20150513

Mertons Jump-Diusion Model
Empirically, stock returns tend to have fat tails,

inconsistent with the Black-Scholes models assumptions.
Stochastic volatility and jump processes have been
proposed to address this problem.
Mertons jump-diusion model is our focus.a
a Merton (1976).
c
2015 Prof. Yuh-Dauh Lyuu, National Taiwan University Page 698
Mertons Jump-Diusion Model (continued)
This model superimposes a jump component on a
diusion component.
The diusion component is the familiar geometric
Brownian motion.
The jump component is composed of lognormal jumps
driven by a Poisson process.
It models the sudden changes in the stock price
because of the arrival of important new information.
c
Let St be the stock price at time t.
The risk-neutral jump-diusion process for the stock
price follows
dSt
= (r k) dt + dWt + k dqt . (81)
St
Above, denotes the volatility of the diusion
component.
c
The jump event is governed by a compound Poisson
process qt with intensity , where k denotes the
magnitude of the random jump.
The distribution of k obeys
2

ln(1 + k) N ,
2
with mean k E (k) = e+ /2
1.
The model with = 0 reduces to the Black-Scholes
model.
c
The solution to Eq. (81) on p. 700 is
(rk 2 /2) t+Wt
St = S0 e U (n(t)), (82)
where

n(t)
U (n(t)) = (1 + ki ) .
i=0
ki is the magnitude of the ith jump with
ln(1 + ki ) N (, 2 ).
k0 = 0.
n(t) is a Poisson process with intensity .
c
Mertons Jump-Diusion Model (concluded)
Recall that n(t) denotes the number of jumps that
occur up to time t.
As k > 1, stock prices will stay positive.
The geometric Brownian motion, the lognormal jumps,
and the Poisson process are assumed to be independent.
c
Tree for Mertons Jump-Diusion Modela
Dene the S-logarithmic return of the stock price S as
ln(S /S).
Dene the logarithmic distance between stock prices S

and S as
| ln(S ) ln(S) | = | ln(S /S) |.

a Dai (R86526008, D8852600), Wang (F95922018), Lyuu, and Liu
(2010).
c
Tree for Mertons Jump-Diusion Model (continued)
Take the logarithm of Eq. (82) on p. 702:

St
Mt ln = X t + Yt , (83)
S0
where
2

Xt r k /2 t + Wt , (84)

n(t)
Yt ln (1 + ki ) . (85)
i=0
It decomposes the S0 -logarithmic return of St into the

diusion component Xt and the jump component Yt .
c
Motivated by decomposition (83) on p. 705, the tree
construction divides each period into a diusion phase
followed by a jump phase.
In the diusion phase, Xt is approximated by the
BOPM.

Hence Xt can make an up move to Xt + t with

probability pu or a down move to Xt t with
probability pd .
c
According to BOPM,
et d
pu = ,
ud
pd = 1 pu ,
except that = r k here.

The diusion component gives rise to diusion nodes.

They are spaced at 2 t apart such as the white
nodes A, B, C, D, E, F, and G on p. 708.
c
( 1)t t ( + 1)t
White nodes are diusion nodes.

Gray nodes are jump nodes. In
the diusion phase, the solid black
h = 2 + 2
lines denote the binomial struc-
q1 ture of BOPM, whereas the dashed
pu q0 2 t lines denote the trinomial struc-
q1
ture. Here m is set to one here
pd for simplicity. Only the double-
circled nodes will remain after the
construction. Note that a and b are
diusion nodes because no jump oc-
curs in the jump phase.
c
Tree for Mertons Jump-Diusion Model (concluded)
In the jump phase, Yt+t is approximated by moves
from each diusion node to 2m jump nodes that match
the rst 2m moments of the lognormal jump.
The m jump nodes above the diusion node are spaced
at h apart.
The same holds for the m jump nodes below the
diusion node.
The gray nodes at time t on p. 708 are jump nodes.
After some work, the size of the tree is O(n2.5 ).
c
Multivariate Contingent Claims
They depend on two or more underlying assets.
The basket call on m assets has the terminal payo
m

max i Si ( ) X, 0 ,
i=1
where i is the percentage of asset i.

