carlo methods allowing to compute an expected value using the law of large
numbers appear to be a fundamental tool for pricing.
Monte-Carlo simulations use a discretisation of the option life period. For asian
options an additional diculty is introduced by the pay-o formula which contains an
integral. Actually, it is necessary to evaluate this integral for each simulation. Several
approximations associated to the initial discretisation are then possible.
We will present in this section three appoximation schemes to compute the integral
and we will attempt to understand and compare their respective relevance.
11
4.2 Lemmas
4.2.1 The brownian bridge
It has been proved that it is possible to build a brownian bridge between t
k
and t
k+1
,
i.e. a gaussian process based on the classical brownian motion W
t
, constrained to 0 at
t
k
and t
k+1
. This process is, for t
k
< u < t
k+1
:
A
t
k
,t
k+1
u
= (W
u
W
t
k
)
u t
k
t
k+1
t
k
(W
t
k+1
W
t
k
)
Then it is possible to build another brownian bridge, constrained to x at t
k
and y at
t
k+1
by adding an ane function to the previous bridge:
B
t
k
,t
k+1
u
= A
t
k
,t
k+1
u
+x +
u t
k
t
k+1
t
k
(y x)
The B
t
k
,t
k+1
u
variance is equal to the A
t
k
,t
k+1
u
variance because their dierence is a
deterministic function of u. Hence it is equal to :
Var(B
t
k
,t
k+1
u
) =
(t
k+1
u)(u t
k
)
(t
k+1
t
k
)
Then :
E(B
t
k
,t
k+1
u
) = E(A
t
k
,t
k+1
u
) +E
_
x +
u t
k
t
k+1
t
k
(y x)
_
E(B
t
k
,t
k+1
u
) = 0 +x +
u t
k
t
k+1
t
k
(y x) =
t
k+1
u
t
k+1
t
k
x +
u t
k
t
k+1
t
k
y
We have the law of a brownian motion constrained to x at t
k
and y at t
k+1
:
L(W
u
|W
t
k
= x, W
t
k+1
= y) = N(
t
k+1
u
t
k+1
t
k
x +
u t
k
t
k+1
t
k
y,
(t
k+1
u)(u t
k
)
t
k+1
t
k
)
12
4.2.2 Probabiliy law of some integrals
We will later need to simulate the integrals (
_
t
k+1
t
k
W
u
du|W
t
k
, W
t
k+1
) and
_
T
0
W
u
du.
We know that both are gaussian random variables as almost sure limits of gaussian
random variables. This section details the computation of their rst two probabilistic
moments :
E(
_
t
k+1
t
k
W
u
du|W
t
k
, W
t
k+1
) =
_
t
k+1
t
k
E(W
u
|W
t
k
, W
t
k+1
)du
=
_
t
k+1
t
k
t
k+1
u
t
k+1
t
k
W
t
k
+
u t
k
t
k+1
t
k
W
t
k+1
du
=
_

(t
k+1
u)
2
2(t
k+1
t
k
)
W
t
k
+
(u t
k
)
2
2(t
k+1
t
k
)
W
t
k+1
_
t
k+1
t
k
Hence :
E(
_
t
k+1
t
k
W
u
du|W
t
k
, W
t
k+1
) =
t
k+1
t
k
2
(W
t
k
+W
t
k+1
)
Concerning the variance :
Var(
_
t
k+1
t
k
W
u
du|W
t
k
, W
t
k+1
) = E(
_
t
k+1
t
k
W
u
du|W
t
k
, W
t
k+1
)
2

_
E(
_
t
k+1
t
k
W
u
du|W
t
k
, W
t
k+1
)
_
2
The rst term can be transformed as follows:
E(
_
t
k+1
t
k
W
u
du|W
t
k
, W
t
k+1
)
2
= E(
_
t
k+1
t
k
W
u
du|W
t
k
, W
t
k+1
)(
_
t
k+1
t
k
W
v
dv|W
t
k
, W
t
k+1
)
= E(
__
t
k+1
t
k
W
u
W
v
dudv|W
t
k
, W
t
k+1
) =
__
t
k+1
t
k
E(W
u
W
v
|W
t
k
, W
t
k+1
) dudv
Now, thanks to the following covariance property:
E(W
u
W
v
) = Cov(W
u
, W
v
) +E(W
u
)E(W
v
)
13
We have:
Var(
_
t
k+1
t
k
W
u
du| . . .) =
__
t
k+1
t
k
Cov(W
u
, W
v
| . . .) dudv
+
_
_
t
k+1
t
k
_
t
k+1
t
k
E(W
u
| . . .) du E(W
v
| . . .) dv
_

