Please read:

A personal appeal from

Wikipedia founder Jimmy Wales
Finite difference methods for option
pricing
From Wikipedia, the free encyclopedia
Jump to: navigation, search
Finite difference methods for option pricing are numerical methods used in
mathematical finance for the valuation of options.
[1]
Finite difference methods were first
applied to option pricing y !duardo "chwart# in 1$%%.
[&]
Finite difference methods can solve derivative pricing prolems that have, in general, the
same level of comple'ity as those prolems solved y tree approaches,
[1]
and are
therefore usually employed only when other approaches are inappropriate. (t the same
time, like tree)ased methods, this approach is limited in terms of the numer of
underlying variales, and for prolems with multiple dimensions, *onte +arlo methods
for option pricing are usually preferred.
,he approach is due to the fact that the evolution of the option value can e modelled via
a partial differential e-uation ./0!1, as a function of .at least1 time and price of
underlying2 see for e'ample 3lack4"choles /0!. 5nce in this form, a finite difference
model can e derived, and the valuation otained.
[&]
6ere, essentially, the /0! is
e'pressed in a discreti#ed form, using finite differences, and the evolution in the option
price is then modelled using a lattice with corresponding dimensions2 here, time runs
from 7 to maturity and price runs from 7 to a 8high8 value, such that the option is deeply
in or out of the money.
,he option is valued as follows:
[9]
*aturity values are simply the difference etween the e'ercise price of the option
and the value of the underlying at each point.
:alues at the oundary prices are set ased on moneyness or aritrage ounds on
option prices.
:alues at other lattice points are calculated recursively, starting at the time step
preceding maturity and ending at time ; 7. 6ere, using a techni-ue such as
+rank4<icolson or the e'plicit method:
1. the /0! is discreti#ed per the techni-ue chosen, such that the value at each lattice
point is specified as a function of the value at later and ad=acent points2 see "tencil
.numerical analysis12
&. the value at each point is then found using the techni-ue in -uestion.
,he value of the option today, where the underlying is at its spot price, .or at any
time>price comination,1 is then found y interpolation.
(s aove, these methods and tree)ased methods are ale to handle prolems which are
e-uivalent in comple'ity. ?n fact, when standard assumptions are applied it can e shown
that the e'plicit techni-ue encompasses the inomial and trinomial tree methods.
[@]
,ree
ased methods, then, suitaly parameteri#ed, are a special case of the e'plicit finite
difference method.
[A]
[edit] References
1. B
a

b
6ull, John +. .&77&1. Options, Futures and Other Derivatives .Ath ed.1.
/rentice 6all. ?"3< 7)19)77$7AC)A.
&. B
a

b
"chwart#, !. .January 1$%%1. 8,he :aluation of Warrants: ?mplementing a
<ew (pproach8. Journal of Financial Economics 4: %$4$@. doi:17.171C>797@)
@7AD.%%1$779%)D. http:>>ideas.repec.org>a>eee>=finec>v@y1$%%i1p%$)$9.html.
9. ^ Wilmott, /.2 6owison, ".2 0ewynne, J. .1$$A1. The Mathematics of Financial
Derivatives: A Student Introduction. +amridge Eniversity /ress.
?"3< 7A&1@$%F$&.
@. ^ 3rennan, *.2 "chwart#, !. ."eptemer 1$%F1. 8Finite 0ifference *ethods and
Jump /rocesses (rising in the /ricing of +ontingent +laims: ( "ynthesis8.
Journal of Financial and Quantitative Analsis .Eniversity of Washington "chool
of 3usiness (dministration1 13 .91: @C1 4 @%@. doi:17.&97%>&9971A&.
http:>>www.=stor.org>pss>&9971A&.
A. ^ Guinstein, *. .&7771. 85n the Gelation 3etween 3inomial and ,rinomial
5ption /ricing *odels8. Journal of Derivatives 8 .&1: @% 4 A7.
doi:17.9$7A>=od.&777.91$1@$.
http:>>we.archive.org>we>&77%7C&&1A79@C>www.in)the)
money.com>pages>author.htm.
[Product Description
Numerical methods for the solution of financial instrument pricing equations are fast
becoming essential for practitioners of modern quantitative finance. Among the most
promising of these new computational finance techniques is the finite difference
methodyet, to date, no single resource has presented a quality, comprehensive
overview of this revolutionary quantitative approach to risk management.