Basket options are essentially options on a portfolio of
stocks or index options.
Option on the best of two risky assets and cash has a
terminal payo of max(S1 ( ), S2 ( ), X).
c
Multivariate Contingent Claims (concluded)a
Name Payo
Exchange option max(S1 ( ) S2 ( ), 0)
Better-o option max(S1 ( ), . . . , Sk ( ), 0)
Worst-o option min(S1 ( ), . . . , Sk ( ), 0)
Binary maximum option I{ max(S1 ( ), . . . , Sk ( )) > X }
Maximum option max(max(S1 ( ), . . . , Sk ( )) X, 0)
Minimum option max(min(S1 ( ), . . . , Sk ( )) X, 0)
Spread option max(S1 ( ) S2 ( ) X, 0)
Basket average option max((S1 ( ), . . . , Sk ( ))/k X, 0)
Multi-strike option max(S1 ( ) X1 , . . . , Sk ( ) Xk , 0)
Pyramid rainbow option max(| S1 ( ) X1 | + + | Sk ( ) Xk | X, 0)

Madonna option max( (S1 ( ) X1 )2 + + (Sk ( ) Xk )2 X, 0)
a Lyuu and Teng (R91723054) (2011).
c
Correlated Trinomial Modela
Two risky assets S1 and S2 follow
dSi
= r dt + i dWi
Si
in a risk-neutral economy, i = 1, 2.
Let
Mi ert ,
2 i2 t
Vi Mi (e 1).
Si Mi is the mean of Si at time t.

Si2 Vi the variance of Si at time t.
a Boyle, Evnine, and Gibbs (1989).
c
Correlated Trinomial Model (continued)
The value of S1 S2 at time t has a joint lognormal
distribution with mean S1 S2 M1 M2 e1 2 t , where is
the correlation between dW1 and dW2 .
Next match the 1st and 2nd moments of the
approximating discrete distribution to those of the
continuous counterpart.
At time t from now, there are ve distinct outcomes.
c
The ve-point probability distribution of the asset prices
is (as usual, we impose ui di = 1)
Probability Asset 1 Asset 2
p1 S1 u1 S2 u2
p2 S1 u1 S2 d2
p3 S1 d1 S2 d2
p4 S1 d1 S2 u2
p5 S1 S2
c
The probabilities must sum to one, and the means must
be matched:
1 = p1 + p2 + p3 + p4 + p5 ,
S1 M1 = (p1 + p2 ) S1 u1 + p5 S1 + (p3 + p4 ) S1 d1 ,
S2 M2 = (p1 + p4 ) S2 u2 + p5 S2 + (p2 + p3 ) S2 d2 .
c
Correlated Trinomial Model (concluded)
Let R M1 M2 e1 2 t .
Match the variances and covariance:
2 2 2 2 2
S1 V1 = (p1 + p2 )((S1 u1 ) (S1 M1 ) ) + p5 (S1 (S1 M1 ) )
2 2
+(p3 + p4 )((S1 d1 ) (S1 M1 ) ),
2 2 2 2 2
S2 V2 = (p1 + p4 )((S2 u2 ) (S2 M2 ) ) + p5 (S2 (S2 M2 ) )
2 2
+(p2 + p3 )((S2 d2 ) (S2 M2 ) ),
S1 S2 R = (p1 u1 u2 + p2 u1 d2 + p3 d1 d2 + p4 d1 u2 + p5 ) S1 S2 .
The solutions are complex (see text).
c
Correlated Trinomial Model Simplieda

Let i r i2 /2 and ui e i t
for i = 1, 2.
The following simpler scheme is good enough:

1 1 t 1 2
p1 = + + + ,
4 2 1 2 2

1 1 t 1 2
p2 = + ,
4 2 1 2 2

1 1 t 1 2
p3 = + + ,
4 2 1 2 2

1 1 t 1 2
p4 = + + ,
4 2 1 2 2
1
p5 = 1 .
2
a Madan, Milne, and Shefrin (1989).
c
Correlated Trinomial Model Simplied (continued)
All of the probabilities lie between 0 and 1 if and only if