_
E(
_
t
k+1
t
k
W
u
du| . . .)
_
2
The last two terms are equal and according to the previous lemma we get, where
t
k
< v < u < t
k+1
:
Cov(W
u
, W
v
|W
t
k
, W
t
k+1
) =
(v t
k
)(t
k+1
u)
(t
k+1
t
k
)
Var(
_
t
k+1
t
k
W
u
du| . . .) =
_
_
_
u
v=t
k
(v t
k
)(t
k+1
u)
(t
k+1
t
k
)
dv+
_
t
k+1
v=u
(u t
k
)(t
k+1
v)
(t
k+1
t
k
)
dv
_
du
=
_
t
k+1
t
k
_
(u t
k
)
2
(t
k+1
u)
2(t
k+1
t
k
)
+
(u t
k
)(t
k+1
u)
2
2(t
k+1
t
k
)
_
du
=
_
t
k+1
t
k
_
(u t
k
)(t
k+1
u)
2(t
k+1
t
k
)
(t
k+1
t
k
)
_
du =
_
t
k+1
t
k
(t
k+1
u)(u t
k
)
2
du
Finally:
Var(
_
t
k+1
t
k
W
u
du|W
t
k
, W
t
k+1
) =
(t
k+1
t
k
)
3
12
L(
_
t
k+1
t
k
W
u
du|W
t
k
, W
t
k+1
) = N((t
k+1
t
k
)
W
t
k
+W
t
k+1
2
,
(t
k+1
t
k
)
3
12
)
Concerning the gaussian random variable
_
T
0
W
u
du,
E(
_
T
0
W
u
du) =
_
T
0
E(W
u
)du = 0
And the variance :
Var(
_
T
0
W
u
du) = E(
_
T
0
W
u
du)
2
0
14
= E
_
(
_
T
0
W
u
du)(
_
T
0
W
v
dv)
_
=
__
T
0
E(W
u
W
v
) dudv
Thanks to the previous covariance property we now have (with E(
_
T
0
W
u
du) = 0 ):
Var(
_
T
0
W
u
du) =
__
T
0
Cov(W
u
, W
v
) dudv =
__
T
0
min(u, v) dudv
=
_
_
_
u
v=0
v dv +
_
T
v=u
u dv
_
du =
_
T
0
_
u
2
2
+u(T u)
_
du
=
T
3
6
+
T
3
2

T
3
3
=
T
3
3
And nally we get:
L(
_
T
0
W
u
du) = N(0,
T
3
3
)
4.2.3 Black - Scholes formula for variance reduction
In order to apply a variance reduction to the three schemes, we will need to calculate
explicitly :
E((e
1
T

T
0
log(S
u
)du
K)
+
)
This can be achieved by using a Black Scholes formula. Indeed
_
T
0
log(S
u
)du follows
a log-normal law. Therefore an analytical result can be obtained by adjusting the
parameters of the closed formula.
For a traditional asset, i.e S
t
= S
0
e
(r

2
2
)t+W
t
, the Black - Scholes formula gives :
V
0
= e
rT
E
_
(S
T
K)
+
_
= C(S
0
, K, T, r, )
The probabilistic moments of this log-normal law are :
E = E((r

2
2
)T +W
T
) = (r

2
2
)T V = Var((r

2
2
)T +W
T
) =
2
t
From there we easily get r and :
r =
E
T
+
V
2T
=
_
V
T
15
For the geometric mean e
1
T

T
0
log(S
u
)du
, the formula is :
E((e
1
T

T
0
log(S
u
)du
K)
+
) = e
r

T
C(S

0
, K, T, r

)
Thus we need to calculate r

and

:
_
T
0
log(S
u
)du = Tlog(S
0
) +
T
2
2
(r

2
2
) +
_
T
0
W
u
du
1
T
_
T
0
log(S
u
)du = log(S
0
) +
T
2
(r

2
2
) +

T
_
T
0
W
u
du
Which leads to:
e
1
T

T
0
log(S
u
)du
= S
0
e
T
2
(r

2
2
)+

T
0
W
u
du
It comes immediately that S

0
= S
0
and an application of the previous lemma con-
cerning the law of the integral gives :
E

