Level 9: Introductory Computational Finance

Goals and Objectives

We discuss various methods to price options:

Exact (closed) solutions.

Monte Carlo (MC) method.

Finite Difference method (FDM).

We discuss the fundamental processes and algorithms that describe how to price options. The focus is on

understanding the mathematical and financial fundamentals in j u s t enough detail so as to be able to

implement option pricing algorithms in C++. We recommend that you consult internet and other sources

(for example, www.datasimfinancial.com) in order to deepen your knowledge of these topics.

The goals of these exercises are:

? Understanding the C++ option pricing code for the above methods; create test programs with various data

sets.

? Getting used to the code style and learning some basic computational finance.

? Making the code more reusable and improving the design to allow for future extensions. In particular,

you’ll need to apply the object-oriented and generic programming techniques from previous sections.

? Comparing the above different methods with respect to accuracy, efficiency and stability. Stress testing

for the full range of parameters.

? Using STL, Boost and Duffy’s data structures.

It is not expected to have the full financial or mathematical background to the enclosed formulae; the focus is

on being able to program these formulae in C++.

Groups A&B: Exact Pricing Methods

Important Instructions:

? You will need to encapsulate all functionality (i.e., option pricing, greeks, matrix pricing) into proper classes.

You should submit Group A and Group B as a single, comprehensive project that takes all described

functionality into account, and presents a unified, well-structured, robust, and flexible design. While you have

full discretion to make specific design decisions in this level, your grade for Groups A and B will be based on

the overall quality of the submitted code in regards to robustness, flexibility, clarity, code commenting,

efficiency, conciseness, taking previously-learned concepts into account, and correctness.

? Your single main() function should fully test each and every aspect of your option pricing classes, to ensure

correctness prior to submission. This is of utmost importance.

? All answers to questions, as well as batch test outputs should be outlined in a document. Additionally, and

justifications for design decisions should be outlined in the document as well.

A. Exact Solutions of One-Factor Plain Options

In this section, we discuss the exact formulae for plain (European) equity options (with zero dividends) and their

sensitivities. These options can be exercised at the expiry time T only. The objectives are:

? Given the exact solution for a given financial quantity (for example, an option price), show how to map

it to C++ code.

? Use STL and Boost libraries as often as you can (do not reinvent the wheel). For example, we try

to use std::vector<T> to model arrays and Boost Random library to generate normal (Gaussian random

variates).

The parameters whose values that need to be initialized are:

? T (expiry time/maturity). This is a number, e.g. T = 1 means one year. K (strike price).

? sig (volatility).

? r (risk-free interest rate).

? S (current stock price where we wish to price the option).

? C = call option price, P = put option price.

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Finally, we note that n(x) is the normal (Gaussian) probability density function and N(x) is the cumulative

normaldistributionfunction,bothofwhicharesupportedin Boost Random.

We give the set of test values for option pricing. We give each set a name so that we can refer to it in later

exercises (we call them batches).

Batch 1: T = 0.25, K = 65, sig = 0.30, r = 0.08, S = 60 (then C = 2.13337, P = 5.84628).

Batch 2: T = 1.0, K = 100, sig = 0.2, r = 0.0, S = 100 (then C = 7.96557, P = 7.96557).

Batch 3: T = 1.0, K = 10, sig = 0.50, r = 0.12, S = 5 (C = 0.204058, P = 4.07326).

Batch 4: T = 30.0, K = 100.0, sig = 0.30, r = 0.08, S = 100.0 (C = 92.17570, P = 1.24750).

Of course, you can use other data sets; there are many resources available but we recommend you test the above

batches at the least.

We now give some mathematical and financial background to the Black-Scholes pricing formula. The formulae

apply to option pricing on a range of underlying securities, but we focus on stocks in these exercises.

We introduce the generalized Black–Scholes formula to calculate the price of a call option on some underlying

asset. In general, the call price is a function:

We can view the call option price C as a vector function because it maps a vector of parameters into a real value.

The exact formula for C is given by:

where N(x) is the standard cumulative normal (Gaussian) distribution function defined by

The cost-of-carry parameter b has specific values depending on the kind of security in question:

? b = r istheBlack–Scholesstock option model.

