CH 21 Hull OFOD9 TH Edition

Chapter 21
Basic Numerical Procedures

Options, Futures, and Other Derivatives, 9th Edition,
Copyright John C. Hull 2014 1
Approaches to Derivatives
Valuation

Trees
Monte Carlo simulation
Finite difference methods
Copyright John C. Hull 2014
2
Binomial Trees
Binomial trees are frequently used to
approximate the movements in the price of
a stock or other asset
In each small interval of time the stock
price is assumed to move up by a
proportional amount u or to move down by
a proportional amount d
3
Movements in Time t
(Figure 21.1, page 451)

4
Su

Sd
S

Tree Parameters for asset
paying a dividend yield of q
Parameters p, u, and d are chosen so that the tree
gives correct values for the mean & variance of the
stock price changes in a risk-neutral world

Mean: e
(rq)At
= pu + (1 p )d
Variance: o
2
At = pu
2
+ (1 p )d
2
e
2(rq)At

A further condition often imposed is u = 1/ d
5

Tree Parameters for asset
paying a dividend yield of q
(continued)
When At is small a solution to the equations is
6

t q r
t
t
e a
d u
d a
p
e d
e u
A
A o
A o
=

=
=
=
) (
The Complete Tree
(Figure 21.2, page 453)
7
S
0
u
4

S
0
u
2

S
0
d
2

S
0
d
4

S
0

S
0
u
S
0
d
S
0

S
0

S
0
u
2

S
0
d
2

S
0
u
3

S
0
u
S
0
d
S
0
d
3

Backwards I nduction
We know the value of the option at the
final nodes
We work back through the tree using
risk-neutral valuation to calculate the
value of the option at each node, testing
for early exercise when appropriate
8
Example: Put Option
(Example 21.1, page 453-455)
S
0
= 50; K = 50; r =10%; o = 40%;
T = 5 months = 0.4167; At = 1 month = 0.0833
In this case

9
5073 0
8909 0 1224 1
8909 0 0084 1
8909 0
1
1224 1
0084 1
12 1 4 0
12 1 1 0
.
. .
. .
.
.
.
/ .
/ .
=
=
= =
= =
= =

p
u
d
e u
e a
Example (continued; Figure 21.3, page 454)

Copyright John C. Hull 2014 10
At each node:
Upper value = Underlying Asset Price 89.07
Lower value = Option Price 0.00
Values in red are a result of exercise. 79.35
0.00
70.70 70.70
0.00 0.00
62.99 62.99
0.64 0.00
56.12 56.12 56.12
2.16 1.30 0.00
50.00 50.00 50.00
4.49 3.77 2.66
44.55 44.55 44.55
6.96 6.38 5.45
39.69 39.69
10.36 10.31
35.36 35.36
14.64 14.64
31.50
18.50
28.07
21.93
Node Time:
0.0000 0.0833 0.1667 0.2500 0.3333 0.4167
Calculation of Delta
Delta is calculated from the nodes at time At

11
Delta =

=
216 696
5612 4455
041
. .
. .
.
Calculation of Gamma
Gamma is calculated from the nodes at time
2At

12
A A
A A
1 2
2
064 377
62 99 50
0 24
377 10 36
50 39 69
064
1165
003
=

= =

=
. .
.
. ;
. .
.
.
.
. Gamma=
1
=0.5(62.99-50)+0.5(50-39.69)
Calculation of Theta
Theta is calculated from the central nodes at
times 0 and 2At

13
Theta= per year
or - . per calendar day
377 4 49
01667
4 3
0012
. .
.
.
=
Calculation of Vega
We can proceed as follows
Construct a new tree with a volatility of 41%
instead of 40%.
Value of option is 4.62
Vega is

14
4 62 4 49 013 . . . =
per 1% change in volatility
Trees for Options on I ndices,
Currencies and Futures Contracts

As with Black-Scholes-Merton:
For options on stock indices, q equals the dividend
yield on the index
For options on a foreign currency, q equals the
foreign risk-free rate
For options on futures contracts q = r
15
Binomial Tree for Stock Paying
Known Dividends
Procedure:
Construct a tree for the stock price less the
present value of the dividends
Create a new tree by adding the present value
of the dividends at each node
This ensures that the tree recombines and
makes assumptions similar to those when
the Black-Scholes-Merton model is used
for European options
16
Control Variate Technique
Value American option, f
A

Value European option using same tree, f
E

Value European option using Black-Scholes
Merton, f
BS

Option price =f
A
+(f
BS
f
E
)

17
Alternative Binomial Tree
(page 465)
Instead of setting u = 1/d we can set each
of the 2 probabilities to 0.5 and
18
t t q r
t t q r
e d
e u
A o A o
A o + A o
=
=
) 2 / (
) 2 / (
2
2
Trinomial Tree (Page 467)
19
6
1
2 12
3
2
6
1
2 12
/ 1
2
2
2
2
3
+
|
|
.
|
\
|
o
o
A
=
=
+
|
|
.
|
\
|
o
o
A
=
= =
A o
r
t
p
p
r
t
p
u d e u
d
m
u
t
S S
Sd
Su
p
u
p
m
p
d
Time Dependent Parameters in a
Binomial Tree (page 468)

