Table of Contents Author Guidelines Submit a Manuscript
The Scientific World Journal
Volume 2015 (2015), Article ID 692847, 6 pages
http://dx.doi.org/10.1155/2015/692847
Research Article

Numerical Algorithm for Delta of Asian Option

School of Economics, Dongbei University of Finance and Economics, 217 Jianshan Street, Dalian, Liaoning 116023, China

Received 8 March 2015; Revised 8 May 2015; Accepted 10 June 2015

Academic Editor: Emiliano A. Valdez

Copyright © 2015 Boxiang Zhang et al. This is an open access article distributed under the Creative Commons Attribution License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited.

Abstract

We study the numerical solution of the Greeks of Asian options. In particular, we derive a close form solution of of Asian geometric option and use this analytical form as a control to numerically calculate of Asian arithmetic option, which is known to have no explicit close form solution. We implement our proposed numerical method and compare the standard error with other classical variance reduction methods. Our method provides an efficient solution to the hedging strategy with Asian options.

1. Introduction

Asian options are referred to as securities with payoffs that depend on the average of the underlying stock price over a time interval. It got its name around 1987, when David Spaughton and Mark Standish worked for Bankers Trust in Tokyo, where they developed the first commercially used pricing formula for options linked to the average price of crude oil. They called the options “Asian options” since they were in Asia (see Falloon and Turner [1]). Asian options have appealing features that attract many investors. For example, end-users of energies or commodities tend to be exposed to the average prices over time, so Asian options suit their needs. Asian options are also popular among international corporations, who have ongoing currency exposures. Asian options tend to be less expensive than comparable Vanilla options, since the volatility in the average value of the underlying asset tends to be less than its spot value. Asian options also reduce the risk of price manipulation of underlying asset that is thinly traded.

The payoff of Asian arithmetic average call option with strike price is given bySince no analytical solution is known, a variety of numerical approximation techniques have been developed to analyze the Asian arithmetic average option. Many authors are devoted to the numerical approximation of the close form formula (see Turnbull and Wakeman [2], Vorst [3], Levy [4], and Levy and Turnbull [5]). Monte Carlo simulation could be a nice approach (see Broadie and Glasserman [6] and Kemna and Vorst [7]), but it can be computational expensive without variation reduction method. It should also be noted that the discretization of the continuous process could introduce errors (see Broadie et al. [8]). Once the approximated pricing formula for the Asian arithmetic option is available, one can obtain the Greeks by applying a shock on the underlying asset price with the finite difference methods.

In this paper, we study the Greeks of Asian arithmetic call option. In particular, we will implement a numerical scheme to compute of Asian arithmetic call option, by Monte Carlo method with a control variate. In Section 3, we briefly introduce the general principle of Monte Carlo method with some variance reduction techniques. In Section 4, we derive a close form pricing formula for the Asian geometric average call option. As a consequence, we obtain an analytical formula for of Asian geometric average call option, which will be used as a control variate in the Monte Carlo simulation. In the last section, we describe the numerical scheme to compute of Asian arithmetic average call option and compare our results with other variance reduction techniques.

2. Existing Literature

The Monte Carlo method can be used to price a wide range of exotic options as well as to analyze their Greeks, especially when the close form solutions do not exist. However, due to the reason of biased estimation and high computation cost, many modified Monte Carlo methods were proposed to estimate the Greeks by simulation.

Broadie and Glasserman [6] developed a method called infinitesimal perturbation analysis, which is based on the relationship between the payoffs and the Greeks of interest. Unlike the infinitesimal perturbation analysis, the likelihood ratio method is based on the probability density function of underlying price and the Greeks. Both methods mentioned above provide unbiased estimators but differ in applicability and effectiveness. Fournié et al. [9] suggested a framework for Greeks estimating that they showed that, under some certain circumstance, the Greeks can be represented by the product of the option payoff and a weight function, which is given by Malliavin calculus theory (see Kohatsu-Higa and Montero [10]).

In order to reduce the variance of the estimators, many techniques have been introduced. The most effective variance reduction technique is the control variate method. In the case of Asian option, the payoff of geometric Asian option is set to be a control variate in order to improve the effectiveness of the payoffs of algorithm Asian option prices.

Other methods include analytic method and finite difference approach. See Boyle and Potapchik [11] for an extensive survey of relevant literature.

3. The Monte Carlo Framework and Variance Reduction Techniques

Nowadays the advance of financial engineering has introduced lots of demands on using Monte Carlo simulations to price the options. Monte Carlo methods are important in many situations where the option price admits a simple risk-neutral valuation formula but not a tractable PDE formulation, like Asian option, for example. As a consequence, the Greeks associate with these options do not admit close form formula but can be obtained numerically by a combination of finite difference method and Monte Carlo method. Let us first outline some general principle of Monte Carlo method and variance reduction techniques.