1 1
1 + t + 2 1 t 2 , (86)
1 2 1 2
1 (87)
We call a multivariate tree (correlation-) optimal if it

guarantees valid probabilities as long as

1 + O( t) < < 1 O( t),
such as the above one.a

a Kao(R98922093) (2011) and Kao (R98922093), Lyuu, and Wen
(D94922003) (2014).
c
Correlated Trinomial Model Simplied (concluded)
But this model cannot price 2-asset 2-barrier options
accurately.a
Few multivariate trees are both optimal and able to
handle multiple barriers.b
An alternative is to use orthogonalization.c
a SeeChang (B89704039, R93922034), Hsu (R7526001, D89922012), and
Lyuu (2006) and Kao (R98922093), Lyuu and Wen (D94922003) (2014)
for solutions.
b See Kao (R98922093), Lyuu, and Wen (D94922003) (2014) for one.
c Hull and White (1990) and Dai (R86526008, D8852600), Lyuu, and
Wang (F95922018) (2012).
c
Extrapolation
It is a method to speed up numerical convergence.
Say f (n) converges to an unknown limit f at rate of
1/n:

c 1
f (n) = f + + o . (88)
n n
Assume c is an unknown constant independent of n.

Convergence is basically monotonic and smooth.
c
Extrapolation (concluded)
From two approximations f (n1 ) and f (n2 ) and
ignoring the smaller terms,
c
f (n1 ) = f+ ,
n1
c
f (n2 ) = f+ .
n2
A better approximation to the desired f is
n1 f (n1 ) n2 f (n2 )
f= . (89)
n1 n2
This estimate should converge faster than 1/n.

The Richardson extrapolation uses n2 = 2n1 .
c
Improving BOPM with Extrapolation
Consider standard European options.
Denote the option value under BOPM using n time
periods by f (n).
It is known that BOPM convergences at the rate of 1/n,
consistent with Eq. (88) on p. 720.
But the plots on p. 282 (redrawn on next page)
demonstrate that convergence to the true option value
oscillates with n.
Extrapolation is inapplicable at this stage.
c
Call value Call value
15.5
13 15.4
12.5
15.3
12
15.2
11.5
15.1
5 10 15 20 25 30 35 0 10 20 30 40 50 60
n n
c
Improving BOPM with Extrapolation (concluded)
Take the at-the-money option in the left plot on p. 723.
The sequence with odd n turns out to be monotonic
and smooth (see the left plot on p. 725).a
Apply extrapolation (89) on p. 721 with n2 = n1 + 2,
where n1 is odd.
Result is shown in the right plot on p. 725.
The convergence rate is amazing.
See Exercise 9.3.8 of the text (p. 111) for ideas in the
general case.
a This can be proved; see Chang and Palmer (2007).
c
Call value Call value
13.4
12.17
13.2
12.16
13
12.15
12.8 12.14
12.6 12.13
12.4 12.12
12.2 12.11
5 10 15 20 25 30 35 5 10 15 20 25 30 35
n n
c
Numerical Methods
c
All science is dominated
by the idea of approximation.
Bertrand Russell
c
Finite-Dierence Methods
Place a grid of points on the space over which the
desired function takes value.
Then approximate the function value at each of these
points (p. 729).
Solve the equation numerically by introducing dierence
equations in place of derivatives.
c
115
110
105
100
95
90
85
80
0 0.05 0.1 0.15 0.2 0.25
c
Example: Poissons Equation
It is 2 /x2 + 2 /y 2 = (x, y).
Replace second derivatives with nite dierences
through central dierence.
Introduce evenly spaced grid points with distance of x
along the x axis and y along the y axis.
The nite dierence form is
(xi+1 , yj ) 2(xi , yj ) + (xi1 , yj )

(xi , yj ) =
(x)2
(xi , yj+1 ) 2(xi , yj ) + (xi , yj1 )
+ 2
.
(y)
c
Example: Poissons Equation (concluded)
In the above, x xi xi1 and y yj yj1 for
i, j = 1, 2, . . . .
When the grid points are evenly spaced in both axes so
that x = y = h, the dierence equation becomes
h2 (xi , yj ) = (xi+1 , yj ) + (xi1 , yj )