Pricing inancial !nstruments, researched and written by Domingo "avella and #urt
$andall, two of the chief proponents of the finite difference method, presents a
logical framework for applying the method of finite difference to the pricing of
financial derivatives. Detailing the algorithmic and numerical procedures that are the
foundation of both modern mathematical finance and the creation of financial
productswhile purposely keeping mathematical comple%ity to a minimumthis long
awaited book demonstrates how the techniques described can be used to accurately
price simple and comple% derivative structures.
rom a summary of stochastic pricing processes and arbitrage pricing arguments,
through the analysis of numerical schemes and the implications of discreti&ationand
ending with case studies that are simple yet detailed enough to demonstrate the
capabilities of the methodology Pricing inancial !nstruments e%plores areas that
include'
Pricing equations and the relationship between (uropean and American
derivatives
Detailed analyses of different stability analysis approaches
#ontinuous and discrete sampling models for path dependent options
)nedimensional and multidimensional coordinate transformations
Numerical e%amples of barrier options, Asian options, forward swaps, and more
*ith an emphasis on how numerical solutions work and how the appro%imations
involved affect the accuracy of the solutions, Pricing inancial !nstruments takes us
through doors opened wide by +lack, ,choles, and -ertonand the arbitrage pricing
principles they introduced in the early ./01sto provide a stepbystep outline for
sensibly interpreting the output of standard numerical schemes. !t covers the
understanding and application of today2s finite difference method, and takes the
reader to the ne%t level of pricing financial instruments and managing financial risk.
Praise for Pricing inancial !nstruments
3Pricing inancial !nstruments is the first broad and accessible treatment of finite
difference methods for pricing derivative securities. "he authors have taken great
care to clearly e%plain both the origins of the pricing problems in a financial setting,
as well as many practical aspects of their numerical methods. "he book covers a
wide variety of applications, such as American options and credit derivatives. +oth
financial analysts and academic assetpricing specialists will want to own a copy.3
Darrell Duffie, Professor of inance ,tanford 4niversity
3!n my e%perience, finite difference methods have proven to be a simple yet powerful
tool for numerically solving the evolutionary PD(s that arise in modern mathematical
finance. "his book should finally dispel the widely held notion that these methods are
somehow difficult or abstract. ! highly recommend it to anyone interested in the
implementation of these methods in the financial arena.3Peter #arr, Principal +ank
of America ,ecurities
3A very comprehensive treatment of the application of finite difference techniques to
derivatives finance. Practitioners will find the many e%tensive e%amples very valuable
and students will appreciate the rigorous attention paid to the many subtleties of
finite difference techniques.3rancis 5ongstaff, Professor "he Anderson ,chool at
4#5A
3"he finite difference approach is central to the numerical pricing of financial
securities. "his book gives a clear and succinct introduction to this important sub6ect.
7ighly recommended.3-ark +roadie, Associate Professor ,chool of +usiness,
#olumbia 4niversity
or updates on new and bestselling *iley inance books' wiley.com8wbns
rom the !nside lap
Pricing inancial !nstruments Numerical methods for the solution of financial
instrument pricing equations are fast becoming essential for practitioners of modern
quantitative finance. Among the most promising of these new computational finance
techniques is the finite difference methodyet, to date, no single resource has
presented a quality, comprehensive overview of this revolutionary quantitative
approach to risk management. Pricing inancial !nstruments, researched and written
by Domingo "avella and #urt $andall, two of the chief proponents of the finite
difference method, presents a logical framework for applying the method of finite
difference to the pricing of financial derivatives. Detailing the algorithmic and
numerical procedures that are the foundation of both modern mathematical finance
and the creation of financial productswhile purposely keeping mathematical
comple%ity to a minimumthis longawaited book demonstrates how the techniques
described can be used to accurately price simple and comple% derivative structures.
rom a summary of stochastic pricing processes and arbitrage pricing arguments,
through the analysis of numerical schemes and the implications of discreti&ationand
ending with case studies that are simple yet detailed enough to demonstrate the
capabilities of the methodologyPricing inancial !nstruments e%plores areas that
include'
Pricing equations and the relationship between (uropean and American derivatives
Detailed analyses of different stability analysis approaches
#ontinuous and discrete sampling models for path dependent options
)nedimensional and multidimensional coordinate transformations
Numerical e%amples of barrier options, Asian options, forward swaps, and more
*ith an emphasis on how numerical solutions work and how the appro%imations
involved affect the accuracy of the solutions, Pricing inancial !nstruments takes us
through doors opened wide by +lack, ,choles, and -ertonand the arbitrage pricing
principles they introduced in the early ./01sto provide a stepbystep outline for
sensibly interpreting the output of standard numerical schemes. !t covers the
understanding and application of today2s finite difference method, and takes the
reader to the ne%t level of pricing financial instruments and managing financial risk.
"ee all /roduct 0escription
<umerical methods for the solution of financial instrument pricing e-uations are fast
ecoming essential for practitioners of modern -uantitative finance. (mong the most
promising of these new computational finance techni-ues is the finite difference method)
yet, to date, no single resource has presented a -uality, comprehensive overview of this
revolutionary -uantitative approach to risk management.
/ricing Financial ?nstruments, researched and written y 0omingo ,avella and +urt
Gandall, two of the chief proponents of the finite difference method, presents a logical
framework for applying the method of finite difference to the pricing of financial
derivatives. 0etailing the algorithmic and numerical procedures that are the foundation of
oth modern mathematical finance and the creation of financial products)while purposely
keeping mathematical comple'ity to a minimum)this long)awaited ook demonstrates
how the techni-ues descried can e used to accurately price simple and comple'
derivative structures.
