Harnessing Finite Difference Methods for Enhanced Option Pricing

This study concludes that finite difference methods are effective for approximating option prices and hedge parameters, particularly when closed-form solutions are impractical. The research highlights the benefits of combining these methods with Monte Carlo simulations to enhance risk management. Future work should focus on empirical validation and exploring advanced models to further improve hedge error analysis.


This content originally appeared on HackerNoon and was authored by Economic Hedging Technology

Abstract and 1. Introduction

1.1 Option Pricing

1.2 Asymptotic Notation (Big O)

1.3 Finite Difference

1.4 The Black-Schole Model

1.5 Monte Carlo Simulation and Variance Reduction Techniques

1.6 Our Contribution

  1. Literature Review
  2. Methodology

3.1 Model Assumption

3.2 Theorems and Model Discussion

  1. Result Analysis
  2. Conclusion and References

5. CONCLUSION

The research findings have demonstrated that finite difference methods offer a powerful tool for approximating option prices and hedging parameters, especially in cases where closed-form solutions are unavailable or impractical. The asymptotic analysis conducted in this study has provided valuable insights into the convergence properties and accuracy of finite difference approximations, shedding light on the optimal choice of discretization schemes and grid sizes for different option contracts. Furthermore, the combination of finite difference methods and Monte Carlo simulation with variance reduction techniques offers a comprehensive approach to hedge error analysis in option pricing. By leveraging the strengths of both methodologies, financial practitioners can obtain more robust and reliable estimates of option prices and hedge parameters, thereby enhancing their risk management capabilities and decision-making processes.

\ It is important to acknowledge the limitations of this study and areas for future research. While the asymptotic analysis provides valuable theoretical insights, further empirical validation is warranted to assess the robustness of the findings across different market conditions and asset classes. Additionally, exploring alternative variance reduction techniques and incorporating more sophisticated models of market dynamics could yield further improvements in hedge error analysis and option pricing accuracy. this study has advanced our understanding of the factors influencing hedge errors and provided practical tools for mitigating their impact on derivative pricing and risk management. As financial markets continue to evolve, the insights gained from this research will remain valuable for academics, practitioners, and policymakers striving to enhance the efficiency and stability of global financial systems.

REFERENCES

[1] C. W. Smith, “Option pricing. A review,” J. financ. econ., vol. 3, no. 1–2, pp. 3–51, 1976, doi: 10.1016/0304-405X(76)90019-2.

\ [2] S. Guernsey, “an Introduction To the Black-Scholes Pde Model,” 2013.

\ [3] B. Peeters, C. L. Dert, and A. Lucas, “Black Scholes for Portfolios of Options in Discrete Time,” SSRN Electron. J., no. 03, 2005, doi: 10.2139/ssrn.469022.

\ [4] J. He, “A Study on Analytical and Numerical Solutions of Three Types of Black-Scholes Models,” Int. J. Trade, Econ. Financ., vol. 13, no. 2, 2022, doi: 10.18178/ijtef.2022.13.2.720.

\ [5] A. S. Shinde and K. C. Takale, “Study of BlackScholes model and its applications,” Procedia Eng., vol. 38, pp. 270–279, 2012, doi: 10.1016/j.proeng.2012.06.035.

\ [6] Y. Zhang, “The value of Monte Carlo model-based variance reduction technology in the pricing of financial derivatives,” PLoS One, vol. 15, no. 2, pp. 1–13, 2020, doi: 10.1371/journal.pone.0229737.

\ [7] P. L. Bonate, “A brief introduction to Monte Carlo simulation,” Clin. Pharmacokinet., vol. 40, no. 1, pp. 15–22, 2001, doi: 10.2165/00003088- 200140010-00002.

\ [8] D. R. Tobergte and S. Curtis, “Importance sampling for high speed statistical Monte-Carlo simulations,” J. Chem. Inf. Model., vol. 53, no. 9, pp. 1689–1699, 2013.

\ [9] E. C. Anderson and M. Stephens, “Importance Sampling and (MC)^3,” Sisg 2020, vol. 2, no. July, pp. 1–29, 2020.

\ [10] I. N. Medvedev, “Vector estimators of the Monte Carlo method with a finite variance,” Russ. J. Numer. Anal. Math. Model., vol. 28, no. 3, pp. 231– 244, 2013, doi: 10.1515/rnam-2013-0014.