= E(
1
T
_
T
0
log(S
u
)du) =
T
2
(r

2
2
) V

= Var(
1
T
_
T
0
log(S
u
)du) =

2
T
3
Using the previous relations between r et , and E et V :
r

=
E

T
+
V

2T
=
(r

2
2
)
2
+

2
6

=
_
V

T
=
_

2
T
3T
r

=
r
2


2
12

3
Finally the requested formula is:
E((e
1
T

T
0
log(S
u
)du
K)
+
) = e
(
r
2

2
12
)T
C(S
0
, K, T,
r
2


2
12
,

3
)
16
4.3 Dierent schemes
4.3.1 Time discretisation
Simulating the asset price evolution requires a time discretisation. The asset follows the
Black Scholes dynamic under risk-neutral probability :
S
t
= S
0
e
(r

2
2
)t+W
t
After having selected T, h and N, such as T = hN, we can compute step by step
(W
t
k
)
0t
k
N
and (S
t
k
)
0t
k
N
using :
_
W
t
k+1
= W
t
k
+ (W
t
k+1
W
t
k
)
S
t
k+1
= S
t
k
e
(r

2
2
)h+(W
t
k+1
W
t
k
)
where (W
t
k+1
W
t
k
) N(0, h).
4.3.2 Riemann scheme
The simplest scheme is the Riemann scheme which corresponds to the rectangle approx-
imation method :
1
T
_
T
0
S
u
du =
h
T
N1

k=0
S
t
k
N
MC
being the number of simulations, the price is then given by:
V
0
=
e
rT
N
MC
N
MC

i=1
_
1
N
N1

k=0
S
t
k
K
_
+
4.3.3 First gaussian scheme
The Riemann scheme does not take into account the S
t
specic distribution at all.
Indeed on each interval ]t
k
, t
k+1
[ , S
t
is unknown but distributed in a particular way.
Therefore it is possible to provide a better evaluation of the integral.
17
So we write:
1
T
_
T
0
S
u
du = E
_
1
T
N1

k=0
_
t
k+1
t
k
S
u
du

(S
t
k
)
0t
k
N
_
=
1
T
N1

k=0
_
t
k+1
t
k
E
_
S
u

(S
t
k
)
0t
k
N
_
du
=
1
T
N1

k=0
_
t
k+1
t
k
E
_
S
0
e
(r

2
2
)u+W
u

(S
t
k
)
0t
k
N
_
du
=
1
T
N1

k=0
_
t
k+1
t
k
S
0
e
(r

2
2
)u
E
_
e
W
u

(S
t
k
)
0t
k
N
_
du
E(e
W
u
)being a Laplace transform, the brownian bridge lemma gives:
E
_
e
W
u

(S
t
k
)
0t
k
N
_
= e

t
k+1
u
h
W
t
k
+
ut
k
h
W
t
k+1
+

2
2
(t
k+1
u)(ut
k
)
h
And nally:
1
T
_
T
0
S
u
du =
1
T
N1

k=0
_
t
k+1
t
k
S
0
e
(r

2
2
)u
e

t
k+1
u
h
W
t
k
+
ut
k
h
W
t
k+1
+

2
2
(t
k+1
u)(ut
k
)
h
du
=
1
T
N1

k=0
_
t
k+1
t
k
S
0
e

ut
k
h
(W
t
k+1
W
t
k
)

2
2
(ut
k
)
2
h
+ru
e
W
t
k
e

2
2
t
k
du
Let us write v =
ut
k
h
. We obtain:
1
T
_
T
0
S
u
du =
1
T
N1

k=0
S
t
k
_
1
0
e
v(W
t
k+1
W
t
k
)

2
2
hv
2
e
rhv
dv
A Taylor formula with respect to h, W
t
k+1
W
t
k
being comparable to

h, gives :
1
T
_
T
0
S
u
du =
h
T
N1

k=0
S
t
k
_
1 +
rh
2
+
W
t
k+1
W
t
k
2
_
We observe that we get the same evaluation by applying a Talyor formula to a
trapezoidal approximation of the integral. This was expected since, brownian increments
being centered, the asset value between t
k
and t
k+1
varies, on average, on the straight
line between S
t
k
and S
t
k+1
. The trapezoidal approximation method seems therefore to
be optimal.
Hence the price is given by :
18
V
0
=
e
rT
N
MC
N
MC

i=1
_
h
T
N1

k=0
S
t
k
_
1 +
rh
2
+
W
t
k+1
W
t
k
2
_
K
_
+
4.3.4 Second gaussian scheme
We have seen that the rst gaussian scheme uses the brownian increments mean prop-
erties. But it still does not take into account the distribution around this mean, i.e.
the asset value variance on each interval ]t
k
, t
k+1
[. We can therefore obtain a more ef-
cient gaussian scheme by taking advantage of the whole information we have about S
probabilistic law.
Thus let us write:
1
T
_
T
0
S
u
du =
1
T
N1

k=0
_
t
k+1
t
k
e
(W
u
W
t
k
)

