PDE Method

Step 1: Set up initial values with the algorithm defined

1. Use Nargin to check all variables are entered.

if nargin~=9

disp('Please check inputs')

return

end

2. Use If statement to check whether these parameters are valid (Time, stock
price, maximum stock price K and variance must be more than 0. Matrix
dimensions must be more than 1).

3. Use If statement to check whether we enter the correct type of option pricing.
if T<=0||S<0||K<0||sigma<0||N<1||M<1||Smax<=0

disp('Please check inputs')

return

end

Otype 1 equates to call option pricing, Otype 2 for put option pricing.

if otype~=0 && otype~=1

disp('Please check inputs')

return

end
Step 2: Set up the matrix
In this step, we will be following the use of these formula:

1. According to the first line of the algorithm, we require a matrix of size I,J. This
line of code sets up a matrix of zeroes with I*J dim.
f = zeros(N+1,M+1);

2. Second portion of algorithm requires us to set up the time and stock price
vectors of N+1,M+1 size(since it includes 0). We define it using the linspace
function.

N+1 and M+1 simply denotes the number of entries we want

% Set the vector of times from 0 to T

Tvec = linspace(0,T,N+1);

% Set the vector of stock prices from 0 to Smax

Svec = linspace(0,Smax,M+1);

3. We find change in t and s using the formula given above.

dt = T/N;

ds = Smax/M;
Step 3: Set up initial values of f

According to the algorithm, we calculate initial values of f with the values calculated
in step 2, and that which is defined with the algorithm given above and below. This
depends also whether it is a call or put option pricing. We use switch function to
funnel the values between the two codes depending on the initial otype the user
keys in.

% Use array solution to set the initial value of f

switch otype

case 0

f(N+1,0+1:M+1) = max(Svec-K,0);

f(:,0+1) = 0;

f(0+1:N+1,M+1) = Smax - K*exp(-r*(T-Tvec));

case 1

f(N+1,0+1:M+1) = max(K-Svec,0);

f(:,0+1) = K*exp(-r*(T-Tvec));

f(0+1:N+1,M+1) = 0;

end
Step 4: Explicit Method

Next, we simply calculate a, b c, for the respective values of j using the algorithm
provided

for j=1:M-1

a(j) = (1/2)*dt*(sigma^2*j^2-r*j);

b(j) = 1-dt*(sigma^2*j^2+r);

c(j) = (1/2)*dt*(sigma^2*j^2+r*j);

end
Step 5
% Built the matrix multiplier A according to matrix notation.
Essentially filling in the diagonals with the a,b,c values in step 4
using diag function.

A = diag([1 b 1],0) + diag([a 0],-1) + diag([0 c],1);

Step 6
1. Do matrix multiplication for AF. Do transposing so rows of A = columns of F

2. Convert AF to Fbar, by adjusting using the algorithm given.Top row will be

done by f=0, bottom row by f(i+1,M+1)=Smax - K*exp(-r*(N-i)*dt).

3. Do the same for the other option type

 % Use array solution to calculate f(i+1,j+1)

switch otype

case 0

for i = N-1:-1:0 %As per formula

f(i+1,0+1:M+1) = A*(f(i+1+1,0+1:M+1)');

f(i+1,0+1)=0;

f(i+1,M+1)=Smax - K*exp(-r*(N-i)*dt);

end

case 1

for i = N-1:-1:0 %As per formula

f(i+1,0+1:M+1) = A*(f(i+1+1,0+1:M+1)');

f(i+1,0+1)= K*exp(-r*(N-i)*dt);

f(i+1,M+1)= 0;

end

end

Step 7: Calculate Option Price

1. The new option price is equal to f(0, stockprice)
2. We simply do

option_price = interp1(Svec,f(0+1,:),S);

3. Interp to do linear interpolation.

4. With interp1(X,V,Xq) , inputting a X and V row, this inbuilt function will return
the value on V when there is a given X q.