UQ in Option Pricing

Tunisia Polytechnic School
King Abdullah University of Science and Technology

Graduation Project Defense
Numerical Methods For Uncertainty Quantication In Option
Pricing
Defended by: Chiheb BEN HAMMOUDA
Supervised by: Dr. Raul TEMPONE
June 28th, 2013
Basic Notions Related To The Project
UQ In Option Pricing: One Dimensional Case
UQ In Option Pricing: Multidimensional Case
Conclusion
Issue: Uncertainty In Option Pricing
Model uncertainty: The choice of the pricing models.
Parametric uncertainty: The values of parameters within the chosen
parametric model.
Mispricing of contingent claims .
Project Aim
Developing a quantitative framework for studying the impact of parametric
uncertainty on option pricing in the case of both European single asset and
basket options under Black-Scholes framework.
2/30
Conclusion
Related Work:
Deterministic methods: Sensitivity derivatives & Worst case analysis.
Probabilistic Uncertainty analysis: Monte Carlo (MC) and Polynomial
Chaos (PC) assuming a uniform distribution for the parametric
uncertainty.
Main Contributions:
Developing one dimensional PC approximation (more ecient than
standard MC) corresponding to the parametric distribution that best
ts volatility s sample data.
Investigating the impact of parametric uncertainty in multidimensional
case by developing Sparse Grid Quadrature (SGQ)technique .
2/30
Conclusion
Outline:
1
Pricing Theory
Uncertainty Quantication(UQ) framework
2
Implementation Details
Numerical Results
3
Numerical Results
4
Conclusion
3/30
Conclusion
Pricing Theory
Uncertainty Quantification(UQ) framework
Outline:
1
Pricing Theory
2
Numerical Results
3
Numerical Results
4
Conclusion
4/30
Conclusion
Pricing Theory
Option Pricing Framework
Black And Scholes Framework: Single Asset Option
dS(t) = S(t)dt +S(t)dW(t)
Black And Scholes Framework: Basket Option
dS
i
(t) = S
i
(t)(rdt +
i
dW
i
(t))
E[dW
i
(t), dW
j
(t)] =
ij
dt.
Martingale Approach:
Option value as the Q-expectation of the discounted payo:
V
0
= E
Q
_
e
rT
V
e
(T)
_
5/30
Conclusion
Pricing Theory
Valuation Formula
Single Asset Option
V (S, 0) =
_
S
0
N(d
1
) Ke
rT
N(d
2
) , Call option
Ke
rT
N(d
2
) S
0
N(d
1
) , Put option
d
1
=
ln(S
0
/K) + (r +

2
2
)(T)
T
, d
2
=
ln(S
0
/K) + (r

2
2
)(T)
T
Basket Option: No closed-form representation
MC/Multidimensional integration (() very time consuming).
Valuation methods based on analytical approximations:
Levys method : using a log-normal distribution with matching
moments.
Beissers method : performing some conditional expectation
techniques.
Jus method : using Taylor expansion.
6/30
Conclusion
Pricing Theory
Techniques
Polynomial Chaos (PC) Approximation.
Sparse Grid Quadrature (SGQ).
7/30
Conclusion
Pricing Theory
Polynomial Chaos (PC)
Polynomial Chaos (PC) Expansions Of (2nd Order) stochastic processes
X(y, t, ()) =
j=0
a
j
(y, t)
j
(())
N
t
j=0
a
j
(y, t)
j
(())
= (
1
,
2
, .....) a set of independent second order random variables
with given joint density p() =
p
i
(
i
).
<
k
l
>=
_

k
()
l
()p()d =
kl

k

2
a
j
(y, t) are the deterministic PC coecients computed numerically.
Knowledge of the a
j
fully characterizes the process X.
8/30
Conclusion
Pricing Theory
Polynomial Chaos (PC)
Polynomial Chaos (PC) Expansions Of (2nd Order) stochastic processes
X(y, t, ()) =
j=0
a
j
(y, t)
j
(())
N
t
j=0
a
j
(y, t)
j
(())
= (
1
,
2
, .....) a set of independent second order random variables
with given joint density p() =
p
i
(
i
).
<
k
l
>=
_