3.1. General Principle of Monte Carlo Method

Let be random variable and let be measurable function such that with . Then we can numerically simulate independent replicas of , denoted by , and approximate by the Monte Carlo estimator:By the law of large number, we know that is a good estimate of in the sense thatHowever, it is important to understand that Monte Carlo method is never exact. The estimating error can be quantified by the so-called standard error defined byIf the standard deviation is small, then it is a good sign that with high probability our Monte Carlo result would be close to the true value. Otherwise, the high standard deviation indicates that our result might be deviating from the true value. It is also important to observe that the standard deviation follows square root rule, which suggests that the convergence is relatively slow. As a consequence, if the standard deviation is high, obtaining a promising accuracy would require high computational cost. Next, we briefly introduce some classical variance reduction techniques.

3.2. Common Random Number Method

The Common Random Number (CRN for short) method is one of the classic variance reduction techniques. The main idea is to use the same random number sequence when the target is the difference of two random variables which depends on the underlying random number sequence. For simplicity, suppose now that we want to estimate , where and are two random variables. It is obvious to see thatIf and are positively correlated, then we could reduce the variance of the estimator. Now suppose and , where is a standard normal random vector and and have the same monotonicity. Then the CRN estimator is defined by the following:where ’s are iid normal distributed. It is easily seen that the variance of is less than the crude Monte Carlo estimator .

3.3. Control Variate Method

Now let us briefly introduce the general idea of control variate method. We want to estimate . Now if we can find another random variable with known mean , then we can construct a family of unbiased estimators of :whereFrom the very definition, it is easily seen that are unbiased estimators. Indeed,Moreover, we haveTo minimize the variance of , we could chooseAs a consequence, to construct a good estimator, we need to choose a random variable that is positively correlated to . Usually, if we could find a random variable with known mean that is positively correlated to , we could simply choose . Intuitively, we could think of as an error adjustment to the unadjusted estimator . If the standard error is high, then deviation of from is large. At the same time, is large, by the fact that and are positively correlated. It would reduce the standard error of , even with a moderate size of .

4. Asian Geometric Option as a Control Variate

The payoff of Asian geometric option is given byUnder the classical Black-Scholes model, we know that the underlying asset is a geometric Brownian motion given by (see Bjork [12] for more details)

Proposition 1. Let be the price of Asian geometric call option under Black-Scholes model. Thenwhere

Proof. It is important to note that the average price follows log normal distribution. Indeed, we have Observe that the integral is normal with mean 0 and variance To simplify our notation, we denote . By the argument above, we know that . Now by the risk-neutral valuation formula, we haveOn the one hand, we havewhere we used the fact that follows standard normal distribution andOn the other hand, we got By change of variable we haveNow putting all pieces together, we haveNow we are ready to compute . By chain rule, we have

5. Numerical Computations

In this part, we describe the numerical scheme of the computation of Asian arithmetic option Greeks with control variate method. Let us first remind the reader of the model. Under the risk-neutral probability measure, the dynamics of the underlying asset is described by the following stochastic differential equation:The solution is given by the geometric Brownian motionThe payoff of Asian arithmetic option is given byThen the numerical scheme follows the next several steps.

Step 1 (sample path generation). Let us first fix some parameters: time to maturity , time steps , initial price , and initial underlying price shock . We denote , and then we generate sample paths and by the following iterative steps:where are copies of iid normal random numbers. It is important to observe that we used the same random numbers for both paths and , for the purpose of variance reduction.

Step 2 (approximating the payoff functions of both Asian arithmetic and Asian geometric option). We first use the Riemann sum to numerically approximate the integral. Indeed,Next, we simulate copies of the Asian arithmetic option payoffSimilarly, we simulate copies of the Asian geometric option payoff

Step 3 (finite difference approximation). Let be the Asian arithmetic option price under the Black-Scholes model, and then Similarly, we construct the sample estimator for Asian geometric option price ,

Step 4 (define the control sample estimator for Asian geometric option Greeks ). ConsiderNext, let us take a look at the results of our proposed numerical simulation and compare it with the classic Common Random Number (CRN for short) with Table 1.
It is very clear that our proposed method is better than the CRN method in the sense that it introduce much smaller standard error than the classic CRN method with the same other parameters.

Table 1: Monte Carlo simulation comparison table: common random number method versus control variate method for Asian arithmetic option.