+(xi , yj+1 ) + (xi , yj1 ) 4(xi , yj ).
Given boundary values, we can solve for the xi s and the

yj s within the square [ L, L ].
From now on, i,j will denote the nite-dierence
approximation to the exact (xi , yj ).
c
Explicit Methods
Consider the diusion equation
D( 2 /x2 ) (/t) = 0, D > 0.
Use evenly spaced grid points (xi , tj ) with distances
x and t, where x xi+1 xi and t tj+1 tj .
Employ central dierence for the second derivative and
forward dierence for the time derivative to obtain

(x, t) (x, tj+1 ) (x, tj )
= + , (90)
t t=tj t

2 (x, t) (xi+1 , t) 2(xi , t) + (xi1 , t)
= + . (91)
x2 x=xi (x)2
c
Explicit Methods (continued)
Next, assemble Eqs. (90) and (91) into a single equation
at (xi , tj ).
But we need to decide how to evaluate x in the rst
equation and t in the second.
Since central dierence around xi is used in Eq. (91),
we might as well use xi for x in Eq. (90).
Two choices are possible for t in Eq. (91).
The rst choice uses t = tj to yield the following
nite-dierence equation,
i,j+1 i,j i+1,j 2i,j + i1,j
=D . (92)
t (x)2
c
Explicit Methods (continued)
The stencil of grid points involves four values, i,j+1 ,
i,j , i+1,j , and i1,j .
Rearrange Eq. (92) on p. 733 as

Dt 2Dt Dt
i,j+1 = i+1,j + 1 i,j + i1,j .
(x)2 (x)2 (x)2
We can calculate i,j+1 from i,j , i+1,j , i1,j , at the

previous time tj (see exhibit (a) on next page).
c
Stencils
xi xi
xi xi
xi xi
tj tj tj tj
= >
c
Explicit Methods (concluded)
Starting from the initial conditions at t0 , that is,
i,0 = (xi , t0 ), i = 1, 2, . . . , we calculate
i,1 , i = 1, 2, . . . .
And then
i,2 , i = 1, 2, . . . .
And so on.
c
Stability
The explicit method is numerically unstable unless
t (x)2 /(2D).
A numerical method is unstable if the solution is

highly sensitive to changes in initial conditions.
The stability condition may lead to high running times
and memory requirements.
For instance, halving x would imply quadrupling
(t)1 , resulting in a running time 8 times as much.
c
Explicit Method and Trinomial Tree
Recall that

Dt 2Dt Dt
i,j+1 = i+1,j + 1 i,j + i1,j .
(x) 2 (x) 2 (x) 2
When the stability condition is satised, the three

coecients for i+1,j , i,j , and i1,j all lie between
zero and one and sum to one.
They can be interpreted as probabilities.
So the nite-dierence equation becomes identical to
backward induction on trinomial trees!
The freedom in choosing x corresponds to similar
freedom in the construction of trinomial trees.
c
Implicit Methods
Suppose we use t = tj+1 in Eq. (91) on p. 732 instead.
The nite-dierence equation becomes
i,j+1 i,j i+1,j+1 2i,j+1 + i1,j+1
=D .
t (x)2
(93)
The stencil involves i,j , i,j+1 , i+1,j+1 , and i1,j+1 .

This method is implicit:
The value of any one of the three quantities at tj+1
cannot be calculated unless the other two are known.
See exhibit (b) on p. 735.
c
Implicit Methods (continued)
Equation (93) can be rearranged as
i1,j+1 (2 + ) i,j+1 + i+1,j+1 = i,j ,
where (x)2 /(Dt).

This equation is unconditionally stable.
Suppose the boundary conditions are given at x = x0
and x = xN +1 .
After i,j has been calculated for i = 1, 2, . . . , N , the
values of i,j+1 at time tj+1 can be computed as the
solution to the following tridiagonal linear system,
c
Implicit Methods (continued)

1,j+1
a 1 0 0 1,j 0,j+1
2,j+1
1 a 1 0 0 2,j

3,j+1
0 1 a 1 0 0 3,j
.

