Wikipedia founder Jimmy Wales Finite difference methods for option pricing From Wikipedia, the free encyclopedia Jump to: navigation, search Finite difference methods for option pricing are numerical methods used in mathematical finance for the valuation of options. [1] Finite difference methods were first applied to option pricing y !duardo "chwart# in 1$%%. [&] Finite difference methods can solve derivative pricing prolems that have, in general, the same level of comple'ity as those prolems solved y tree approaches, [1] and are therefore usually employed only when other approaches are inappropriate. (t the same time, like tree)ased methods, this approach is limited in terms of the numer of underlying variales, and for prolems with multiple dimensions, *onte +arlo methods for option pricing are usually preferred. ,he approach is due to the fact that the evolution of the option value can e modelled via a partial differential e-uation ./0!1, as a function of .at least1 time and price of underlying2 see for e'ample 3lack4"choles /0!. 5nce in this form, a finite difference model can e derived, and the valuation otained. [&] 6ere, essentially, the /0! is e'pressed in a discreti#ed form, using finite differences, and the evolution in the option price is then modelled using a lattice with corresponding dimensions2 here, time runs from 7 to maturity and price runs from 7 to a 8high8 value, such that the option is deeply in or out of the money. ,he option is valued as follows: [9] *aturity values are simply the difference etween the e'ercise price of the option and the value of the underlying at each point. :alues at the oundary prices are set ased on moneyness or aritrage ounds on option prices. :alues at other lattice points are calculated recursively, starting at the time step preceding maturity and ending at time ; 7. 6ere, using a techni-ue such as +rank4<icolson or the e'plicit method: 1. the /0! is discreti#ed per the techni-ue chosen, such that the value at each lattice point is specified as a function of the value at later and ad=acent points2 see "tencil .numerical analysis12 &. the value at each point is then found using the techni-ue in -uestion. ,he value of the option today, where the underlying is at its spot price, .or at any time>price comination,1 is then found y interpolation. (s aove, these methods and tree)ased methods are ale to handle prolems which are e-uivalent in comple'ity. ?n fact, when standard assumptions are applied it can e shown that the e'plicit techni-ue encompasses the inomial and trinomial tree methods. [@] ,ree ased methods, then, suitaly parameteri#ed, are a special case of the e'plicit finite difference method. [A] [edit] References 1. B a
b 6ull, John +. .&77&1. Options, Futures and Other Derivatives .Ath ed.1. /rentice 6all. ?"3< 7)19)77$7AC)A. &. B a
b "chwart#, !. .January 1$%%1. 8,he :aluation of Warrants: ?mplementing a <ew (pproach8. Journal of Financial Economics 4: %$4$@. doi:17.171C>797@) @7AD.%%1$779%)D. http:>>ideas.repec.org>a>eee>=finec>v@y1$%%i1p%$)$9.html. 9. ^ Wilmott, /.2 6owison, ".2 0ewynne, J. .1$$A1. The Mathematics of Financial Derivatives: A Student Introduction. +amridge Eniversity /ress. ?"3< 7A&1@$%F$&. @. ^ 3rennan, *.2 "chwart#, !. ."eptemer 1$%F1. 8Finite 0ifference *ethods and Jump /rocesses (rising in the /ricing of +ontingent +laims: ( "ynthesis8. Journal of Financial and Quantitative Analsis .Eniversity of Washington "chool of 3usiness (dministration1 13 .91: @C1 4 @%@. doi:17.&97%>&9971A&. http:>>www.=stor.org>pss>&9971A&. A. ^ Guinstein, *. .&7771. 85n the Gelation 3etween 3inomial and ,rinomial 5ption /ricing *odels8. Journal of Derivatives 8 .&1: @% 4 A7. doi:17.9$7A>=od.&777.91$1@$. http:>>we.archive.org>we>&77%7C&&1A79@C>www.in)the) money.com>pages>author.htm. [Product Description Numerical methods for the solution of financial instrument pricing equations are fast becoming essential for practitioners of modern quantitative finance. Among the most promising of these new computational finance techniques is the finite difference methodyet, to date, no single resource has presented a quality, comprehensive overview of this revolutionary quantitative approach to risk management. Pricing inancial !nstruments, researched and written by Domingo "avella and #urt $andall, two of the chief proponents of the finite difference method, presents a logical framework for applying the method of finite difference to the pricing of financial derivatives. Detailing the algorithmic and numerical procedures that are the foundation of both modern mathematical finance and the creation of financial productswhile purposely keeping mathematical comple%ity to a minimumthis long awaited book demonstrates how the techniques described can be used to accurately price simple and comple% derivative structures. rom a summary of stochastic pricing processes and arbitrage pricing arguments, through the analysis of numerical schemes and the implications of discreti&ationand ending with case studies that are simple yet detailed enough to demonstrate the capabilities of the methodology Pricing inancial !nstruments e%plores areas that include' Pricing equations and the relationship between (uropean and American derivatives Detailed analyses of different stability analysis approaches #ontinuous and discrete sampling models for path dependent options )nedimensional and multidimensional coordinate transformations Numerical e%amples of barrier options, Asian options, forward swaps, and more *ith an emphasis on how numerical solutions work and how the appro%imations involved affect the accuracy of the solutions, Pricing inancial !nstruments takes us through doors opened