Professional Documents
Culture Documents
Dr P. V. Johnson
School of Mathematics
2013
Dr P. V. Johnson MATH60082
Review
Discretising the Problem
Explicit finite difference method
Overview
O UTLINE
1 R EVIEW
Last time
Todays Lecture
Dr P. V. Johnson MATH60082
Review
Discretising the Problem
Explicit finite difference method
Overview
O UTLINE
1 R EVIEW
Last time
Todays Lecture
2 D ISCRETISING THE P ROBLEM
Finite-difference approximations
Constructing the grid
Discretised equations
Dr P. V. Johnson MATH60082
Review
Discretising the Problem
Explicit finite difference method
Overview
O UTLINE
1 R EVIEW
Last time
Todays Lecture
2 D ISCRETISING THE P ROBLEM
Finite-difference approximations
Constructing the grid
Discretised equations
3 E XPLICIT FINITE DIFFERENCE METHOD
System of equations
Stability and Convergence
Dr P. V. Johnson MATH60082
Review
Discretising the Problem
Explicit finite difference method
Overview
O UTLINE
1 R EVIEW
Last time
Todays Lecture
2 D ISCRETISING THE P ROBLEM
Finite-difference approximations
Constructing the grid
Discretised equations
3 E XPLICIT FINITE DIFFERENCE METHOD
System of equations
Stability and Convergence
4 O VERVIEW
Summary
Dr P. V. Johnson MATH60082
Review
Discretising the Problem Last time
Explicit finite difference method Todays Lecture
Overview
Dr P. V. Johnson MATH60082
Review
Discretising the Problem Last time
Explicit finite difference method Todays Lecture
Overview
Dr P. V. Johnson MATH60082
Review
Finite-difference approximations
Discretising the Problem
Constructing the grid
Explicit finite difference method
Discretised equations
Overview
A PPROXIMATIONS
V 1 2 V
V (S + S, t) = V (S, t) + S + 2 (S)2 2 + O((S)3 )
S S
V 1 2V
V (S S, t) = V (S, t) S + 2 (S)2 2 + O((S)3 )
S S
V 1 2 V
V (S, t + t) = V (S, t) + t + 2 (t)2 2 + O((t)2 )
t t
Dr P. V. Johnson MATH60082
Review
Finite-difference approximations
Discretising the Problem
Constructing the grid
Explicit finite difference method
Discretised equations
Overview
V V (S + S, t) V (S, t) 1 2 V
(S, t) = + S 2 + O((S)2 )
S S 2 S
V (S + S, t) V (S, t)
= + O(S)
S
From equations (1) and (2):
V V (S + S, t) V (S S, t)
(S, t) = + O((S)2 )
S 2S
Dr P. V. Johnson MATH60082
Review
Finite-difference approximations
Discretising the Problem
Constructing the grid
Explicit finite difference method
Discretised equations
Overview
2 V V (S + S, t) 2V (S, t) + V (S S, t)
(S, t) = + O((S)2 )
S 2 (S)2
For t we have
V V (S, t + t) V (S, t) 1 2 V
(S, t) = + t 2 + O((t)2 )
t t 2 t
V (S, t + t) V (S, t)
= + O(t)
t
Dr P. V. Johnson MATH60082
Review
Finite-difference approximations
Discretising the Problem
Constructing the grid
Explicit finite difference method
Discretised equations
Overview
V (S, T ) = max(S X, 0)
V (0, t) = 0
V (S, t) Se(Tt) Xer(Tt) as S
Dr P. V. Johnson MATH60082
Review
Finite-difference approximations
Discretising the Problem
Constructing the grid
Explicit finite difference method
Discretised equations
Overview
V (S, T ) = max(X S, 0)
V (0, t) = Xer(Tt)
V (S, t) 0 as S
We will now form a finite difference grid that describes the
S t space in which we need to solve the Black-Scholes
equation.
Dr P. V. Johnson MATH60082
Review
Finite-difference approximations
Discretising the Problem
Constructing the grid
Explicit finite difference method
Discretised equations
Overview
V (S, T ) = max(X S, 0)
V (0, t) = Xer(Tt)
V (S, t) 0 as S
We will now form a finite difference grid that describes the
S t space in which we need to solve the Black-Scholes
equation.
For a numerical method we need to truncate the range of S.
Dr P. V. Johnson MATH60082
Review
Finite-difference approximations
Discretising the Problem
Constructing the grid
Explicit finite difference method
Discretised equations
Overview
Dr P. V. Johnson MATH60082
Review
Finite-difference approximations
Discretising the Problem
Constructing the grid
Explicit finite difference method
Discretised equations
Overview
Dr P. V. Johnson MATH60082
Review
Finite-difference approximations
Discretising the Problem
Constructing the grid
Explicit finite difference method
Discretised equations
Overview
upper boundary
SU
.