2
2
(ut
k
)+r(ut
k
)
du
A Taylor formula gives, this time:
1
T
_
T
0
S
u
du =
h
T
N1

k=0
S
t
k
_
1 +
rh
2
+

h
_
t
k+1
t
k
(W
u
W
t
k
)du
_
where, according to the lemma the random variable
_
_
t
k+1
t
k
(W
u
W
t
k
)du |W
t
k
, W
t
k+1
_
follows the gaussian law :
L(
_
t
k+1
t
k
(W
u
W
t
k
)du|W
t
k
, W
t
k+1
) = N(
h
2
(W
t
k+1
W
t
k
),
h
3
12
)
Finally the price is given by:
V
0
=
e
rT
N
MC
N
MC

i=1
_
h
T
N1

k=0
S
t
k
1
T
_
T
0
S
u
du K
_
+
4.3.5 Schemes convergence
Previous commentaries about the relevance of the dierent schemes exempt us from
exposing convergence proofs or convergence speeds computation. We are now able to
understand that the second gaussian scheme is more ecient than the rst one, which is
itself more ecient than the Riemann scheme. Finally let us admit that the convergence
speed of the second gaussian scheme is comparable to
1
N
2
while convergence speeds of
the two others are comparable to
1
N

N
.
19
4.4 Variance Reduction
4.4.1 Principle and implementation
The central limit theorem gives an evaluation of the error committed with Monte Carlo
simulations. It is comparable to

Var
_
e
rT
(
1
T

T
0
S
u
duK)
+
_
N
MC
. Increasing the precision
requires therefore one of the following actions:
increase N
MC
but the computation time proportionally
reduce the variance of the random variable whose expected value we try to estimate
The second alternative, which is especially ecient in the case of asian options, is well
known: it is the Variance Reduction method. The idea is to approximate the pay-o
arithmtic mean by a geometric mean. Thus we write :
e
rT
E
_
(
1
T
_
T
0
S
u
du K)
+
_
=
e
rT
E
_
(
1
T
_
T
0
S
u
du K)
+
(e
1
T

T
0
ln(S
u
)du
K)
+
_
+e
rT
E
_
(e
1
T

T
0
ln(S
u
)du
K)
+
_
Among these two expected values:
we estimate the rst one with a Monte Carlo method. The variance of the quantity,
whose expected value is evaluated, is much lower than the previous variance.
we compute the second one by applying a Black - Scholes formula.
We have:
e
1
T

T
0
ln(S
u
)du
= S
0
e
T
2
(r

2
2
)+

T
0
W
u
du
Simulating this quantity requires therefore to estimate
_
T
0
W
u
du. This can be achieved
by using the three previously mentioned schemes. Thus we obtain the three following
esimations :
20
The Riemann scheme:
e
rT
N
MC
N
MC

i=1
_
_
h
N1

k=0
S
t
k
K
_
+

_
S
0
e
T
2
(r

2
2
)+
h
T

N1
k=0
W
t
k
K
_
+
_
The rst gaussian scheme:
e
rT
N
MC
N
MC

i=1
_
_
h
T
N1

k=0
S
t
k
_
1 +
rh
2
+
W
t
k+1
W
t
k
2
_
K
_
+

_
S
0
e
T
2
(r

2
2
)+
h
2T

N1
k=0
(W
t
k
+W
t
k+1
)
K
_
+
_
The second gaussian scheme:
e
rT
N
MC
N
MC

i=1
_
_
h
T
N1

k=0
S
t
k
_
1 +
rh
2
+

h
_
t
k+1
t
k
(W
u
W
t
k
)du
_
K
_
+

_
S
0
e
T
2
(r

2
2
)+

N1
k=0
t
k+1
t
k
W
u
du
_
+
_
According to the lemma the second expected value is given by:
e
rT
E((e
1
T

T
0
log(S
u
)du
K)
+
) = e
(
r
2
+

2
12
)T
C(S
0
, K, T,
r
2


2
12
,

3
)
Finally, by adding the simulated quantity and the explicitely computed quantity, we
obtain an unbiased price estimation whose accuracy is increased.
4.4.2 The oating strike case
In the oating strike case, the control variate creates an additional problem. Indeed the
second expeceted value we have to compute is, this time:
E
_
(S
T
e
1
T

T
0
log(S
u
)du
)
+
_
21
Hence we have to compute the price of the option whose pay-o is:
(S
T
e
1
T

T
0
log(S
u
)du
)
+
A change of numeraire leads then to the following formula:
C
0
= E
_
_
S
0
S
0
e
(r+
2
2
)
T
2