k
()
l
()p()d =
kl

k

2
a
j
(y, t) are the deterministic PC coecients computed numerically.
Knowledge of the a
j
fully characterizes the process X.
Advantage Of PC
E[X] = a
0
Var[X]
N
t
k=1
(a
k
)
2

k

2
8/30
Conclusion
Pricing Theory
Sparse Grid Quadrature (SGQ)
Principle
If SG
l
f =
|k|
1
l+d1
k
f =
l+d1
j=d
|k|
1
=j
k
f, | k |
1
:=
d
j=1
k
j
Tensor product
k
f := (
k
1
...
k
d
)f :=
n
k
1
i
1
=1
...
n
k
d
i
d
=1
k
1
i
1
...
k
d
i
d
f(x
l
1
i
1
, ..., x
l
d
i
d
), where
k
= U
m
k
U
m
k1
for k 1, where U
m
k
: univariate quadrature.
9/30
Conclusion
Pricing Theory
Sparse Grid Quadrature (SGQ)
Advantages
The number of nodes has a polynomial (instead of exponential)
dependence on the dimension of the integral.
(N) = O
_
N
s
(ln N)
(d1)(s+1)
_
9/30
Conclusion
Numerical Results
Outline:
1
Pricing Theory
2
Numerical Results
3
Numerical Results
4
Conclusion
10/30
Conclusion
Numerical Results
Introduction
Objective
Investigating the eect of uncertainty in volatility on the price of European
single asset option.
Implementation Steps
1
Modeling the randomness in volatility.
2
Developing MC and PC Approximation algorithms to compute
the mean quantities, bounds and the sample density of the put
option price.
3
Comparing the eciency of standard MC versus surrogate PC/MC
method.
11/30
Conclusion
Numerical Results
Data Description
0 500 1000 1500 2000 2500
600
800
1000
1200
1400
1600
trading days
S
&
P

5
0
0

I
n
d
e
x

S&P 500 Index
0 20 40 60 80 100 120 140
0%
10%
20%
30%
40%
50%
60%
70%
80%
Months
S
&
P

5
0
0

3
0

D
a
y

V
o
l
a
t
i
l
i
t
y

S&P 500 30 Day Volatility
Fig: S&P 500 Index and historical volatility from 2000 to 2010.
12/30
Conclusion
Numerical Results
Modeling Uncertainty
0.4 0.2 0 0.2 0.4 0.6 0.8 1
0
1
2
3
4
5
6
Volatility

D
e
n
s
i
t
y

f
u
n
c
t
i
o
n

sample density
lognormal density
Fig:Historical volatility density
13/30
Conclusion
Numerical Results
PC Approximation by Stochastic Collocation Method
Expansion Of The Solution as a PC Series
V (S, t; ) = V (S, t; g())
p
k=0
k
(S, t)H
k
(),
where H
k
are the Hermite Polynomials and N(0, 1)
PC Coecients
k
(S, t) =
_
V (S, t; g())H
k
()dP
=
_
R
V (S, t; g(x))H
k
(x)f
(x)dx
Gauss-Hermite Quadrature Rule
k
(S, t)
J
j=1
V (S, t; g(x
j
))H
k
(x
j
)w
j
14/30
Conclusion
Numerical Results
PC Approximation by Stochastic Collocation Method
Expansion Of The Solution as a PC Series
V (S, t; g())
p
k=0
k
(S, t)H
k
(),
where
k
are the Hermite Polynomials and N(0, 1)
PC Coecients
k
(S, t) =
_
V (S, t; g())H
k
()dP
=
_
R
V (S, t; g(x))H
k
(x)f
(x)dx
Gauss-Hermite Quadrature Rule
k
(S, t)
J
j=1
V (S, t; g(x
j
))H
k
(x
j
)w
j
14/30
Conclusion
Numerical Results
PC Approximation Orders
1 2 3 4 5 6 7 8 9 10 11
10
9
8
7
6
5
4
3
2
1
0
1
2
PC degree k
l
o
g
1
0

