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Siti N. Ibrahim

, John G. OHara

University of Essex, Wivenhoe Park, Colchester CO4 3SQ

sniibr@essex.ac.uk

,johara@essex.ac.uk

Nick Constantinou

Essex Business School

University of Essex, Wivenhoe Park, Colchester CO4 3SQ

nconst@essex.ac.uk

AbstractThe basis of the option universe has been the

European option, and much literature has been devoted to the

extension of this option to create many new exotic options,

including some with nonlinear payoffs. In this work, we study a

European-style power option pricing, under a constant volatility

dynamics, using the risk-neutral valuation within the Black-

Scholes framework. Apart from applying the closed-form solu-

tion, we price the power option using the Fast Fourier Transform

(FFT) technique which requires an analytical characteristic

function of the power option. The resulting approximations are

then compared with other numerical methods such as the Monte

Carlo simulations, which show promising results and demonstrate

the efciency of the FFT technique as it can compute option

prices for a whole range of strike prices. Besides, we show that

there exists a relationship between the power call option and the

power put option that is similar to the put-call parity relationship

of vanilla options. We also nd a transformation between the

underlying asset and the power contract which enables us to

obtain the pricing formulas of the power options from the vanilla

options, as well as simplify the Greeks for power options. In

addition to the Greeks derived from the closed-form solution, we

present the Greeks using the pricing formula obtained from a

characteristic function.

I. INTRODUCTION

Options have been used and improved extensively since they

were rst introduced. Each time new options emerge, most

of these are exotic options, also referred to as non-standard

options because the payoffs are different than the payoff of a

standard vanilla option. One such option is the power option,

and there is lack of analysis on this type of option.

There are a number of variations on the simple option payoff

which rely on the power of the underlying. These are known

as power options. These options are typied by signicant

leverage; a small change in the value of the underlying leads

to signicant changes in the value of the power option (see

1; 2). In (3) and (4), they provide a closed-form formula for

power options, and show that power options can be hedged

with a package of standard vanilla options. Additionally, (5)

have studied power options within a general class of nonlinear

payoffs.

In a recent study, (6) shows that the solution to a special

model for hedging strategies in an illiquid markets is identical

to the structure of a power option. In addition, the structure of

a power call option is very similar to the payoff of a Constant

Proportional Portfolio Insurance (CPPI) strategy, a portfolio

insurance strategy that involves dynamically trading a risky

asset, such as stocks, and a risk-free asset, such as government

bonds (see 7; 8). The payoff of the CPPI strategy depends on

the terminal value of the risky asset raised to a positive power.

The CPPI strategy is a signicant strategy within the structured

product market that has recently come to the attention of

nancial regulators (9) following the subprime crisis.

In this work, we employ three methods in pricing the power

options. The rst approach uses the closed-form solution

which is obtained using the risk-neutral valuation method,

similar to the Black-Scholes framework (10). The second ap-

proach utilizes the widely-used Monte Carlo simulation (11),

as a benchmark to compare the efciency of these methods.

Finally, the third approach is the Fast Fourier Transform (FFT)

technique which was rst introduced by (12) to obtain the

Discrete Fourier Transform (DFT) and its inverse. Implement-

ing the DFT involves N points where for added efciency,

the value N is a power of 2 and it is essential to have an

extensively large N data set. This reduces the number of

computations from O(N

2

) to O(N ln N). For an introduction

to the method of FFT in nance, see (13).

The rst application of the FFT technique to option pricing

was presented in the seminal work of (14), and has gained

popularity in the literature of option pricing (see 15; 16; 17).

In option pricing, to implement this technique, it is important

to have an analytical characteristic function of the stock

price process. The technique transforms the probability density

function of the options; thus making it a exible option

pricing method where we are able to encapsulate properties

such as stochastic volatility and mean-reversion, whilst still

maintaining its exceptional computational efciency. Besides,

this approach gives an insight to the behaviour of the option

prices as a function of the strike prices, which is a signicant

advantage of the method as simple linear interpolation can

be used to obtain the desired price for any given strike;

hence improving the speed of calculation in option pricing.

Following their work (see 14), much literature has extended

this method to price other types of options, specically exotic

options, such as spread options (18) and Asian options (19).

II. CLOSED-FORM SOLUTION OF A POWER OPTION

In this section we present the mathematical foundation of

the derivation of the closed-form solution for a power option

within the Black-Scholes environment. Under risk-neutrality,

the underlying asset price, S

t

, is assumed to follow the process

dS

t

= rS

t

dt + S

t

dW

t

(II.1)

2012 4th Computer Science and Electronic Engineering Conference (CEEC) University of Essex, UK

978-1-4673-2666-7/12/$31.00 2012 IEEE 1

where r is a risk-free rate, is a (constant) volatility of the

asset price log returns, and W

t

is a standard Brownian motion.