\ [11] E. Saliby and R. J. Paul, “A farewell to the use of antithetic variates in monte carlo simulation,” J. Oper. Res. Soc., vol. 60, no. 7, pp. 1026–1035, 2009, doi: 10.1057/palgrave.jors.2602645.

\ [12] P. W. Glynn and R. Szechtman, “Some New Perspectives on the Method of Control Variates,” Monte Carlo Quasi-Monte Carlo Methods 2000, pp. 27–49, 2002, doi: 10.1007/978-3-642-56046-0_3.

\ [13] W. Gustafsson, “Evaluating the Longstaff-Schwartz method for pricing of American options,” 2015.

\ [14] L. Andersen and M. Broadie, “Primal-dual simulation algorithm for pricing multidimensional American options,” Manage. Sci., vol. 50, no. 9, pp. 1222–1234, 2004, doi: 10.1287/mnsc.1040.0258.

\ [15] E. Wipplinger, Jim Gatheral: The volatility surface, a practitioner’s guide, vol. 22, no. 1. 2008. doi: 10.1007/s11408-007-0072-4.

\ [16] M. Avellaneda and S. Stoikov, “High-frequency trading in a limit order book,” Quant. Financ., vol. 8, no. 3, pp. 217–224, 2008, doi: 10.1080/14697680701381228.

\ [17] S. Mayoral, D. Moreno, and A. Zareei, “Using a hedging network to minimize portfolio risk,” Financ. Res. Lett., vol. 44, no. April, p. 102044, 2022, doi: 10.1016/j.frl.2021.102044.

\ [18] S. Gayathri Devi, K. Selvam, and S. P. Rajagopalan, “An abstract to calculate big o factors of time and space complexity of machine code,” IET Conf. Publ., vol. 2011, no. 583 CP, pp. 844–847, 2011, doi: 10.1049/cp.2011.0483.

\ [19] M. S. H. Mojumder, M. N. Haque, and M. J. Alam, “Efficient Finite Difference Methods for the Numerical Analysis of One-Dimensional Heat Equation,” J. Appl. Math. Phys., vol. 11, no. 10, pp. 3099–3123, 2023, doi: 10.4236/jamp.2023.1110204.

\ [20] I. R. Khan and R. Ohba, “Taylor series based finite difference approximations of higher-degree derivatives,” J. Comput. Appl. Math., vol. 154, no. 1, pp. 115–124, 2003, doi: 10.1016/S0377- 0427(02)00816-6. [21] S. Danho, “Pricing Financial Derivatives with the Finite Difference Method,” p. 237, 2017.

\ [22] G. Connor and T. Lasarte, “An Introduction to Hedge Funds Strategies. Introductory Guide,” pp. 1–16, 2004, [Online]. Available: http://eprints.lse.ac.uk/24675/1/dp477.pdf

\ [23] M. Nurul Anwar and L. Sazzad Andallah, “A Study on Numerical Solution of Black-Scholes Model,” J. Math. Financ., vol. 08, no. 02, pp. 372–381, 2018, doi: 10.4236/jmf.2018.82024.

\ [24] J. Akahori, F. Barsotti, and Y. Imamura, “Hedging error as generalized timing risk,” Quant. Financ., vol. 23, no. 4, pp. 693–703, 2023, doi: 10.1080/14697688.2022.2154255.

\ [25] R. C. A. Oomen and G. J. Jiang, “Hedging Derivatives Risks - A Simulation Study,” SSRN Electron. J., no. May, 2005, doi: 10.2139/ssrn.302525.

\ [26] K. A. Froot, “Hedging Portfolios with Real Assets,” J. Portf. Manag., vol. 21, no. 4, pp. 60–77, 1995, doi: 10.3905/jpm.1995.409527.

\ [27] H. E. LELAND, “Option Pricing and Replication with Transactions Costs,” J. Finance, vol. 40, no. 5, pp. 1283–1301, 1985, doi: 10.1111/j.1540- 6261.1985.tb02383.x.

\ [28] T. Hayashi and P. A. Mykland, “Evaluating hedging errors: An asymptotic approach,” Math. Financ., vol. 15, no. 2, pp. 309–343, 2005, doi: 10.1111/j.0960-1627.2005.00221.x.

\ [29] J.-L. Prigent, R. Hentati, and A. Kaffel, “Dynamic versus static optimization of hedge fund portfolios: the relevance of performance measures,” Int. J. Bus., vol. 15, no. 156, pp. 1–17, 2010.