? b=r - q is the Mortonmodelwithcontinuousdividendyieldq.

? b = 0 istheBlack–Scholesfutures option model.

? b=r - R is the GarmanandKohlhagencurrencyoptionmodel,whereRistheforeignrisk-freeinterest

rate.

Thus, we can find the price of a plain call option by using formula (2). Furthermore, it is possible to differentiate

C with respect to any of the parameters to produce a formula for the option sensitivities.

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The corresponding formula for a put option is:

For the case of stock options, you take b = r in your calculations.

There is a relationship between the price of a European call option and the price of a European put option when

they have the same strike price K and maturity T. This is called put-call parity and is given by the formula:

This formula is used when creating trading strategies.

Answer the following questions:

a) Implement the above formulae for call and put option pricing using the data sets Batch 1 to Batch 4. Check

your answers, as you will need them when we discuss numerical methods for option pricing.

b) Apply the put-call parity relationship to compute call and put option prices. For example, given the call price,

compute the put price based on this formula using Batches 1 to 4. Check your answers with the prices from

part a). Note that there are two useful ways to implement parity: As a mechanism to calculate the call (or put)

price for a corresponding put (or call) price, or as a mechanism to check if a given set of put/call prices

satisfy parity. The ideal submission will neatly implement both approaches.

c) Say we wish to compute option prices for a monotonically increasing range of underlying values of S, for

example 10, 11, 12, …, 50. To this end, the output will be a vector. This entails calling the option pricing

formulae for each value S and each computed option price will be stored in a std::vector<double>

object. It will be useful to write a global function that produces a mesh array of doubles separated by a mesh

size h.

d) Now we wish to extend part c and compute option prices as a function of i) expiry time, ii) volatility, or iii)

any of the option pricing parameters. Essentially, the purpose here is to be able to input a matrix (vector of

vectors) of option parameters and receive a matrix of option prices as the result. Encapsulate this

functionality in the most flexible/robust way you can think of.

Option Sensitivities, aka the Greeks

Option sensitivities are the partial derivatives of the Black-Scholes option pricing formula with respect to one of

its parameters. Being a partial derivative, a given greek quantity is a measure of the sensitivity of the option

price to a small change in the formula’s parameter. There are exact formulae for the greeks; some examples are:

Answer the following questions:

a) Implement the above formulae for gamma for call and put future option pricing using the data set: K = 100,

S = 105, T = 0.5, r = 0.1, b = 0 and sig = 0.36. (exact delta call = 0.5946, delta put = -0.3566).

b) We now use the code in part a to compute call delta price for a monotonically increasing range of

underlying values of S, for example 10, 11, 12, …, 50. To this end, the output will be a vector and it entails

calling the above formula for a call delta for each value S and each computed option price will be store in a

std::vector<double> object. It will be useful to reuse the above global function that produces a mesh

array of double separated by a mesh size h.

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c) Incorporate this into your above matrix pricer code, so you can input a matrix of option parameters and receive

a matrix of either Delta or Gamma as the result.

d) We now use divided differences to approximate option sensitivities. In some cases, an exact formula may not

exist (or is difficult to find) and we resort to numerical methods. In general, we can approximate first and

second-order derivatives in S by 3-point second order approximations, for example:

In this case the parameter h is ‘small’ in some sense. By Taylor’s expansion you can show that the above

approximations are second order accurate in h to the corresponding derivatives.

The objective of this part is to perform the same calculations as in parts a and b, but now using divided

differences. Compare the accuracy with various values of the parameter h (In general, smaller values of h

produce better approximations but we need to avoid round-offer errors and subtraction of quantities that are

very close to each other). Incorporate this into your well-designed class structure.

B. Perpetual American Options

A European option can only be exercised at the expiry date T and an exact solution is known. An American

option is a contract that can be exercised at any time prior to T. Most traded stock options are American style. In

general, there is no known exact solution to price an American option but there is one exception, namely

perpetual American options. The formulae are:

for put options.

In general, the perpetual price is the time-homogeneous price and is the same as the normal price when the

expiry price T tends to infinity. In general, American options are worth more than European options.