From a summary of stochastic pricing processes and aritrage pricing arguments, through
the analysis of numerical schemes and the implications of discreti#ation)and ending with
case studies that are simple yet detailed enough to demonstrate the capailities of the
methodology) /ricing Financial ?nstruments e'plores areas that include:
H /ricing e-uations and the relationship e)tween !uropean and (merican derivatives
H 0etailed analyses of different staility analysis approaches
H +ontinuous and discrete sampling models for path dependent options
H 5ne)dimensional and multi)dimensional coordinate transformations
H <umerical e'amples of arrier options, (sian options, forward swaps, and more
With an emphasis on how numerical solutions work and how the appro'imations
involved affect the accuracy of the solutions, /ricing Financial ?nstruments takes us
through doors opened wide y 3lack, "choles, and *erton)and the aritrage pricing
principles they introduced in the early 1$%7s)to provide a step)y)step outline for
sensily interpreting the output of standard numerical schemes. ?t covers the
understanding and application of todayIs finite difference method, and takes the reader to
the ne't level of pricing financial instruments and managing financial risk.
/raise for /ricing Financial ?nstruments
8/ricing Financial ?nstruments is the first road and accessile treatment of finite
difference methods for pricing derivative securities. ,he authors have taken great care to
clearly e'plain oth the origins of the pricing prolems in a financial setting, as well as
many practical aspects of their numerical methods. ,he ook covers a wide variety of
applications, such as (merican options and credit derivatives. 3oth financial analysts and
academic asset)pricing specialists will want to own a copy.8)0arrell 0uffie, /rofessor of
Finance "tanford Eniversity
8?n my e'perience, finite difference methods have proven to e a simple yet powerful
tool for numerically solving the evolutionary /0!s that arise in modern mathematical
finance. ,his ook should finally dispel the widely held notion that these methods are
somehow difficult or astract. ? highly recommend it to anyone interested in the
implementation of these methods in the financial arena.8)/eter +arr, /rincipal 3ank of
(merica "ecurities
8( very comprehensive treatment of the application of finite difference techni-ues to
derivatives finance. /ractitioners will find the many e'tensive e'amples very valuale
and students will appreciate the rigorous attention paid to the many sutleties of finite
difference techni-ues.8)Francis Jongstaff, /rofessor ,he (nderson "chool at E+J(
8,he finite difference approach is central to the numerical pricing of financial securities.
,his ook gives a clear and succinct introduction to this important su=ect. 6ighly
recommended.8)*ark 3roadie, (ssociate /rofessor "chool of 3usiness, +olumia
Eniversity
For updates on new and estselling Wiley Finance ooks: wiley.com>wns
,his three)day course shows how to use the Finite 0ifference *ethod .F0*1 to price a
range of one)factor and many)factor option pricing models for e-uity and interest rate
prolems that we specify as partial differential e-uations ./0!s1. We introduce and
elaorate modern and roust finite difference methods that solve pricing prolems and
that remain stale and accurate for various cominations of input parameters, payoff
functions and oundary conditions.
,his course discusses all aspects of option pricing, starting from the /0! specification of
the model through to defining roust and appropriate F0 schemes which we then use to
price multi)factor /0! to ensure good accuracy and staility. ,he contents of the course
have een updated and revised to reflect new results and developments in the field.
Course Highlights
?n general, you learn how to analyse, design and assemle finite difference schemes in
computational finance applications. "ome of the specific skills that you learn are:
) 0efine an unamiguous, water)tight /0! for an option model
) Ket a real understanding of finite differences, from ( to L
) Mnow which schemes work and when
) (pply F0* to a wide range of option pricing models
) Jearn roust and accurate algorithms
) Kuidelines on implementation in +NN, +O, parallel and K/Es
?n short, you will learn the latest developments in this field and e ale to use them
immediately in your own work. "ource code for the models is provided.
Prerequisites
+andidates should have a good ackground in mathematics and knowledge of financial
derivatives.
Wht do !ou recei"e#
Full set of slides, +0 with software and a copy of 0aniel 0uffyIs ook 8Finite 0ifference
*ethods in Financial !ngineering: ( /artial 0ifferential !-uation (pproach8. Pou are
invited to ask -uestions on your own specific applications as well.
,he price includes coffee, tea, lunch and refreshments.
Who should ttend#
,his course has een developed so that you can use the theory to solve e'isting prolems
as well as applying the knowledge to the pricing of new financial instruments. ?n
particular, the course is for professionals with a strong mathematical ackground:
) Financial engineers who design new pricing models
) (nalysts and -uants
) 5ther professionals who wish to understand and apply advanced numerical methods to
derivatives pricing
Course $utor
0aniel J. 0uffy has 3( .*od1, *"c and /h0 degrees, all of which in mathematics and
numerical analysis. 6e has een working with numerical methods on finance, industry
and engineering since 1$%$. 6e has written four ooks on numerical methods and +NN
for -uantitative finance and he has developed a numer of new schemes for this field as
well as more than &7 years of training e'perience.
Wht h"e pre"ious delegtes sid#
) 8*y e'pectations were topped2 can go now and implement 9d models using splitting8
) 8Geally liked it. :ery informative8
) 8? would enthusiastically recommend this course to colleagues8
) 8!'cellent course8