6. Conclusion

We study the numerical solution for the Delta of Asian arithmetic option, which was known to have no explicit analytical closed form solution. With the Delta of Asian geometric option as a control, we provided a simple, fast, intuitive, and reliable numerical solution in the sense that the standard errors of Monte Carlo simulation were reduced greatly. We also mention that, in recent years, many authors have been actively involved in the research of calculating Greeks of Asian type option using various approaches. For instance, in [13], the authors provided formulas for the Greeks of Asian arithmetic option, which involves the time integral of geometric Brownian motion. As stated in the paper, the results are consistent with the Monte Carlo simulation. In [14], with the advanced tool of Malliavin calculus, the authors give a quasiexplicit formula for the Asian option Greeks. Also, in [15], a PDE approach was utilized to understand the numerical value of the Asian option Greeks. To summarize, we believe that it is challenging but worth efforts to obtain more accurate value for the Asian arithmetic option Greeks, for the purpose of hedging strategy. Among various approximating methods, our numerical scheme provides a very neat and efficient choice when one wants to calculate hedge position of a portfolio that involves the Asian average options. Because the assumption of high correlation for the two variates needs to hold, the performance on other Greeks, however, still needs to be examined.

Conflict of Interests

The authors declare that there is no conflict of interests regarding the publication of this paper.

Acknowledgments

This research is supported by National Natural Science Foundation of China under Grants (nos. 71171035 and 71471030) and MOE (Ministry of Education in China) Youth Foundation Project of Humanities and Social Sciences (no. 13YJC790185).

References

  1. W. Falloon and D. Turner, “The evolution of a market,” in Managing Energy Price Risk, Risk Books, London, UK, 1999. View at Google Scholar
  2. S. M. Turnbull and L. M. Wakeman, “A quick algorithm for pricing European average options,” The Journal of Financial and Quantitative Analysis, vol. 26, no. 3, pp. 377–389, 1991. View at Publisher · View at Google Scholar
  3. T. Vorst, “Prices and hedge ratios of average exchange rate options,” International Review of Financial Analysis, vol. 1, no. 3, pp. 179–193, 1992. View at Publisher · View at Google Scholar · View at Scopus
  4. E. Levy, “Pricing European average rate currency options,” Journal of International Money and Finance, vol. 11, no. 5, pp. 474–491, 1992. View at Publisher · View at Google Scholar · View at Scopus
  5. E. Levy and S. Turnbull, “Average inteligence,” Risk, vol. 5, pp. 53–59, 1992. View at Google Scholar
  6. M. Broadie and P. Glasserman, “Estimating security price derivatives using simulation,” Management Science, vol. 42, no. 2, pp. 269–285, 1996. View at Publisher · View at Google Scholar · View at Zentralblatt MATH · View at Scopus
  7. A. G. Z. Kemna and A. C. F. Vorst, “A pricing method for options based on average asset values,” Journal of Banking and Finance, vol. 14, no. 1, pp. 113–129, 1990. View at Publisher · View at Google Scholar · View at Scopus
  8. M. Broadie, P. Glasserman, and S. G. Kou, “Connecting discrete and continuous path-dependent options,” Finance and Stochastics, vol. 3, no. 1, pp. 55–82, 1999. View at Publisher · View at Google Scholar · View at MathSciNet
  9. E. Fournié, J.-M. Lasry, J. Lebuchoux, and P.-L. Lions, “Applications of Malliavin calculus to MONte-Carlo methods in finance. II,” Finance and Stochastics, vol. 5, no. 2, pp. 201–236, 2001. View at Publisher · View at Google Scholar · View at MathSciNet
  10. A. Kohatsu-Higa and M. Montero, “Malliavin calculus in finance,” in Handbook of Computational and Numerical Methods in Finance, pp. 111–174, Birkhäuser, 2004. View at Google Scholar
  11. P. Boyle and A. Potapchik, “Prices and sensitivities of Asian options: a survey,” Insurance: Mathematics & Economics, vol. 42, no. 1, pp. 189–211, 2008. View at Publisher · View at Google Scholar · View at MathSciNet · View at Scopus
  12. T. Bjork, Arbitrage Theory in Continuous Time, Oxford University Press, 2004.
  13. J. Choi and K. Kim, “The derivatives of Asian call option prices,” Communications in Mathematical Sciences, vol. 6, no. 3, pp. 557–568, 2008. View at Publisher · View at Google Scholar · View at Zentralblatt MATH · View at MathSciNet · View at Scopus
  14. Z. Yang, C. O. Ewald, and O. Menkens, “Pricing and hedging of Asian options: quasi-explicit solutions via Malliavin calculus,” Mathematical Methods of Operations Research, vol. 74, no. 1, pp. 93–120, 2011. View at Publisher · View at Google Scholar · View at Scopus
  15. Z. A. Elshegmani and R. R. Ahmed, “Analytical solution for an arithmetic asian option using Mellin transforms,” International Journal of Mathematical Analysis, vol. 5, no. 25–28, pp. 1259–1265, 2011. View at Google Scholar · View at MathSciNet · View at Scopus