\ [30] R. A. Jarrow, D. Lando, and F. Yu, “Default Risk and Diversification : Theory and Empirical Implications * Default Risk and Diversification: Theory and Empirical Implications Abstract,” no. 607, 2003.

\ [31] S. Kim, D. Jeong, C. Lee, and J. Kim, “Finite difference method for the multi-asset black-scholes equations,” Mathematics, vol. 8, no. 3, pp. 1–17, 2020, doi: 10.3390/math8030391.

\ [32] D. Jeong, M. Yoo, and J. Kim, “Finite Difference Method for the Black–Scholes Equation Without Boundary Conditions,” Comput. Econ., vol. 51, no. 4, pp. 961–972, 2018, doi: 10.1007/s10614-017- 9653-0.

\ [33] T. Guo, Black-Scholes Process and Monte Carlo Simulation-Based Options Pricing. Atlantis Press International BV, 2023. doi: 10.2991/978-94-6463- 010-7_75.

\ [34] P. Glasserman, “Monte Carlo Methods in Financial Engineerring,” J. Chem. Inf. Model., vol. 53, no. 9, pp. 1689–1699, 2013.

\ [35] Q. Jiang*, “Comparison of Black–Scholes Model and Monte-Carlo Simulation on Stock Price Modeling,” vol. 109, no. Icemci, pp. 135–137, 2020, doi: 10.2991/aebmr.k.191217.025.

\ [36] E. Derman and E. K, “Stochastic Caclulus for Finance,” pp. 1–63, 2000.

\

:::info Authors:

(1) Agni Rakshit, Department of Mathematics, National Institute of Technology, Durgapur, Durgapur, India (spiritualagnimath.statml@gmail.com);

(2) Gautam Bandyopadhyay, Department of Management Studies, National Institute of Technology, Durgapur, Durgapur, India (gbandyopadhyay.dms@nitdgp.ac.in);

(3) Tanujit Chakraborty, Department of Science and Engineering & Sorbonne Center for AI, Sorbonne University, Abu Dhabi, United Arab Emirates (tanujit.chakraborty@sorbonne.ae).

:::


:::info This paper is available on arxiv under CC by 4.0 Deed (Attribution 4.0 International) license.

:::

\


This content originally appeared on HackerNoon and was authored by Economic Hedging Technology


Print Share Comment Cite Upload Translate Updates
APA

Economic Hedging Technology | Sciencx (2024-10-23T06:23:35+00:00) Harnessing Finite Difference Methods for Enhanced Option Pricing. Retrieved from https://www.scien.cx/2024/10/23/harnessing-finite-difference-methods-for-enhanced-option-pricing/

MLA
" » Harnessing Finite Difference Methods for Enhanced Option Pricing." Economic Hedging Technology | Sciencx - Wednesday October 23, 2024, https://www.scien.cx/2024/10/23/harnessing-finite-difference-methods-for-enhanced-option-pricing/
HARVARD
Economic Hedging Technology | Sciencx Wednesday October 23, 2024 » Harnessing Finite Difference Methods for Enhanced Option Pricing., viewed ,<https://www.scien.cx/2024/10/23/harnessing-finite-difference-methods-for-enhanced-option-pricing/>
VANCOUVER
Economic Hedging Technology | Sciencx - » Harnessing Finite Difference Methods for Enhanced Option Pricing. [Internet]. [Accessed ]. Available from: https://www.scien.cx/2024/10/23/harnessing-finite-difference-methods-for-enhanced-option-pricing/
CHICAGO
" » Harnessing Finite Difference Methods for Enhanced Option Pricing." Economic Hedging Technology | Sciencx - Accessed . https://www.scien.cx/2024/10/23/harnessing-finite-difference-methods-for-enhanced-option-pricing/
IEEE
" » Harnessing Finite Difference Methods for Enhanced Option Pricing." Economic Hedging Technology | Sciencx [Online]. Available: https://www.scien.cx/2024/10/23/harnessing-finite-difference-methods-for-enhanced-option-pricing/. [Accessed: ]
rf:citation
» Harnessing Finite Difference Methods for Enhanced Option Pricing | Economic Hedging Technology | Sciencx | https://www.scien.cx/2024/10/23/harnessing-finite-difference-methods-for-enhanced-option-pricing/ |

Please log in to upload a file.




There are no updates yet.
Click the Upload button above to add an update.

You must be logged in to translate posts. Please log in or register.