(
k
)

log
10
(
k
) for J=30
log
10
(
k
) for J=100
Fig:Convergence of PC coecients
15/30
Conclusion
Numerical Results
Sample Densities V (S, t; )
0 50 100 150 200 250 300
0
0.005
0.01
0.015
0.02
0.025
0.03
0.035
0.04
Option Price V
D
e
n
s
i
t
y

o
f

V
(
1
2
0
0
)

Density of V(1200):PC
Density of V(1200): MC
0 50 100 150 200 250 300
0
0.01
0.02
0.03
0.04
0.05
0.06
0.07
0.08
Option Price V
D
e
n
s
i
t
y

o
f

V
(
8
0
0
)

Fig: Density of V(1200) and V(800) by MC and PC methods.
0 50 100 150 200 250 300
0
0.005
0.01
0.015
Option Price V
D
e
n
s
i
t
y

o
f

V
(
1
0
0
0
)

Fig:Density of V(1000) by MC and PC methods
16/30
Conclusion
Numerical Results
Mean Quantities of V (S, t; )
200 400 600 800 1000 1200 1400 1600 1800
0
100
200
300
400
500
600
700
800
S

M
e
a
n

o
f

V
(
S
)

Mean of V(S): MC
Mean of V(S): PC
200 400 600 800 1000 1200 1400 1600 1800
0
5
10
15
20
25
30
35
40
45
S
S
t
d
e
v

o
f

V
(
S
)

Stdev of V(S): MC
Stdev of V(S): PC
Fig:The mean and standard deviation of V(S, 0; ) with random.
S 800 1000 1200
Mean of V(S,0,)(MC) 172.1635 53.0375 17.6456
Mean of V(S,0,)(PC) 172.1638 53.0373 17.6454
Stdev of V(S,0,)(MC) 28.0329 41.0428 28.7341
Stdev of V(S,0,)(PC) 28.0328 41.0421 28.7343
tab: Statistics of V(S,t,) computed with MC and PC methods
17/30
Conclusion
Numerical Results
Cost Analysis
Surrogate PC/MC Method
V (S, t;
i
)
p
k=0
k
(S, t)H
k
(
i
).
k
(S, t)
J
j=1
V (S, t; g(x
j
))H
k
(x
j
)w
j
.
Eciency of Standard MC Versus Surrogate PC/MC Method
C
sur
C
MC
=
J.T
solver
+N.T
PCsum
N.T
solver
=
J
N
+
T
PCsum
T
solver
J N,
J
N
= 3.10
4
Maximal eciency up to 3000.
Method Time (the Mean) Time (the Stdev)
MC (N = 100000) 0.0571 0.0396
PC (p = 10, J = 30) 0.0011 0.0069
tab: Eciency of MC versus PC
18/30
Conclusion
Numerical Results
Outline:
1
Pricing Theory
2
Numerical Results
3
Numerical Results
4
Conclusion
19/30
Conclusion
Numerical Results
Introduction
Objective
Investigating the eect of uncertainty in the assets returnscovariance
matrix on basket option price.
Implementation Steps
1
Modeling the randomness in the covariance matrix by Wishart
Distribution.
2
Analyzing dierent approximation methods of arithmetic basket option
price and selecting the best one.
3
Computing the mean of basket option price via three ways:
Nested MC Simulation.
MC + Approximation
SGQ +Approximation.
Data
DAX 30 index listings in 2012.
20/30
Conclusion
Numerical Results
Comparison of Approximation Methods For Basket Option Pricing
Tested methods
Levys Approximation/ Beissers Approximation / Jus Taylor Expansion.
Analysis
Varying the Correlations
ij
,the Strike K, Stock Prices S
0
i
, the
volatilities
i
.
Dev =
_
1
n
n
i=1
(MC
i
V
i
)
2
,
Conclusion
Jus method: the best approximation except for the case of
inhomogeneous volatilities.
Beissers approach: the only reliable method in the case of
inhomogeneous volatilities.
21/30
Conclusion
Numerical Results
Computing The Mean Of Basket Option Price
E(V (S
1
, S
2
, .....S
d
, )) =
_
R
d(d+1)
2
()()d.
Methods
Nested MC Simulation.
MC+ Approximation ().
SGQ+ Approximation ().
22/30
Conclusion
Numerical Results
SGQ +Approximation
_
R
d(d+1)
2
()()d =
_
R
d
(
1
,
2
, .....,
d
)
1
,
2
,.....,
d
d
1
d
2
...d
d
.
Dimension Reduction Procedure to Reduce The computational Cost of SGQ
1
Generating a sample of random matrices following Wishart
distribution and having (sample covariance matrix) and n (time
series length of data) as parameters.
2
Performing a spectral decomposition for each matrix of the previous
sample and storing the corresponding eigenvalues.
3
Fitting the distribution of each eigenvalue by the best parametric
density function.
Result
Normal distribution with dierent parameters best ts eigenvalues densities
Gauss hermite quadrature as the univariate quadrature in SGQ method.
23/30
Conclusion
Numerical Results
Case of Four Dimensional Basket Put Option
1 2 3 4 5 6 7 8 9 10
5
4.5
4
3.5
3
2.5
2
1.5
1
level
l
o
g
1
0
(
e
r
r
o
r
)