. . . . . . . . .
. . . . . . . . .
. . . . .
=

. . . ,
.

. . . . . . . . .
. . . . . . . . .
. . . . . . . .

.
0 0 1 a 1
.

N 1,j

.
0 0 1 a N,j N +1,j+1
N,j+1
where a 2 .
c
Implicit Methods (concluded)
Tridiagonal systems can be solved in O(N ) time and
O(N ) space.
Never invert a matrix to solve a tridiagonal system.
The matrix above is nonsingular when 0.
A square matrix is nonsingular if its inverse exists.
c
Crank-Nicolson Method
Take the average of explicit method (92) on p. 733 and
implicit method (93) on p. 739:
i,j+1 i,j
t

1 i+1,j 2i,j + i1,j i+1,j+1 2i,j+1 + i1,j+1
= D +D .
2 (x)2 (x)2
After rearrangement,
i+1,j+1 2i,j+1 + i1,j+1 i+1,j 2i,j + i1,j
i,j+1 = i,j + .
2 2
This is an unconditionally stable implicit method with

excellent rates of convergence.
c
Stencil
xi+1
xi
xi+1
tj tj+1
c
Numerically Solving the Black-Scholes PDE (65) on p.
583
See text.
Brennan and Schwartz (1978) analyze the stability of
the implicit method.
c
Monte Carlo Simulationa
Monte Carlo simulation is a sampling scheme.
In many important applications within nance and
without, Monte Carlo is one of the few feasible tools.
When the time evolution of a stochastic process is not
easy to describe analytically, Monte Carlo may very well
be the only strategy that succeeds consistently.
aA top 10 algorithm according to Dongarra and Sullivan (2000).
c
The Big Idea
Assume X1 , X2 , . . . , Xn have a joint distribution.
E[ g(X1 , X2 , . . . , Xn ) ] for some function g is
desired.
We generate

(i) (i)
x1 , x2 , . . . , x(i)
n , 1iN
independently with the same joint distribution as

(X1 , X2 , . . . , Xn ).
Set

(i) (i)
Yi g x1 , x2 , . . . , x(i)
n .
c
The Big Idea (concluded)
Y1 , Y2 , . . . , YN are independent and identically
distributed random variables.
Each Yi has the same distribution as
Y g(X1 , X2 , . . . , Xn ).
Since the average of these N random variables, Y ,

satises E[ Y ] = , it can be used to estimate .
The strong law of large numbers says that this
procedure converges almost surely.
The number of replications (or independent trials), N , is
called the sample size.
c
Accuracy
The Monte Carlo estimate and true value may dier
owing to two reasons:
1. Sampling variation.
2. The discreteness of the sample paths.a
The rst can be controlled by the number of replications.
The second can be controlled by the number of
observations along the sample path.
a Thismay not be an issue if the nancial derivative only requires
discrete sampling along the time dimension, such as the discrete barrier
option.
c
Accuracy and Number of Replications
The statistical error of the sample mean Y of the

random variable Y grows as 1/ N .
Because Var[ Y ] = Var[ Y ]/N .
In fact, this convergence rate is asymptotically optimal.a
So the variance of the estimator Y can be reduced by a
factor of 1/N by doing N times as much work.
This is amazing because the same order of convergence
holds independently of the dimension n.
a The Berry-Esseen theorem.
c
Accuracy and Number of Replications (concluded)
In contrast, classic numerical integration schemes have
an error bound of O(N c/n ) for some constant c > 0.
n is the dimension.
The required number of evaluations thus grows
exponentially in n to achieve a given level of accuracy.
The curse of dimensionality.
The Monte Carlo method is more ecient than
alternative procedures for multivariate derivatives when
n is large.
c
Monte Carlo Option Pricing
For the pricing of European options on a
dividend-paying stock, we may proceed as follows.
Assume
dS
= dt + dW.
S
Stock prices S1 , S2 , S3 , . . . at times t, 2t, 3t, . . .
can be generated via

