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Comparison of an Analytical Expression of the Value of an American Put with standard MethodsPowerPoint Presentation

Comparison of an Analytical Expression of the Value of an American Put with standard Methods

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Comparison of an Analytical Expression of the Value of an American Put with standard Methods

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Comparison of an Analytical Expression of the Value of an American Put with standard Methods. -Vicky Sharma. Background(1). Partial Differential Equation (PDE) A differential equation of a function of 2 or more equations comprising of partial derivatives of the function .

Comparison of an Analytical Expression of the Value of an American Put with standard Methods

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Comparison of an Analytical Expression of theValue of an American Put with standard Methods

-Vicky Sharma

- Partial Differential Equation (PDE)
- A differential equation of a function of 2 or more equations comprising of partial derivatives of the function.

- Boundary Value Problem
- Boundary value problem is a differential equation together with a set of
additional restraints. A solution to a boundary value problem is a solution tothe differential equation which also satisfies the boundary conditions.

- Boundary value problem is a differential equation together with a set of

- Black-Scholes PDE for the price of the option
- The value of the option is known at expiry. This is known as the terminal condition.
- European Options are only exercised at maturity.
- Terminal condition becomes the boundary condition. The PDE can be solved for a unique solution – Black-Scholes Formula

- American Options can be exercised at any time before maturity
- There is no boundary for each time instant before maturity – there is no analytical solution.

- European Options are only exercised at maturity.

- Without dividends, it is in-optimal to exercise an american call before maturity.
- Same as european call, problem can be solved with a combination of binomial tree and black-scholes formula.

- American Puts are different
- There exists a critical price Sf(t) at time t below which it is optimal to exercise the put.
- This price is called the optimal exercise price at time t

- The optimal exercise price is the boundary condition for the PDE for an american put
- The optimal exercise boundary is a part of the solution
- The problem becomes a free boundary problem

- The optimal exercise boundary is a part of the solution

- There exists a critical price Sf(t) at time t below which it is optimal to exercise the put.

- The optimal exercise boundary defines the value of the put option when exercised.
- If the optimal exercise boundary is known,, monte-carlo simulations are used to compute the present discounted values of the maximum value of the put when it crosses the boundary.
- An average over multiple simulations (assuming log-normal model) gives the value of the put option.

- The problem of finding the analytical approximation to the american put becomes the problem of finding optimal exercise boundary.
- There have been several attempts in the past.
- Most of the solutions were complex and inaccurate for larger maturities.

- There have been several attempts in the past.
- A recently proposed method has used laplace transformation with pseudo steady state approximation to solve for the optimal boundary and price of american put.
- We will look at this approach and compare it’s performance to the binomial tree model and the real-world stock prices.

- The following transformations transform the black-scholes PDE with a terminal condition to a PDE with an initial condition.
- X = Strike, τ= T – t.
- Sf(t) = optimal exercise price.

- The Next transformation is on V. V is replaced by U, where
- U = V + S – 1 when S <= 1
- U = V, when S > 1

- The PDE is now changed.
- There are additional constraints on the continuity and differentiability of U at S = 1.

- Pseudo-Steady State Approximation
- We assume that the optimal exercise boundary changes slower than the diffusion of the put value.
- Hence, the stock price can be taken as the constant Sf(t) at the boundary.
- This helps in taking the laplace transform of S around the boundary.
- L(S) = Sf/p (p = laplace transform variable)

- Using Laplace Transformation
- The author used laplace transformation to convert the PDE to a linear differential equation.

- A linear transformation of variable t (time from start) to time to expiration translates terminal condition to initial condition.

The solution for laplace transform

Is calculated easily

The boundary conditions are used to solve for the unknown variables

- The laplace transform of the optimal boundary can be computed.
- The problem is to compute the inverse transform.
- The laplace transform of Sf has poles at at zero and the negative half plane.

- Hence, the inverse laplace transform must be computed over a line in the tight-half plane.

- The problem is to compute the inverse transform.

A closed region is used to compute a known

Line integral over the poles.

The integrals over C2 and C6 vanish. Integrals

Over C3 and C5 are symmetric and add up to an

Imaginary number.

The optimal exercise boundary is then calculated by the above expression

The value of american put is

Approximated by the above

expression

Interest rate and

Volatility remain

Constant and the

Stock pays

No dividends

Stock Price = $100, risk-free rate = 10%, σ = 0.30 and expiry = 1 year,

The analytical approximation follows the binomial tree model closely.

Black Scholes formula underestimates by a large margin as maturity increases

- We used Yahoo Stock and put Prices for our comparison.
- In order to calibrate the model (deduce volatility), 3 years of daily closing stock prices for yahoo were used.
- Black Scholes assumption of log-normal stock prices used to estimate volatility.
- LIBOR Rates were used for risk free rate
- At the time, it was 4.63%

- The duration of stock prices from November 26, 2004 through November 26, 2007.
- The latest stock price was $26.13

- In order to calibrate the model (deduce volatility), 3 years of daily closing stock prices for yahoo were used.
- Price of a put contract (for 100 shares) have been plotted
- Market price is the arithmetic average of the bid and offer prices

Maturity = 1 Month

In the Money

Out of Money

The analytical approximation compares fairly well with the market and binomial

tree prices.

Maturity = 5 Months

At the Money

The approximation compares fairly well with the binomial tree prices. The greatest

error with the market prices is seen around at-the-money mark

Maturity = 7 Months

At the Money

The increase in maturity does not affect the comparison with binomial tree model.

The numerical computation results in some under-estimation of the analytical value.

Hence, the analytical approximation is more accurate if more time is provided

computation

Maturity = 13 Months

At the Money

Out of Money

Option.

Strike = $20

The analytical approximation underestimates out of money options quite significantly.

In all cases, the approximation performs as good as the binomial model.

In the Money

Option.

Strike = $30

The analytical approximation’s accuracy improves as the option gets in the money.

It may also be due to the fact that computation now has larger numbers to process

Heavily In the Money Option.

Strike = $40

For seriously in the money options, the difference between market prices and

Analytical approximations is small. This is mainly due to the fact that the value is

Dominated by the intrinsic value of the option.

- The computation of optimal exercise boundary results in some interesting results:-
- The value of the optimal exercise price at expiry is the strike price

- However, there seems to be a non-zero limit of the optimal exercise price even for large maturities
- We show the optimal exercise boundaries for a maturity of 1 month (0.0834 years) and 3 different strikes.

The optimal

Exercise price

Reaches

Strike at

maturity

Optimal boundary seems to approach a

Common minimum value as maturity increases

The optimal exercise boundary rises sharply towards the strike price at maturity.

Hence, the behavior is non-linear. As maturity increases, the optimal exercise

Boundary at t = 0 reaches the same limit for all strikes.

The new approximation formula provides a single expression for the value of american put.

No iterations are needed.

Several concepts, like the perpetual exercise price and value are easily explained.

Compares well with established models

Computation can be slower than the numerical methods.

No significant improvement over binomial tree model.

Seriously under-estimates out-of-money options

The new expression has some advantages and disadvantages

Advantages

Disadvantages