T
0

s
T
dW
s
_
+
_
Where we have, using the brownian increments independence :
Var(
_
T
0
sdW
s
) =
_
T
0
s
2
Var(dW
s
) =
_
T
0
s
2
ds =
T
3
Proceeding as we did in the lemma we nally obtain a formula for the price we are
looking for :
e
(
r
2
+

2
12
)T
P(S
0
, K, T, (
r
2
+

2
12
),

3
)
where P is the european put function which is given by the Black - Scholes formula.
4.5 The hedging problem
After having computed the price and having sold the contract, the bank has to work out
a hedging strategy in order to replicate the pay-o. This strategy consists in computing
the delta which is the quantity of asset S to be held in the portfolio.
Working out the 2-dimensional PDE has led us to show also that the equality:

t
=
V
S
t
that remains true for Asian Options. The delta is therefore the price sensibiliy with
respect to the asset value. The main goal of this section is to estimate this quantity by
Monte Carlo methods.
4.6 Hedging by resimulation
The rst alternative is to evaluate the partial derivative with respect to the asset value
using a nite dierences method.
To compute
0
we use the following process:
22
we compute the option price with the real initial asset value S
0
by evaluating :
V
0
= e
rT
E
_
(
1
T
_
T
0
S
u
du K)
+
|S
0
_
then we compute the option price with a perturbed value S
0
+p by evaluating:
V
perturbed
0
= e
rT
E
_
(
1
T
_
T
0
S
u
du K)
+
|S
0
+p
_
where p is the mentioned perturbation
we nally compute :
V
perturbed
0
V
0
p
and we obtain an estimation of
0
.
If the two expected values are computed independently, i.e. if the two Monte Carlo
simulations sets use independent brownian trajectories, then it is possible to evaluate
the estimator variance. Indeed, whatever the Monte Carlo estimator E
MC
we choose to
compute the expected value, the Monte Carlo error is:
1

N
MC

Var
_
e
rT
p
_
E
MC
(S
0
+p) E
MC
(S
0
)
_
_
=
1

N
MC

e
2rT
p
2
_
Var
_
E
MC
(S
0
+p)
_
+Var
_
E
MC
(S
0
)
_
_

N
MC
_
2
p
2
Var
_
e
rT
E
MC
(S
0
)
_
=

2
p

N
MC

Var
_
e
rT
_
(
1
T
_
T
0
S
u
du K)
+
_
_
A dilemma then appears when choosing p:
if p is small the estimation variance is high and the results are not reliable
23
if p is big the nite dierences scheme is inaccurate and the result is biased
In practice we choose p and N
MC
in order to set p

N
MC
to a high value.
However the best solution is to estimate the two expected values with the same brownian
simulations. The estimator variance is then much smaller and the results are much more
precise.
We can extend the nite dierences scheme to the computation of the delta at any
given moment of the option life time. Indeed the asian option price at any given time,
as a path-dependent option price, is given by:
V
t
= e
r(Tt)
E
_
(
1
T
_
T
0
S
u
du K)
+
| F
t
_
where F
t
stands for the past until t.
Hence we can write:
V
t
= e
r(Tt)
E
_
_
1
T
_
T
t
S
u
du (K
1
T
_
t
0
S
u
du)
_
+

S
t
,
1
T
_
t
0
S
u
du
_
We compute then:
V
perturbe
t
= e
r(Tt)
E
_
_
1
T
_
T
t
S
u
du (K
1
T
_
t
0
S
u
du)
_
+

S
t
+p,
1
T
_
t
0
S
u
du
_
And we obtain:

t
=
V
perturbe
t
V
t
p
24
4.7 Hedging by Pathwise method
The delta computation problem is:

t
=

S
t
E
_
e
r(Tt)
(
1
T
_
T
0
S
u
du K)
+

F
t
_
The pathwise method relies upon an integral - derivative switch, i.e a dierenciation
under the integral sign of the option pay-o, which is piecewise dierentiable. This
method leads to an expression for
0
:

0
= e
rT
E
_
1
{
1
T

T
0
S
u
duK}
1
T
_
T
0
S
u
du
S
0
_
This formula can be extended to compute delta at any given time.
Let us write the option price at any given time:
V
t
= e
r(Tt)
E
_
_
1
T
_
T
t
S
u
du (K
1
T
_
t
0
S
u
du)
_
+