Making r or q a function of time does not
affect the geometry of the tree. The
probabilities on the tree become functions of
time.
We can make o a function of time by making
the lengths of the time steps inversely
proportional to the variance rate.
20
Monte Carlo Simulation and
How could you calculate t by randomly
sampling points in the square?
21
Monte Carlo Simulation and Options

When used to value European stock options,
Monte Carlo simulation involves the following
steps:
1. Simulate 1 path for the stock price in a risk
neutral world
2. Calculate the payoff from the stock option
3. Repeat steps 1 and 2 many times to get many
sample payoffs
4. Calculate mean payoff
5. Discount mean payoff at risk free rate to get an
estimate of the value of the option
22
Sampling Stock Price Movements

In a risk neutral world the process for a
stock price is

where is the risk-neutral return
We can simulate a path by choosing time
steps of length At and using the discrete
version of this

where c is a random sample from |(0,1)
23
t S t S S A c o + A = A
dS S dt S dz = +
A More Accurate Approach

(Equation 21.15, page 471)
24
( )
( )
( ) t t
e t S t t S
t t t S t t S
dz dt S d
A c o + A o
= A +
A oc + A o = A +
o + o =

or

is this of version discrete The

Use
2 /
2
2
2
) ( ) (
2 /
) ( ln ) ( ln
2 /
ln
Extensions
When a derivative depends on several
underlying variables we can simulate
paths for each of them in a risk-neutral
world to calculate the values for the
derivative
25
Sampling from Normal
Distribution (Page 473)
In Excel =NORMSINV(RAND()) gives a
random sample from |(0,1)
26
To Obtain 2 Correlated Normal
Samples
Obtain independent normal samples x
1
and x
2

and set

Use a procedure known as Choleskys
decomposition when samples are required from
more than two normal variables (see page 473)
2
2 1 2
1 1
1 + = c
= c
x x
x
Options, Futures, and Other Derivatives, 9th Edition, Copyright John C. Hull 2014 27
Standard Errors in Monte Carlo
Simulation

The standard error of the estimate of the
option price is the standard deviation of the
discounted payoffs given by the simulation
trials divided by the square root of the
number of observations.
28
Application of Monte Carlo
Simulation
Monte Carlo simulation can deal with path
dependent options, options dependent on
several underlying state variables, and
options with complex payoffs
It cannot easily deal with American-style
options
29
Determining Greek Letters
For A:
1. Make a small change to asset price
2. Carry out the simulation again using the same
random number streams
3. Estimate A as the change in the option price
divided by the change in the asset price

Proceed in a similar manner for other Greek
letters
30
Variance Reduction Techniques
Antithetic variable technique
Control variate technique
Importance sampling
Stratified sampling
Moment matching
Using quasi-random sequences
31
Sampling Through the Tree
32
Instead of sampling from the stochastic
process we can sample paths randomly
through a binomial or trinomial tree to value a
derivative
At each node that is reached we sample a
randon number between 0 and 1. If it is
betweeb 0 and p, we take the up branch; if it
is between p and 1, we take the down branch
Finite Difference Methods
Finite difference methods aim to
represent the differential equation in
the form of a difference equation
We form a grid by considering
equally spaced time values and stock
price values
Define
i,j
as the value of at time iAt
when the stock price is jAS
33
The Grid
34
Finite Difference Methods
(continued)
35

2

2
Set

2
1

or
2
1 1
2
2
1 1
2
2
1 1
2
2
2 2
S

S
S
S

S

S
S

S
r
S
S
S
S q r
t

i,j i,j i,j
i,j i,j i,j i,j
i,j i,j
+
=
c
c
|
|
.
|
\
|

=
c
c
=
c
c
=
c
c
+
c
c
+
c
c
+
+
+
) (
I mplicit Finite Difference Method
36

: form the of
form the of equation an node each for obtain to
Set
1 1 1
1
c b a
t

t

,j i i,j j i,j j i,j j
i,j ,j i
+ +
+
= + +
=
c
c
Explicit Finite Difference Method
37
c b a
j i, j , i
S f S f
,j i
*
j ,j i
*
j ,j i
*
j i,j 1 1 1 1 1
2
1
+ + + +
+ + =
+
c c c c

: form the of equations solving involves This
method difference finite explicit the obtain we
point ) ( the at are they as point ) ( the at
same the be to assumed are and If
2
I mplicit vs Explicit Finite
Difference Method
The explicit finite difference method is
equivalent to the trinomial tree approach
The implicit finite difference method is
equivalent to a multinomial tree approach
38
I mplicit vs Explicit
Finite Difference Methods (Figure 21.16, page 484)

39
i , j
i +1, j
i +1, j 1
i +1, j +1
i +1, j
i , j
i , j 1
i , j +1
Implicit
Method
Explicit
Method
Other Points on Finite Difference
Methods

It is better to have ln S rather than S as the
underlying variable
Improvements over the basic implicit and
explicit methods:
Hopscotch method
Crank-Nicolson method
40

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Chapter 21

Basic Numerical Procedures

A More Accurate Approach

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