The Black-Scholes formula for the prices of a vanilla call

option, C, and vanilla put option, P, on the underlying with

time to maturity, and strike price, K are given by:

C = S

t

N(d

1

) Ke

r

N(d

2

) (II.2)

P = Ke

r

N(d

2

) S

t

N(d

1

). (II.3)

where N(.) is the standard cumulative normal distribution

function, and

d

1

=

ln(

St

K

) + (r +

1

2

2

)

, (II.4)

d

2

= d

1

. (II.5)

Following that, the vanilla call and put options satisfy the put-

call parity relationship:

C + Ke

r

= P + S

t

. (II.6)

Similar to a vanilla option, a power call option gives its holder

the right but not the obligation to buy multiple units of asset

for a strike price at maturity; whereas a power put option gives

its holder the right but not the obligation to sell multiple units

of asset at maturity, for a strike price. The payoff function for

a power call option, PC, and a power put option, PP, are as

follows:

PC

Payoff

= max(S

T

K, 0), (II.7)

PP

Payoff

= max(K S

T

, 0). (II.8)

The similarity between the vanilla and power options enables

us to follow closely the derivation of a vanilla option within

the Black-Scholes environment, under risk-neutrality. Suppose

f = ln S

t

. Using It os lemma, we determine that the process

followed by f is given by:

d(ln S

t

) = (r

1

2

2

) dt + dW

t

. (II.9)

This demonstrates that f = ln S

t

follows a generalized

Wiener process with a constant drift (r

1

2

2

), and a constant

volatility . Therefore, the change in f = ln S

t

for some

time is normally distributed with mean (r

1

2

2

), and

variance

2

2

. Mathematically,

ln S

ln S

t

+ (r

1

2

2

),

2

. (II.10)

Hence S

T

has a log-normal distribution. In a risk-neutral

world, the price of a power call option is computed as the

discounted risk-neutral conditional expectation of the terminal

payoff (II.7) at a risk-free rate r :

PC = e

r

E

Q

[max(S

T

K, 0)] (II.11)

= S

t

e

(1)(r+

1

2

2

)

N(d

1,

)

Ke

r

N(d

2,

). (II.12)

Analogously, given the terminal payoff (II.8), the power put

price is:

PP = e

r

E

Q

[max(K S

T

, 0)] (II.13)

= Ke

r

N(d

2,

)

S

t

e

(1)(r+

1

2

2

)

N(d

1,

), (II.14)

where

d

1,

=

ln(

S

t

K

) + (r

1

2

2

+

2

)

, (II.15)

d

2,

= d

1,

. (II.16)

If = 1, the closed-form solutions (II.12) and (II.14)

become the closed-form solution for a vanilla call and put

option, respectively. Additional to that, an integral element of

Equation (II.12) and Equation (II.14) is

S

t,

= S

t

e

(1)(r+

1

2

2

)

, (II.17)

which (20) refers to as a power contract with unit strike, and

acts like the underlying of a power option. The following

lemma provides the power put-power call parity relationship

which employs a similar approach to the put-call parity

relationship given in (II.6):

Lemma II.1 (Power Put-Power Call Parity Relationship).

PC + Ke

r

= PP + S

t

e

(1)(r+

1

2

2

)

. (II.18)

Hence, Lemma II.1 implies that a portfolio consisting of

a power call option and cash is equivalent to a portfolio

consisting of a power put option and a power contract. As far

as the authors are aware, this relationship is new. The proof

to Lemma II.1 is straightforward.

According to (21), options on the power of the underlying

can be obtained from a vanilla option by an appropriate

adjustment of the underlying, interest rates and volatility.

However, we generalize this transformation by considering

the power contract. This transformation results in a compact

representation of the prices of the power option, their Greeks,

and in particular, the so-called power put-power call parity

relationship. For that reason, we come to the following lemma:

Lemma II.2 (Vanilla-Power Transformation). Consider the

following transformations:

S

t

S

t,

= S

t

e

(1)(r+

1

2

2

)

, (II.19)

= . (II.20)

Thus, given the pricing formulas for a vanilla call option, C,

and a vanilla put option, P, we can obtain the pricing formulas

for a power call option, PC, and a power put option, PP,

using the transformations (II.19) and (II.20). For notational

brevity, let C(S

t

S

t,

;

t

S

t,

;

PC = C(), (II.21)

PP = P(). (II.22)