S
t
,
1
T
_
t
0
S
u
du
_
Hence we have:

t
= e
r(Tt)
E
_
1
{
1
T

T
t
S
u
duK
1
T

t
0
S
u
du}
1
T
_
T
t
S
u
du
S
t

S
t
,
1
T
_
t
0
S
u
du
_
And nally:

t
= e
r(Tt)
E
_
1
{
1
T

T
0
S
u
duK}
1
T
_
T
t
S
u
du
S
t

S
t
,
1
T
_
t
0
S
u
du
_
The pathwise method improves the nite dierences method since:
it takes into account the pay-o dierentiability properties
it spares us the dicult perturbation choice
it does not require any resimulation and it is therefore more ecient
25
4.8 Numerical results
The second gaussian scheme superiority having been proved, we wont verify it in the
following section. All the simulations will be executed with this scheme.
4.8.1 The zero strike case
In the zero strike case we have closed formulas for pricing and hedging. Indeed the price
is given by:
e
rT
E(
1
T
_
T
0
S
u
du)
Hence we have :
V
0
= e
rT
E(
1
T
_
T
0
S
0
e
(r

2
2
)u+W
u
du)
=
S
0
e
rT
T
_
T
0
e
(r

2
2
)u
E(e
W
u
du) =
S
0
e
rT
T
_
T
0
e
(r

2
2
)u
e

2
2
u
du
thanks to a Laplace transform.
Hence :
V
0
=
S
0
e
rT
rT
(e
rT
1)
And nally
V
0
=
S
0
rT
(1 e
rT
)
We conclude also that

0
=
1
rT
(1 e
rT
)
These formulas can be extended to any given time:
V
t
=
S
t
rT
(1 e
r(Tt)
)

t
=
1
rT
(1 e
r(Tt)
)
26
These closed formulas allow us to verify the accuracy of the used numerical methods
and the validity of their results. However, we wont be able to use the variance reduction
method which is not dened in the zero strike case. We show here, on a same chart, the
theoritical price (in blue) and the simulated price (in red) as functions of the interest
rate for the following parameters values:
S
0
= 100, = 0.2, T = 1 year, N = 10, N
MC
= 20000
0.00 0.02 0.04 0.06 0.08 0.10 0.12 0.14 0.16
92
93
94
95
96
97
98
99
100
27
Then the same prices as functions of the initial asset value for:
r = 0.1, = 0.2, T = 1 year, N = 10, N
MC
= 20000
95 96 97 98 99 100 101 102 103 104 105
90
91
92
93
94
95
96
97
98
99
100
Tests are conclusive: graphs coincide.
28
We then plot the theoritical hedging (in blue) and the simulated hedging (in red),
rst by resimulation and then by pathwise method, as functions of time :
0 2 4 6 8 10 12
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
0 2 4 6 8 10 12
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
29
This particular case gives also the opportunity to evaluate the required discretisation
to obtain a price with a penny precision.
Let us place on a same chart the theoritical price and the simulated price, as functions
of N, the number of time steps, for the following parameters:
S
0
= 100, r = 0.1, = 0.2, T = 1 year, N
MC
= 100000
0 10 20 30 40 50 60
95.06
95.08
95.10
95.12
95.14
95.16
95.18
95.20
95.22
95.24
Even with N
MC
= 100000 and N = 60 we dont obtain the penny precision. Results
are not reliable.
In fact for a given number of simulation, variance does not decrease when N increases.
That is what the following graph shows, for the following parameters :
S
0
= 100, r = 0.1, = 0.2, T = 1 year, N
MC
= 50000
30
0 10 20 30 40 50 60
69
70
71
72
73
74
75
A variance reduction is required.
4.8.2 Trust intervals
Commentaries about numerical price simulations require to dene a 95% trust interval.
Its litteral expression is given by the central limit theorem:
_
X
M
1, 96
_
Var(X)
M
, X
M
+ 1, 96
_
Var(X)
M
_
where X is the random variable whose expected value we try to estimate and X
M
is the
Monte Carlo mean for M simulations.
It requires to evaluate the estimator variance. For this purpose we use the unbiased
variance Monte Carlo estimator:
M
M 1
_
1
M
M