Answer the following questions:

a) Program the above formulae, and incorporate into your well-designed options pricing classes.

b) Test the data with K = 100, sig = 0.1, r = 0.1, b = 0.02, S = 110 (check C = 18.5035, P = 3.03106).

c) We now use the code in part a) to compute call and put option price for a monotonically increasing range of

underlying values of S, for example 10, 11, 12, …, 50. To this end, the output will be a vector and this

exercise entails calling the option pricing formulae in part a) for each value S and each computed option

price will be stored in a std::vector<double> object. It will be useful to reuse the above global

function that produces a mesh array of double separated by a mesh size h.

d) Incorporate this into your above matrix pricer code, so you can input a matrix of option parameters and

receive a matrix of Perpetual American option prices.

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Groups C&D: Monte Carlo Pricing Methods

C. Monte Carlo 101

For this section, all necessary code is provided. You are expected to submit a document with the answers to the

below three questions, but not any code. The document should contain a detailed, complete analysis and will be

graded on how well it demonstrates understanding of the accuracy and efficiency of Monte Carlo methods in the

below context.

We focus on a linear, constant-coefficient, scalar (one-factor) problem. In particular, we examine the case of a

one-factor European call option using the assumptions of the original Black Scholes equation. We give an

overview of the process.

At the expiry date t = T the option price is known as a function of the current stock price and the strike price.

The essence of the Monte Carlo method isthat we carry out a simulation experiment by finding the solution of a

stochastic differential equation (SDE) from time t = 0 to time t = T. This process allows us to compute the

stock price at t = T and then the option price using the payoff function. We carry out M simulations or draws

by finding the solution of the SDE and we calculate the option price at t = T . Finally, we calculate the

discountedaverage ofthe simulatedpayoff andwe are done.

Summarizing, the process is:

1. Construct a simulated path of the underlying stock.

2. Calculate the stock price at t = T.

3. Calculate the call price at t = T (use the payoff function).

Execute steps 1–3 M times.

4. Calculate the averaged call price at t = T.

5. Discount the price found in step 4 to t = 0.

The first step is to replace continuous time by discrete time. To this end, we divide the interval [0, T ] (where T

is the expiry date) into a number of subintervals as shown in Figure 1. We define N + 1 mesh points as follows:

In general, we speak of a non-uniform mesh when the sizes of the subintervals are not necessarily the same.

However, in this book we consider a class of finite difference schemes where the N subintervals have the same

size (we then speak of a uniform mesh), namely ￠t = T=N.

Having defined how to subdivide [0,T ] into subintervals, we are now ready to motivate our finite difference

schemes; for the moment we examine the scalar linear SDE with constant coefficients:

Regarding notation, we do not show the dependence of variable X on t and when we wish to show this dependence

we prefer to write X = X(t) instead of the form Xt .

t0 = 0 tn

tn+ 1 T = tN

Figure 1 Mesh generation

We write equation (6) as a stochastic integral equation between the (arbitrary) times s and t as follows:

tn

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We evaluate equation (7) at two consecutive mesh points and using the fact that the factors a and b in equation

(6) are constant we get the exact identity:

We now approximate equation (8) and in this case we replace the solution X of equation (8) by a new discrete

function Y (that is, one that is defined at mesh points) by assuming that it is constant on each subinterval; we

then arrive at the discrete equation:

This is called the (explicit) Euler-Maruyama scheme and it is a popular method when approximating the

solution of SDEs. In some cases we write the solution in terms of a discrete function Xn if there is no confusion

between it and the solution of equations (6) or (7). In other words, we can write the discrete equation (9) in the

equivalent form:

In many examples the mesh size is constant and furthermore the Wiener increments are well-known computable

quantities:

Incidentally, we generate increments of the Wiener process by a random number generator for independent

Gaussian pseudo-random numbers, for example Box-Muller, Polar Marsaglia, Mersenne Twister or lagged

Fibonacci generator methods. In this book, we focus exclusively on the generators in Boost Random.

We deal almost exclusively with one-step marching schemes; in other words, the unknown solution at time level

n + 1 is calculated in terms of known values at time level n.