2012 4th Computer Science and Electronic Engineering Conference (CEEC) University of Essex, UK

2

and it is straightforward on noting that:

d

1,

= d

1

(), (II.23)

d

2,

= d

2

(). (II.24)

Consequently, using Lemma II.2, yields Lemma II.1:

C() + Ke

r

= P() + S

t

(). (II.25)

We nally note that similar to the vanilla options, the

power options satisfy the following useful symmetry relation-

ships (see 20):

PC(S

t

, K, , r, ) = PP(S

t

, K, , r, ),

b PC(S

t

, K, , r, ) = PC(b S

t

, b K, , r, ),

PC(S

t

, K, , r, ) = PP(S

t

, K, , r, ),

PP(S

t

, K, , r, ) = PC(S

t

, K, , r, ).

III. POWER OPTION PRICING USING THE FFT

The essence behind the FFT approach is the characteris-

tic function of the stochastic process. Provided that this is

obtained analytically, we can use this approach to price the

options. The characteristic function is dened as follows:

Denition III.1 (Characteristic Function). For a one-

dimensional stochastic process X

t

, 0 t T, the charac-

teristic function is the Fourier transform of the probability

density function q

T

(X

T

) given as follows:

(v) = E

Q

(e

ivX

T

) =

e

ivX

T

q

T

(X

T

) dX

T

. (III.1)

Let (, F, Q) be a probability space on which is dened

a Brownian motion, W

t

, 0 t T, a ltration generated

by the Brownian motion, F

t

, 0 t T, and a risk-neutral

probability, Q. It os Lemma implies that S

T

is also a geometric

Brownian motion (4; 2), that follows:

dS

t

= (r +

1

2

1

2

2

)S

t

dt + S

t

dW

t

. (III.2)

Suppose that the asset price follows a lognormal process, then

we have:

d(ln S

t

) = (r

1

2

2

) dt + dW

t

. (III.3)

Let s = ln S

T

and k = ln K. It follows that the lognormal

asset price probability density function is given as follows:

q

T

(s

T

) =

1

2

e

(

s[s+(r

1

2

2

)]

)

2

2

2

. (III.4)

Consequently, we obtain the following characteristic function

for the log-normal asset price for a power option:

(v) = e

iv[s+(r

1

2

2

)]

1

2

(

v)

2

. (III.5)

On that account, and Lemma II.2, we have the following:

Lemma III.1 (Characteristic Function via Vanilla-Power

Transformation). Using the Vanilla-Power Transformation, the

characteristic function for a power option,

(v), is obtain-

able from the characteristic function of a vanilla option, (v),

that is:

(v)() =

(v). (III.6)

Let K be the strike price and be the time to maturity of a

power option with terminal asset price S

T

, which is governed

by the dynamics given in (III.2). From here on, we consider

the power call option as the power put option is obtainable in

a similar way. We dene X

t

= ln S

t

and k =

ln K

. Moreover,

we express the option pricing function (II.11) as a function of

the log strike k instead of the terminal log asset price X

T

,

PC

T

(k) = e

r

k

(e

X

T

e

k

)f

T

(X

T

) dX

T

, (III.7)

where f

T

(X

T

) is the density function of the process X

T

.

Following (14), for > 0, we dene a modied power call

price,

PC

T

(k) = e

k

PC

T

(k), (III.8)

where the Fourier Transform (FT) of

PC

T

(k) is given by:

F

(v) =

e

ivk

PC

T

(k) dk. (III.9)

Applying the inverse FT to (III.9), then substituting (III.8)

with (III.7) into (III.9), and also by the denition of the

characteristic function (III.1), we obtain the price of a power

call option as follows:

PC

T

(k) =

e

k

2

e

ivk

F

where

F

(v) = e

r

[v i( + 1)]

( + iv)( + iv + 1)

. (III.11)

Thus for an efcient implementation of the FFT, a closed-form

representation of the characteristic function

(v) is required,

which we have shown earlier, has the form of (III.5). Given the

pricing function (III.10), we can price the power call option

as follows:

PC

T

(k

u

) =

e

ku

j=1

e

i

2

N

(j1)(u1)

e

ibvj

F

(v

j

)

3

[3 + (1)

j

j1

], (III.12)

where v

j

= (j 1), k

u

= b + (u 1), b =

N

2

, =

2

N

, and

n

is the Kronecker delta function which is unity for

n = 0 and zero otherwise. The choice of and is essential

because it governs this approach. A small gives us a range

of prices across a wide range of strike prices; while a large

value of can give inaccurate prices. Moreover, the FFT is an

algorithm that evaluate the summations of the following form

efciently:

X(k) =

N

j=1

e

i

2

N

(j1)(k1)

x(j), k = 1, . . . , N (III.13)

with x(j) = e

ibvj

F

(v

j

)

3

[3 + (1)

j

j1

]. Hence, the

2012 4th Computer Science and Electronic Engineering Conference (CEEC) University of Essex, UK

3

presentation of the power call price in the form (III.12) is

a special case of (III.13) which enables the use of the FFT.