i=1
X
2
i
X
2
M
_
31
4.8.3 Numerical results
Let us start with the test of the required discretisation to obtain a penny precision but
this time with a variance reduction method and for the following parameters:
S
0
= K = 100, r = 0.1, = 0.2, T = 1 an, N
MC
= 20000
0 10 20 30 40 50 60
7.023
7.027
7.031
7.035
7.039
7.043
7.047
7.051
With a variance reduction, for only N
MC
= 20000 simulations, N = 10 steps are
enough to obtain a penny precision.
In fact variance is very quickly stable around a very small value, as shows the fol-
lowing chart :
32
10 20 30 40 50 60
0.151
0.155
0.159
0.163
0.167
0.171
0.175
The variance reduction eciency is even more obvious on the following graphs where
we plot prices and trust intervals as functions of N
MC
without variance reduction and
then with variance reduction, with the parameters :
S
0
= K = 100, r = 0.1, = 0.2, T = 1 an, N = 30
33
10000 20000 30000 40000 50000 60000 70000 80000 90000 100000
6.88
6.92
6.96
7.00
7.04
7.08
7.12
7.16
7.20
7.24
10000 20000 30000 40000 50000 60000 70000 80000 90000 100000
7.028
7.030
7.032
7.034
7.036
7.038
7.040
7.042
7.044
7.046
7.048
We now give a results table where we have chosen the parameters:
S
0
= 100, r = 0.1, T = 1 an, N = 10, N
MC
= 20000
34
Fixed str. Fixed str. Floating str. Floating str.
Price Price
K /
0
/
0
Trust int. Trust int.
95 9.285 / [9.283 , 9.287] 0.914
0.1 100 5.252 / [5.250 , 5.253] 0.778 5.437 / [5.435 , 5.438] 0.054
105 2.293 / [2.291 , 2.295] 0.495
95 10.297 / [10.291 , 10.302] 0.781
0.2 100 7.039 / [7.034 , 7.044] 0.653 7.289 / [7.283 , 7.294] 0.073
105 4.504 / [4.499 , 4.510] 0.499
95 13.710 / [13.690 , 13.730] 0.673
0.4 100 11.118 / [11.096 , 11.139] 0.598 11.521 / [11.501 , 11.541] 0.115
105 8.901 / [8.880 , 8.922] 0.509
35
Chapter 5
Pricing and hedging with
determinist methods
5.1 Problem and context
The evaluation methods that we have seen until now are probabilistic. They relie upon
the Black - Scholes model for the asset value. We review in this section a determinist
pricing and hedging method which relies upon the discret binomial Cox Ross Rubinstein
model.
Following this CRR model we have:
S
t
k+1
=
_
S
t
k
e

h
with a probability u
S
t
k
e

h
with a probability 1 u
Where h is the time step and u is the CRR risk-neutral probability given by:
u =
e
rh
e

h
e

h
e

h
5.2 Forward Shooting Grid
5.2.1 Pricing
The FSG method, which has been introduced by Barraquand and Pudet
[4]
, lies in build-
ing a double discretisation grid, one for the asset value and the other for the asset
average.
Let us note (S
n
j
)
j
and (I
n
k
)
k
the sets of values that respectively S and I can take at
time nh.
36
We then write:
S
n
j
= S
0
e
jZ
et I
n
k
= S
0
e
kY
where Z =

h and Y = Z with
1

supposed to be an integer.
The recurrency relation between I values at nh and I values et (n + 1)h is:
I
n+1
k
+

=
(n + 1)A
n
k
+S
n+1
j
+

1
n + 2
Hence we get, for the index numbers:
k
+

= Nearest
_
log
(n+1)e
kZ
+e
(j
+

1)Z
n+2
Z
_
We prove also that k
m(n)
=
n

.
After having fully built the grid, we compute, backward and step by step, the option
price on the grid. The recurrency relation is:
V
n
j,k
= uV
n+1
j+1,k
+
+ (1 u)V
n+1
j1,k

where the initialisation is:

V
N
j,k
= e
rT
(I
N
k
K)
+
The option price is given by V
0
0,0
.
5.2.2 Hedging
With this method we only have to compute
0
. Indeed the binomial model is less robust
than the Black-Scholes model. It is more sensitive with respect to changes of parameters.
The grid has therefore to be rebuilt at each step, with the current parameters.
The relation
t
=
V
t
S
t
, which usually gives the delta value, does not have any sense
anymore and we must go back to the autonancing condition to compute the hedging.
Thus we have:
V
01
=
0
S
01
+ (V
0

0
S
0
)rh =
0
(S
0
rhS
0
) + rV
0
h
Let us write V
+
and V

the option prices which have been computed at the penulti-

mate backward algorithm step. We nally get:

0
= u
V
+
V
0
(1 + rh)
S
0
(e

h
1 rh)
+ (1 u)
V

V
0
(1 + rh)
S
0
(e

h
1 rh)
37
5.2.3 Algorithm complexity
At each backward algorithm step, i.e at each n, we have to compute at the most
2n

+1
k values for at the most 2n + 1 j values, i.e (2n + 1)(
2n

+ 1) values in total. n varying

between N 1 and 0, the number of values we have to compute is, at the most
N1

n=0
(2n + 1)(
2n

+ 1)
The algorithm time complexity will therefore be comparable to O(
N
3

).
The algorithm implemetation contains a triple loop which is organised like:
Loop on n
Loop on j
Loop on k
Space complexity then seems to be comparable to O(
N
3