wide by +lack, ,choles, and -ertonand the arbitrage pricing principles they introduced in the early ./01sto provide a stepbystep outline for sensibly interpreting the output of standard numerical schemes. !t covers the understanding and application of today2s finite difference method, and takes the reader to the ne%t level of pricing financial instruments and managing financial risk. Praise for Pricing inancial !nstruments 3Pricing inancial !nstruments is the first broad and accessible treatment of finite difference methods for pricing derivative securities. "he authors have taken great care to clearly e%plain both the origins of the pricing problems in a financial setting, as well as many practical aspects of their numerical methods. "he book covers a wide variety of applications, such as American options and credit derivatives. +oth financial analysts and academic assetpricing specialists will want to own a copy.3 Darrell Duffie, Professor of inance ,tanford 4niversity 3!n my e%perience, finite difference methods have proven to be a simple yet powerful tool for numerically solving the evolutionary PD(s that arise in modern mathematical finance. "his book should finally dispel the widely held notion that these methods are somehow difficult or abstract. ! highly recommend it to anyone interested in the implementation of these methods in the financial arena.3Peter #arr, Principal +ank of America ,ecurities 3A very comprehensive treatment of the application of finite difference techniques to derivatives finance. Practitioners will find the many e%tensive e%amples very valuable and students will appreciate the rigorous attention paid to the many subtleties of finite difference techniques.3rancis 5ongstaff, Professor "he Anderson ,chool at 4#5A 3"he finite difference approach is central to the numerical pricing of financial securities. "his book gives a clear and succinct introduction to this important sub6ect. 7ighly recommended.3-ark +roadie, Associate Professor ,chool of +usiness, #olumbia 4niversity or updates on new and bestselling *iley inance books' wiley.com8wbns rom the !nside lap Pricing inancial !nstruments Numerical methods for the solution of financial instrument pricing equations are fast becoming essential for practitioners of modern quantitative finance. Among the most promising of these new computational finance techniques is the finite difference methodyet, to date, no single resource has presented a quality, comprehensive overview of this revolutionary quantitative approach to risk management. Pricing inancial !nstruments, researched and written by Domingo "avella and #urt $andall, two of the chief proponents of the finite difference method, presents a logical framework for applying the method of finite difference to the pricing of financial derivatives. Detailing the algorithmic and numerical procedures that are the foundation of both modern mathematical finance and the creation of financial productswhile purposely keeping mathematical comple%ity to a minimumthis longawaited book demonstrates how the techniques described can be used to accurately price simple and comple% derivative structures. rom a summary of stochastic pricing processes and arbitrage pricing arguments, through the analysis of numerical schemes and the implications of discreti&ationand ending with case studies that are simple yet detailed enough to demonstrate the capabilities of the methodologyPricing inancial !nstruments e%plores areas that include' Pricing equations and the relationship between (uropean and American derivatives Detailed analyses of different stability analysis approaches #ontinuous and discrete sampling models for path dependent options )nedimensional and multidimensional coordinate transformations Numerical e%amples of barrier options, Asian options, forward swaps, and more *ith an emphasis on how numerical solutions work and how the appro%imations involved affect the accuracy of the solutions, Pricing inancial !nstruments takes us through doors opened wide by +lack, ,choles, and -ertonand the arbitrage pricing principles they introduced in the early ./01sto provide a stepbystep outline for sensibly interpreting the output of standard numerical schemes. !t covers the understanding and application of today2s finite difference method, and takes the reader to the ne%t level of pricing financial instruments and managing financial risk. "ee all /roduct 0escription <umerical methods for the solution of financial instrument pricing e-uations are fast ecoming essential for practitioners of modern -uantitative finance. (mong the most promising of these new computational finance techni-ues is the finite difference method) yet, to date, no single resource has presented a -uality, comprehensive overview of this revolutionary -uantitative approach to risk management. /ricing Financial ?nstruments, researched and written y 0omingo ,avella and +urt Gandall, two of the chief proponents of the finite difference method, presents a logical framework for applying the method of finite difference to the pricing of financial derivatives. 