IV. THE GREEKS

In this section, we present the Greeks Delta (), Gamma

(), Rho (), Theta (), and Vega () for the power

option obtained from the closed-form solution as given in

Section II, and also from the pricing formula obtained via

the characteristic function as shown in Section III.

A. Using the Closed-Form Solution

Given the closed-form solution for a power call op-

tion (II.12), the sensitivity measures are as follows:

PC

=

S

t

S

t,

N(d

1,

),

PC

=

(S

t

)

2

S

t,

[( 1)N(d

1,

+

1

(d

1,

)],

PC

=

S

t,

( 1)N(d

1,

) + Ke

r

N(d

2,

)

PC

= S

t,

[( 1)(r +

1

2

2

)N(d

1,

)

(d

1,

)] rKe

r

N(d

2,

),

PC

= S

t,

[(

2

)N(d

1,

) +

(d

1,

)].

The Greeks of a power put option can be obtained from the

Greeks of the power call option using the power put-power call

parity relationship as shown in Lemma II.1. Consequently, we

present the Greeks of the power contract (II.17) in the usual

manner, given by the following lemma::

Lemma IV.1 (The Greeks of a Power Contract). Given the

power contract S

t,

, the associated Greeks are as follows:

=

S

t

S

t,

=

S

t

S

t,

, (IV.1)

=

2

S

2

t

S

t,

=

1

S

t

, (IV.2)

=

r

S

t,

= ( 1)S

t,

, (IV.3)

=

t

S

t,

= ( 1)(r +

1

2

2

)S

t,

, (IV.4)

S

t,

= ( 1)S

t,

. (IV.5)

Besides, in conjunction with Lemma II.2, the Greeks for

the power option can be succinctly expressed via the Greeks

of the power contract and the Greeks of the vanilla options.

The following lemma shows the transformation:

Lemma IV.2 (The Greeks Using Vanilla-Power Transforma-

tion). Given the Greeks of a power contract and the Greeks of

a vanilla call option, C, the Greeks of the power call option,

PC, can be presented as the following:

PC

=

C

()

, (IV.6)

PC

=

C

()

2

+

C

()

, (IV.7)

PC

=

C

() +

C

()

, (IV.8)

PC

=

C

() +

C

()

, (IV.9)

PC

=

C

() +

C

()

. (IV.10)

Note that the transformation produces equivalent expressions

for the Greeks of the power put option.

B. Using the FFT based Pricing Formula

In Section III, we provide an analytical characteristic func-

tion of a power option. (22) uses the price of a vanilla option

obtained from its characteristic function to derive delta and

gamma of the option. Thus, using Equation (III.10), we extend

this to derive the Greeks for the power call option as follows:

PC

=

e

k

S

t

0

e

ivk

e

r

[v i( + 1)]

( + iv)

dv,

PC

=

e

k

(S

t

)

2

0

e

ivk

e

r

(( + iv + 1) 1)

[v i( + 1)]

( + iv)

dv,

PC

=

e

k

0

e

ivk

e

r

(i[v i( + 1)] 1)

[v i( + 1)]

( + iv)

dv,

PC

=

e

k

0

e

ivk

e

r

{r + ri[v i( + 1)]

1

2

2

i[v i( + 1)]

1

2

2

[v i( + 1)]

2

}

[v i( + 1)]

( + iv)

dv,

PC

=

e

k

0

e

ivk

e

r

[v i( + 1)]

{i [v i( + 1)]}

[v i( + 1)]

( + iv)

dv.

The equivalent Greeks for the power put option may be

obtained from the power put-power call parity relationship.

V. NUMERICAL RESULTS

In this section, we present the computational result of the

prices of the power call option. We price the power call option

using the closed-form solution obtained within the Black-

Scholes environment, the FFT pricing formula, and the Monte

Carlo (MC) simulation.

1

Table I documents the prices of a power call option across

a range of strikes and maturities with S = 10, r = 0.02,

and = 0.2, using the closed-form solution. While Table II

documents the prices obtained using the FFT and the Monte

1

The computations were implemented in MATLAB and conducted on an

Intel Core 2 Duo processor P8400 @ 2.26 GHz machine running under

Windows Vista Service Pack 2 with 2GB RAM.