). However, if we only keep

the current price value at each time step, space complexity becomes comparable to
O(
N
2

).
5.3 Numerical results
We present in this section the same type of results as for the Monte Carlo methods, i.e the
zero strike case and a panoramic results table. It should be noted that some vagueness
remains in the litterature about the method implementation (Barraquand and Pudet
[4]
do not mention any discounting of the price computed on grid and Temam
[5]
mentions
an integer part and not a round). Formulas which have been described in the previous
section lead to the right result.
5.3.1 Zero strike case
We show here, on a same chart, the theoritical price (in blue) and the simulated price
for N = 100 (in red), for N = 50 (in green), and N = 10 (in black) as functions of the
interest rate for the following parameters values:
S
0
= 100, = 0.2, T = 1 year, = 0.1
38
0.00 0.02 0.04 0.06 0.08 0.10 0.12 0.14 0.16
92
93
94
95
96
97
98
99
100
39
Then the same prices as functions of the initial asset value for:
r = 0.1, = 0.2, T = 1 year, = 0.1
95 96 97 98 99 100 101 102 103 104 105
90
91
92
93
94
95
96
97
98
99
100
Graphs coincid again. Let us notice that N = 50 gives correct results already.
5.3.2 Numerical results
S
0
= 100, r = 0.1, T = 1 an, = 0.1
40
Fixed str. Fixed str. Floating str. Floating str.
Price N = 50 Price N = 50
K /
0
/
0
Price N = 100 Price N = 100
95 9.292 / 9.292 0.905
0.1 100 5.253 / 5.257 0.764 5.420 / 5.436 0.060
105 2.276 / 2.289 0.485
95 10.295 / 10.299 0.775
0.2 100 7.038 / 7.043 0.644 7.275 / 7.311 0.078
105 4.497 / 4.505 0.492
95 13.707 / 13.741 0.664
0.4 100 11.107 / 11.135 0.587 11.512 / 11.572 0.120
105 8.895 / 8.917 0.509
41
Chapter 6
Extensions
To improve the project, we could consider various extensions concerning the methods
we use but also the way we implement them. Some go further than simply pricing and
hedging Asian Options but they are essential to the practical use of these options.
6.1 Improvement of the determinist method
It is possible to make the determinist method more accurate and more ecient by two
dierent ways:
Emmanuel Temam mentions a linear interpolation which lies in considering, not
only k
+
and k

but also k
+
+1 and k

+1. By introducing a normalised error we

obtain a new recurrency relation for the price computation on the grid.
Hull and White use another space discretisation, which is not quadratic anymore
but linear. The same algorithm as before leads then to a more accurate method.
6.2 Sensibilities computation
Sensibilities computation is essential in nance since it makes possible to test the model
robustness and to assess errors due to a wrong parametrisation. Unlike the standard
european options, there is no closed formula for the Greeks in the case of Asian Options.
We have already detailed the computation of the sensibility with respect to the asset
price, which is nothing else but the hedging. We could also consider :
42
A nite dierences Monte Carlo method to compute other sensibilities such as the
vega and the gamma which appear in the tracking error commited when a wrong
market volatility estimation has been done
An improvement of the Monte Carlo methods by implementing the Pathwise and
the Likelihood Ratio algorithms
6.3 Eciency comparison of the pricing methods
In this project we have not been able to compare the eciency of the dierent methods
we have implemented. Indeed all the methods have been developed in Scilab which is
especially ecient in the matricial computation but much less powerful in basic routines
than for example C++. By developing all the methods in C++ we could compare the
times required to obtain a given precision by the dierent methods. In this project we
have just veried that all the methods were unbiased and that increasing the discreti-
sation parameters results in increasing the precision.
43
Bibliography
[1] Broadie, Glasserman : Estimating Security Price Derivatives Using Simulation (1994)
[2] Mc Cann, Nordstrom : Energy Derivatives (1995)
[3] Rogers, Shi : The Value of an Asian Option (1995)
[4] Barraquand, Pudet : Pricing of American Path-dependent Contingent Claims (1996)
[5] Temam : Couverture Approchee des Options Exotiques. Pricing des Options Asiatiques
(2001)
[6] Lapeyre, Temam : Competitive Monte Carlo Methods for the Pricing of Asian Op-
tions(2003)
[7] Dubois : Dierences Finies Caracteristiques pour les Options Asiatiques(2003)
44