.
pde holds in this region terminal
boundary
jS Vji
.
. option value at
i,j-th point of grid
2S
S
lower boundary
0
0 t 2t ... it ... T
Dr P. V. Johnson MATH60082
Review
Finite-difference approximations
Discretising the Problem
Constructing the grid
Explicit finite difference method
Discretised equations
Overview
upper boundary
SU
S
lower boundary
0
0 t 2t ... it (i+1)t ... T
Dr P. V. Johnson MATH60082
Review
Finite-difference approximations
Discretising the Problem
Constructing the grid
Explicit finite difference method
Discretised equations
Overview
Vji Vji+1
+1
Vji 1
Dr P. V. Johnson MATH60082
Review
Finite-difference approximations
Discretising the Problem
Constructing the grid
Explicit finite difference method
Discretised equations
Overview
V 1 2 2 2 V V
+ S + (r )S rV = 0
t 2 S2 S
The BSM equation approximates to
Vji+1 Vji +1
Vji+ i+1
1 2Vj
+1
Vji 1
+ 12 2 j2 (S)2
t (S)2
+1
Vji+ i+1
1 Vj1
+(r )jS rVji = 0
2S
the unknown here is Vji as we have been working
backward in time.
Dr P. V. Johnson MATH60082
Review
Discretising the Problem System of equations
Explicit finite difference method Stability and Convergence
Overview
Dr P. V. Johnson MATH60082
Review
Discretising the Problem System of equations
Explicit finite difference method Stability and Convergence
Overview
Dr P. V. Johnson MATH60082
Review
Discretising the Problem System of equations
Explicit finite difference method Stability and Convergence
Overview
S
Impose lower boundary at 0
0
0 t 2t ... it (i+1)t ... T
Dr P. V. Johnson MATH60082
Review
Discretising the Problem System of equations
Explicit finite difference method Stability and Convergence
Overview
B OUNDARY C ONDITIONS
Dr P. V. Johnson MATH60082
Review
Discretising the Problem System of equations
Explicit finite difference method Stability and Convergence
Overview
P ROBABILISTIC I NTERPRETATION
1
E[Sij ] = E[Sij+1 ] (1)
1 + rt
the expected future value of S, following GBM, under the
risk-neutral probability discounted at the risk-free rate.
Dr P. V. Johnson MATH60082
Review
Discretising the Problem System of equations
Explicit finite difference method Stability and Convergence
Overview
P ROBABILISTIC I NTERPRETATION
1
E[Sij ] = E[Sij+1 ] (1)
1 + rt
the expected future value of S, following GBM, under the
risk-neutral probability discounted at the risk-free rate.
A, B and C can then be interpreted as the risk-neutral
probabilities.
Dr P. V. Johnson MATH60082
Review
Discretising the Problem System of equations
Explicit finite difference method Stability and Convergence
Overview
S TABILITY
Dr P. V. Johnson MATH60082
Review
Discretising the Problem System of equations
Explicit finite difference method Stability and Convergence
Overview
S TABILITY
Dr P. V. Johnson MATH60082
Review
Discretising the Problem System of equations
Explicit finite difference method Stability and Convergence
Overview
S TABILITY
r
j>| |
2
Dr P. V. Johnson MATH60082
Review
Discretising the Problem System of equations
Explicit finite difference method Stability and Convergence
Overview
1
t <
2 j2
which means that you need to ensure that the time interval
is small enough.
The stability therefore restricts your choice of t, S
t cannot be too small, or else computation will take too
long
then this puts lower bound on size of S
Dr P. V. Johnson MATH60082
Review
Discretising the Problem System of equations
Explicit finite difference method Stability and Convergence
Overview
C ONVERGENCE
Dr P. V. Johnson MATH60082
Review
Discretising the Problem System of equations
Explicit finite difference method Stability and Convergence
Overview
C ONVERGENCE
Dr P. V. Johnson MATH60082
Review
Discretising the Problem System of equations
Explicit finite difference method Stability and Convergence
Overview
C ONVERGENCE
Dr P. V. Johnson MATH60082
Review
Discretising the Problem System of equations
Explicit finite difference method Stability and Convergence
Overview
N ONLINEARITY ERROR
Dr P. V. Johnson MATH60082
Review
Discretising the Problem System of equations
Explicit finite difference method Stability and Convergence
Overview
N ONLINEARITY ERROR
Dr P. V. Johnson MATH60082
Review
Discretising the Problem
Summary
Explicit finite difference method
Overview
S UMMARY
Dr P. V. Johnson MATH60082
Review
Discretising the Problem
Summary
Explicit finite difference method
Overview
S UMMARY
Dr P. V. Johnson MATH60082