2012 4th Computer Science and Electronic Engineering Conference (CEEC) University of Essex, UK

4

Carlo simulation approach. For the FFT approach, we take

= 0.25, N = 2

10

and = 0.75. In addition, we take

N = 500, 000 simulations to price the power call option

using the Monte Carlo simulation approach. It can be seen that

the prices obtained from these three methods are perfect. The

closed-form solution gives the prices almost instantaneously.

However, our purpose is to show the efciency of the FFT

technique over the Monte Carlo simulation approach. Taking

the Monte Carlo simulation as the benchmark, from Table II,

we see that the FFT technique gives accurate approximation

prices since the percentage difference (taken relative to the

FFT prices) between the prices are less than one percent.

Moreover, the FFT technique is efcient as it takes, on average,

0.00173925 seconds to produce the prices of the power call

option; whereas the Monte Carlo simulation takes 0.12466025

seconds, on average. This shows that the FFT technique

is almost a hundred percent faster than the Monte Carlo

simulation technique.

TABLE I

PRICES OF A POWER CALL OPTION USING THE CLOSED-FORM SOLUTION

Strike, K T (years) Analytic

50 0.5 53.5730

50 1 57.4619

50 1.5 61.5987

75 0.5 30.2920

75 1 36.0529

75 1.5 41.5097

100 0.5 13.4945

100 1 20.5851

100 1.5 26.7456

125 0.5 4.9558

125 1 11.0876

125 1.5 16.8614

Figure 1 shows the comparison of the three methods we

employ in pricing the power call option with = 2. The

margin is so small that the graph ts almost perfectly to each

other. Additionally, we show in Figure 2 that a power call can

be replicated using a package of vanilla calls; for instance,

a power call with an underlying S = 25, can be replicated

with a package of 121 vanilla calls. Meanwhile in Figure 3,

we observe that the delta and gamma of a power call and a

vanilla call share the same shape, except that the values are

heightened for the power call.

VI. CONCLUSION

The FFT method has found wide applications in many elds.

In this paper, the fundamental premise was to investigate the

valuation of a European-style power option using the closed-

form solution within the Black-Scholes environment, and the

TABLE II

PRICES OF A POWER CALL OPTION USING THE FAST FOURIER

TRANSFORM AND THE MONTE CARLO SIMULATION

Strike, K T (years) MC FFT Difference (%)

50 0.5 53.5692 53.5670 0.004107

50 1 57.4705 57.4565 0.024360

50 1.5 61.5994 61.5936 0.009416

75 0.5 30.3249 30.2892 0.117725

75 1 36.0173 36.0500 0.090790

75 1.5 41.3348 41.5067 0.415872

100 0.5 13.4910 13.4980 0.051886

100 1 20.6567 20.5857 0.343714

100 1.5 26.8525 26.7448 0.401080

125 0.5 4.9236 4.9592 0.723048

125 1 11.1136 11.0889 0.222250

125 1.5 16.8566 16.8615 0.029069

TABLE III

RUNNING-TIME COMPARISON FOR PRICING A POWER CALL OPTION FOR

T = 1.

Strike, K MC (seconds) FFT (seconds)

50 0.178384 0.003852

75 0.068980 0.001444

100 0.081065 0.001474

125 0.078022 0.001555

Fig. 1. Power Call Prices Using the Closed-Form Solution, Fast Fourier

Transform and Monte Carlo Simulation for Different Maturities.

FFT technique. We choose the FFT method to price the power

call option because it is exible and reliably fast. This is

proven in the numerical results by comparing this approach

to the Monte Carlo simulation technique.

Not only do we demonstrate the method of pricing a power

option, we also show that there exists a power put-power call

parity relationship which follows a similar approach to the

2012 4th Computer Science and Electronic Engineering Conference (CEEC) University of Essex, UK

5

Fig. 2. Power Call Replicated with Vanilla Calls using K = 20, = 2.

Fig. 3. Comparison of the Delta and Gamma for a Power Call and a Vanilla

Call.

put-call parity relationship. Following that, we show that the

pricing formula can easily be obtained in a concise way from

a vanilla option via a transformation that involves a power

contract and a scaled volatility. Using the same transformation,

we can obtain a concise form of the Greeks of a power option

which are derived from the closed-form solution. Besides, we

provide another way to present the Greeks of the power option,

that is by deriving the pricing formula of the power option

obtained using the characteristic function.

REFERENCES

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2012 4th Computer Science and Electronic Engineering Conference (CEEC) University of Essex, UK

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