0etailing the algorithmic and numerical procedures that are the foundation of oth modern mathematical finance and the creation of financial products)while purposely keeping mathematical comple'ity to a minimum)this long)awaited ook demonstrates how the techni-ues descried can e used to accurately price simple and comple' derivative structures. From a summary of stochastic pricing processes and aritrage pricing arguments, through the analysis of numerical schemes and the implications of discreti#ation)and ending with case studies that are simple yet detailed enough to demonstrate the capailities of the methodology) /ricing Financial ?nstruments e'plores areas that include: H /ricing e-uations and the relationship e)tween !uropean and (merican derivatives H 0etailed analyses of different staility analysis approaches H +ontinuous and discrete sampling models for path dependent options H 5ne)dimensional and multi)dimensional coordinate transformations H <umerical e'amples of arrier options, (sian options, forward swaps, and more With an emphasis on how numerical solutions work and how the appro'imations involved affect the accuracy of the solutions, /ricing Financial ?nstruments takes us through doors opened wide y 3lack, "choles, and *erton)and the aritrage pricing principles they introduced in the early 1$%7s)to provide a step)y)step outline for sensily interpreting the output of standard numerical schemes. ?t covers the understanding and application of todayIs finite difference method, and takes the reader to the ne't level of pricing financial instruments and managing financial risk. /raise for /ricing Financial ?nstruments 8/ricing Financial ?nstruments is the first road and accessile treatment of finite difference methods for pricing derivative securities. ,he authors have taken great care to clearly e'plain oth the origins of the pricing prolems in a financial setting, as well as many practical aspects of their numerical methods. ,he ook covers a wide variety of applications, such as (merican options and credit derivatives. 3oth financial analysts and academic asset)pricing specialists will want to own a copy.8)0arrell 0uffie, /rofessor of Finance "tanford Eniversity 8?n my e'perience, finite difference methods have proven to e a simple yet powerful tool for numerically solving the evolutionary /0!s that arise in modern mathematical finance. ,his ook should finally dispel the widely held notion that these methods are somehow difficult or astract. ? highly recommend it to anyone interested in the implementation of these methods in the financial arena.8)/eter +arr, /rincipal 3ank of (merica "ecurities 8( very comprehensive treatment of the application of finite difference techni-ues to derivatives finance. /ractitioners will find the many e'tensive e'amples very valuale and students will appreciate the rigorous attention paid to the many sutleties of finite difference techni-ues.8)Francis Jongstaff, /rofessor ,he (nderson "chool at E+J( 8,he finite difference approach is central to the numerical pricing of financial securities. ,his ook gives a clear and succinct introduction to this important su=ect. 6ighly recommended.8)*ark 3roadie, (ssociate /rofessor "chool of 3usiness, +olumia Eniversity For updates on new and estselling Wiley Finance ooks: wiley.com>wns ,his three)day course shows how to use the Finite 0ifference *ethod .F0*1 to price a range of one)factor and many)factor option pricing models for e-uity and interest rate prolems that we specify as partial differential e-uations ./0!s1. We introduce and elaorate modern and roust finite difference methods that solve pricing prolems and that remain stale and accurate for various cominations of input parameters, payoff functions and oundary conditions. ,his course discusses all aspects of option pricing, starting from the /0! specification of the model through to defining roust and appropriate F0 schemes which we then use to price multi)factor /0! to ensure good accuracy and staility. ,he contents of the course have een updated and revised to reflect new results and developments in the field. Course Highlights ?n general, you learn how to analyse, design and assemle finite difference schemes in computational finance applications. "ome of the specific skills that you learn are: ) 0efine an unamiguous, water)tight /0! for an option model ) Ket a real understanding of finite differences, from ( to L ) Mnow which schemes work and when ) (pply F0* to a wide range of option pricing models ) Jearn roust and accurate algorithms ) Kuidelines on implementation in +NN, +O, parallel and K/Es ?n short, you will learn the latest developments in this field and e ale to use them immediately in your own work. "ource code for the models is provided. Prerequisites +andidates should have a good ackground in mathematics and knowledge of financial derivatives. Wht do !ou recei"e# Full set of slides, +0 with software and a copy of 0aniel 0uffyIs ook 8Finite 0ifference *ethods in Financial !ngineering: ( /artial 0ifferential !-uation (pproach8. Pou are invited to ask -uestions on your own specific applications as well. ,he price includes coffee, tea, lunch and refreshments. Who should ttend# ,his course has een developed so that you can use the theory to solve e'isting prolems as well as applying the knowledge to the pricing of new financial instruments. ?n particular, the course is for professionals with a strong mathematical ackground: ) Financial engineers who design new pricing models ) (nalysts and -uants ) 5ther professionals who wish to understand and apply advanced numerical methods to derivatives pricing Course $utor 0aniel J. 0uffy has 3( .*od1, *"c and /h0 degrees, all of which in mathematics and numerical analysis. 6e has een working with numerical methods on finance, industry and engineering since 1$%$. 6e has written four ooks on numerical methods and +NN for -uantitative finance and he has developed a numer of new schemes for this field as well as more than &7 years of training e'perience. Wht h"e pre"ious delegtes sid# ) 8*y e'pectations were topped2 can go now and implement 9d models using splitting8 ) 8Geally liked it. :ery informative8 ) 8? would enthusiastically recommend this course to colleagues8 ) 8!'cellent course8