Answer the following questions:

a) Study the source code in the file TestMC.cpp and relate it to the theory that we have just discussed. The

project should contain the following source files and you need to set project settings in VS to point to the

correct header files:

Compile and run the program as is and make sure there are no errors.

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b) Run the MC program again with data from Batches 1 and 2. Experiment with different value of NT (time

steps) and NSIM (simulations or draws). In particular, how many time steps and draws do you need in order

to get the same accuracy as the exact solution? How is the accuracy affected by different values for

NT/NSIM?

c) Now we do some stress-testing of the MC method. Take Batch 4. What values do we need to assign to NT

and NSIM in order to get an accuracy to two places behind the decimal point? How is the accuracy affected

by different values for NT/NSIM?

D. Advanced Monte Carlo

This section will build upon the provided Monte Carlo code from the previous section, by adding methods to

track the accuracy of the MC simulation. You are expected to submit code in addition to a document with the

answers to the below questions. The document should contain a detailed, complete analysis and will be graded on

how well it presents understanding of the accuracy and efficiency of Monte Carlo methods in the below context.

We wish to add functionality to the Monte Carlo pricer by providing estimates for the standard deviation (SD)

and standard error (SE), defined by:

Implement this new functionality and test the software for a range of data for call and put options.

Answer the following questions:

a) Create generic functions to compute the standard deviation and standard error based on the above formulae.

The inputs are a vector of size M (M = NSIM), the interest-free rate and expiry time T. Integrate this new

code into TestMC.cpp. Make sure that the code compiles.

b) Run the MC program again with data from Batches 1 and 2. Experiment with different values of NT (time

steps) and NSIM (simulations or draws). How do SD and SE react for these different run parameters, and is

there any pattern in regards to the accuracy of the MC (when compared to the exact method)?

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E. Excel Visualization

For this section, almost all necessary code is provided. You will need to tweak the code (i.e. the Excel Import

paths) to work on your own machine and MS Excel version. Submission should consist of the working code and

example Excel output files.

We have developed a small package that allows us to display the output from the above schemes in Excel

spreadsheets. We have provided ready-made test programs that you can customize to suit your needs. Make sure

that you have the first FOUR files and ONE active test program in your project:

Answer the following questions:

a) Compile and run the sample programs TestSingleCurve.cpp, TestTwoCurve.cpp and TestMultipleCurve.cpp.

Make sure that everything compiles and that you get Excel output.

b) We now wish to compute option price for a monotonically increasing range of underlying values of S, for

example 10, 11, 12, …, 50. To this end, the output will be a vector and this exercise entails calling the exact

option pricing formulae) for each value S and each computed option price will be stored in a

std::vector<double> object. It will be useful to write a global function that produces a mesh array of

double separated by a mesh size h. Print the output in Excel.

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F. Finite Difference Methods (Introduction)

For this section, all necessary code is provided. You will need to tweak the code to work on your own machine

and MS Excel version. Submission should consist of the working code, example Excel output files, and a

document analyzing the accuracy of FDM versus the exact method. Alternatively, you may choose to modify the

code to output to the console (instead of Excel).

As FDM is a very advanced topic, this section is meant to be a brief taste of how FDM may be implemented using

the C++ techniques learned throughout this course. However, students are not expected to understand the

intricacies of FDM for option pricing, at this juncture, as that is the topic of a number of advanced MFE-level

courses.

The objective is to run the code as is and is not intended as a course in the finite difference method.

The explicit Euler method is conditionally stable by which we mean that the mesh size k in time must be much

less than the mesh size h in space (worst-case scenario is that k = O(h

2) ). The objective of this exercise is to

determine what the relationships are. Thus, for various values of h determine the value of k above which the

finite difference approximation is no longer accurate.

Answer the following questions:

a) Compile and run the project as in and make sure that you get Excel output. Examine the code and try to get

an idea of what is going on. The following files should be in the project:

b) In this exercise we test the FD scheme. We run the programs using the data from Batches1 to 4. Compare

your answers with those from the previous exercises. That’s all.

Remark: since we are using an explicit method, there is a relationship N = J*J where J is the number of mesh

points in space and N is the number of mesh points in time. This is somewhat pessimistic and you can try with

smaller values of N.

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