( 2 /2) t+ t
Si+1 = Si e , N (0, 1). (94)
c
Monte Carlo Option Pricing (continued)
If we discretize dS/S = dt + dW directly, we will
obtain

Si+1 = Si + Si t + Si t .
But this is locally normally distributed, not lognormally,

hence biased.a
In practice, this is not expected to be a major problem
as long as t is suciently small.
a Contributed by Mr. Tai, Hui-Chin (R97723028) on April 22, 2009.
c
Monte Carlo Option Pricing (continued)
Non-dividend-paying stock prices in a risk-neutral
economy can be generated by setting = r and t = T .
1: C := 0; {Accumulated terminal option value.}

2: for i = 1, 2, 3, . . . , N do
(r 2 /2) T + T
3: P := S e , N (0, 1);
4: C := C + max(P X, 0);
5: end for
6: return CerT /N ;
c
Monte Carlo Option Pricing (concluded)
Pricing Asian options is also easy.
1: C := 0;
2: for i = 1, 2, 3, . . . , N do
3: P := S; M := S;
4: for j = 1, 2, 3, . . . , n do
(r 2 /2)(T /n)+
5: P := P e T /n
;
6: M := M + P ;
7: end for
8: C := C + max(M/(n + 1) X, 0);
9: end for
10: return CerT /N ;
c
How about American Options?
Standard Monte Carlo simulation is inappropriate for
American options because of early exercise (why?).
It is dicult to determine the early-exercise point based
on one single path.
But Monte Carlo simulation can be modied to price
American options with small biases (pp. 807).a
a Longsta and Schwartz (2001).
c
Delta and Common Random Numbers
In estimating delta, it is natural to start with the
nite-dierence estimate
r E[ P (S + ) ] E[ P (S ) ]
e .
2
P (x) is the terminal payo of the derivative security
when the underlying assets initial price equals x.
Use simulation to estimate E[ P (S + ) ] rst.
Use another simulation to estimate E[ P (S ) ].
Finally, apply the formula to approximate the delta.
This is also called the bump-and-revalue method.
c
Delta and Common Random Numbers (concluded)
This method is not recommended because of its high
variance.
A much better approach is to use common random
numbers to lower the variance:

P (S + ) P (S )
er E .
2
Here, the same random numbers are used for P (S + )

and P (S ).
This holds for gamma and cross gammas (for
multivariate derivatives).
c
Problems with the Bump-and-Revalue Method
Consider the binary option with payo

1, if S(T ) > X,
0, otherwise.
Then

1, if P (S + ) > X and
P (S + ) P (S ) = P (S ) ] < X ,

0, otherwise.
So the nite-dierence estimate per run for the

(undiscounted) delta is 0 or O(1/ ).
This means high variance.
c
Gamma
The nite-dierence formula for gamma is

P (S + ) 2 P (S) + P (S )
er E .
2
For a correlation option with multiple underlying assets,

the nite-dierence formula for the cross gamma
2 P (S1 , S2 , . . . )/(S1 S2 ) is:

P (S1 + 1 , S2 + 2 ) P (S1 1 , S2 + 2 )
er E
41 2

P (S1 + 1 , S2 2 ) + P (S1 1 , S2 2 )
.
c
Gamma (continued)
Choosing an of the right magnitude can be
challenging.
If is too large, inaccurate Greeks result.
If is too small, unstable Greeks result.
This phenomenon is sometimes called the curse of
dierentiation.
c
Gamma (continued)
In general, suppose
i
i

r r P (S)
i
e E[ P (S) ] = e E
i
holds for all i > 0, where is a parameter of interest.
Then formulas for the Greeks become integrals.
As a result, we avoid , nite dierences, and
resimulation.
c
Gamma (continued)
This is indeed possible for a broad class of payo
functions.a
Roughly speaking, any payo function that is equal
to a sum of products of dierentiable functions and
indicator functions with the right kind of support.
For example, the payo of a call is
max(S(T ) X, 0) = (S(T ) X)I{ S(T )X0 } .
The results are too technical to cover here (see next

page).
a Teng (R91723054) (2004) and Lyuu and Teng (R91723054) (2011).
c
Gamma (continued)
Suppose h(, x) H with pdf f (x) for x and gj (, x) G
for j B, a nite set of natural numbers.
Then