log
10
(error)
Fig: Error of Sparse Grid Quadrature(log
10
(| SGQ
l+1
SGQ
l
|))
Method Price Mean CI (95%) CPU time
Nested MC (n
1
= 10
4
) 0.0931 [0.091 0.095] 9.77 e + 03
Nested MC+CV (n
1
= 10
4
) 0.0931 [0.093 0.093] 2.37 e + 04
MC(n = 10
5
) + Approx 0.0931 [0.093 0.093] 1.30 e + 03
SG (level10,23023 pts) 0.0930 444.22
tab: The mean of basket option price by dierent methods
24/30
Conclusion
Numerical Results
Case of Six Dimensional Basket Put Option
1 2 3 4 5 6 7 8 9 10
5
4.5
4
3.5
3
2.5
2
1.5
1
level
l
o
g
1
0
(
e
r
r
o
r
)

log
10
(error)
Fig:Error of Sparse Grid Quadrature(log
10
(| SGQ
l+1
SGQ
l
|)): Six Dimensional
Basket Put Price
Method Price Mean CI(95%) CPU time
Nested MC (n
1
= 10
4
) 0.0829 [0.081 0.084] 7.07 e + 003
Nested MC+CV (n
1
= 10
4
) 0.0829 [0.082 0.083] 2.13 e + 004
MC (n = 10
5
)+ Approx 0.0829 [0.082 0.082] 1.92 e + 003
SG (level9, 125879 pts) 0.0821 2.14e + 003
tab: The mean of basket option price by dierent methods
25/30
Conclusion
Numerical Results
Basket Put Price Density
0.08 0.09 0.1 0.11 0.12
0
10
20
30
40
50
60
70
80
90
Basket put price

d
e
n
s
i
t
y

sample density
fitting normal density
Fig: Density of four dimensional basket put price
0.06 0.07 0.08 0.09 0.1 0.11
0
10
20
30
40
50
60
70
80
90
Basket put price

d
e
n
s
i
t
y

sample density
fitting normal density
Fig: Density of six dimensional basket put price
26/30
Conclusion
Outline:
1
Pricing Theory
2
Numerical Results
3
Numerical Results
4
Conclusion
27/30
Conclusion
Summary
One Dimensional Case
Performing a probabilistic approach to investigate the impact of
uncertainty in the volatility on option pricing.
Same results obtained by Standard MC and PC approximation
methods.
The surrogate PC/MC method signicantly more ecient than
standard Monte Carlo.
Multidimensional Case
Investigating the eect of uncertainty in the assets returns covariance
matrix on basket option pricing (MC and SGQ techniques).
Methods using approximation of basket option price more ecient.
The performance of SGQ for high dimensional problems.
28/30
Conclusion
Possible Extensions
One Dimensional Case
Implemented methods can be applied with slight modication to any
kind of option or pricing model.
Multidimensional Case
Developing Multidimensional PC approximation to investigate the
performance of this probabilistic technique for higher dimensional
problems.
Constructing better dimension adaptive sparse grids may improve the
performance of SGQ.
29/30
Conclusion
Thank you for your attention !
30/30

UQ in Option Pricing

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Tunisia Polytechnic School

King Abdullah University of Science and Technology

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