h(, x) 1{g (,x)>0} (x) f (x) dx
jB
j

= h (, x) 1{g (,x)>0} (x) f (x) dx
jB
j

+ h(, x)Jl (, x) 1{g (, x)>0} (x) f (x) ,
j
lB jB\l x=l ()
where
gl (, x) gl (, x)/
Jl (, x) = sign for l B.
xk gl (, x)/x
c
Gamma (concluded)
Similar results have been derived for Levy processes.a
Formulas are also recently obtained for credit
derivatives.b
In queueing networks, this is called innitesimal
perturbation analysis (IPA).c
a Lyuu, Teng (R91723054), and Wang (2013).
b Lyuu, Teng (R91723054), and Tzeng (2014).
c Cao (1985); Ho and Cao (1985).
c
Biases in Pricing Continuously Monitored Options
with Monte Carlo
We are asked to price a continuously monitored
up-and-out call with barrier H.
The Monte Carlo method samples the stock price at n
discrete time points t1 , t2 , . . . , tn .
A sample path
S(t0 ), S(t1 ), . . . , S(tn )
is produced.
Here, t0 = 0 is the current time, and tn = T is the
expiration time of the option.
c
with Monte Carlo (continued)
If all of the sampled prices are below the barrier, this
sample path pays max(S(tn ) X, 0).
Repeating these steps and averaging the payos yield a
Monte Carlo estimate.
c
1: C := 0;
2: for i = 1, 2, 3, . . . , N do
3: P := S; hit := 0;
4: for j = 1, 2, 3, . . . , n do
(r 2 /2) (T /n)+ (T /n)
5: P := P e ;
6: if P H then
7: hit := 1;
8: break;
9: end if
10: end for
11: if hit = 0 then
12: C := C + max(P X, 0);
13: end if
14: end for
15: return CerT /N ;
c
with Monte Carlo (continued)
This estimate is biased.a
Suppose none of the sampled prices on a sample path
equals or exceeds the barrier H.
It remains possible for the continuous sample path
that passes through them to hit the barrier between
sampled time points (see plot on next page).
a Shevchenko (2003).
c
H
c
with Monte Carlo (concluded)
The bias can certainly be lowered by increasing the
number of observations along the sample path.
However, even daily sampling may not suce.
The computational cost also rises as a result.
c

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Mertons Jump-Diusion Model

Empirically, stock returns tend to have fat tails,

Dene the logarithmic distance between stock prices S

| ln(S ) ln(S) | = | ln(S /S) |.

It decomposes the S0 -logarithmic return of St into the

except that = r k here.

White nodes are diusion nodes.

where i is the percentage of asset i.

Si Mi is the mean of Si at time t.

The solutions are complex (see text).

a Madan, Milne, and Shefrin (1989).

We call a multivariate tree (correlation-) optimal if it

such as the above one.a

Wang (F95922018) (2012).

Assume c is an unknown constant independent of n.

This estimate should converge faster than 1/n.

(xi+1 , yj ) 2(xi , yj ) + (xi1 , yj )

h2 (xi , yj ) = (xi+1 , yj ) + (xi1 , yj )

Given boundary values, we can solve for the xi s and the

We can calculate i,j+1 from i,j , i+1,j , i1,j , at the

A numerical method is unstable if the solution is

When the stability condition is satised, the three

The stencil involves i,j , i,j+1 , i+1,j+1 , and i1,j+1 .

i1,j+1 (2 + ) i,j+1 + i+1,j+1 = i,j ,

where (x)2 /(Dt).

This is an unconditionally stable implicit method with

independently with the same joint distribution as

Since the average of these N random variables, Y ,

But this is locally normally distributed, not lognormally,

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Here, the same random numbers are used for P (S + )

So the nite-dierence estimate per run for the

For a correlation option with multiple underlying assets,

max(S(T ) X, 0) = (S(T ) X)I{ S(T )X0 } .

The results are too technical to cover here (see next

S(t0 ), S(t1 ), . . . , S(tn )

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