Monte Carlo Methods

Monte Carlo Methods for Options
Ömür UĞUR
Institute of Applied Mathematics

Middle East Technical University, Ankara, Turkey
July 24, 2010
Ömür UĞUR (Middle East Technical University) Monte Carlo Methods for Options @ Yeditepe July 24, 2010 1 / 38
Outline
1 Monte Carlo Methods

Basics of Monte Carlo Integration
Option Pricing by Monte Carlo Simulation
2 Variance Reduction Techniques

Antithetic Variates
Control Variates
3 Exploring Matlab Codes

Monte Carlo Method for European Options
Variance Reduction Techniques
Monte Carlo Methods Basics of Monte Carlo Integration
Outline


Antithetic Variates
Control Variates

Monte Carlo Integration

Consider the problem of computing a multidimensional integral of the form
Z
I= g(x) dx,
A
n
where A ⊂ R is Lebesgue measurable. We may estimate I by randomly sampling
a sequence of points xi ∈ A, i = 1, 2, . . . , N , and building the estimator
N
vol(A) X
IbN = g(xi ),
N i=1
where vol(A) denotes the volume of the region A. Quite often we consider the
unit hypercube
A = [0, 1]n = [0, 1] × [0, 1] × · · · × [0, 1],
so that vol(A) = 1.
The strong law of large numbers implies that
lim IbN = I
N →∞
with probability one.

Monte Carlo Integration (cont.)

More generally, if X denotes a vector random variable with joint density function
f (x), x ∈ Rn , then the Monte Carlo integration may be used to estimate the
expected value Z
E [g(X)] = g(x)f (x) dx
Rn
of an arbitrary function g of X.
Basics of Samples I
For a family of independent identically distributed (i.i.d.) random variables
∞
{Xi }i=1 , the partial sum SN is defined by
N
X
SN = Xi = X1 + X2 + · · · + XN . (1)
i=1
Associated with SN is the sample mean X̄N which is another random variable
given by
N
1 1 X
X̄N = SN = Xi . (2)
N N i=1
This is an unbiased estimator of the parameter
µ = E [Xi ]
Basics of Samples II
of the i.i.d. sample Xi . In other words, the expectation of X̄N is the same as µ,
since
1
E X̄N = E [SN ] = E [Xi ] = µ, (3)
N
∞
due to the i.i.d. sequence {Xi }i=1 .
Strong Law of Large Numbers
Theorem (Strong Law of Large Numbers)

∞
For a family of i.i.d. random variables {Xi }i=1 , suppose that the mean
µ = E [Xi ] exists. Then,
N
1 X
lim X̄N = lim Xi = µ
N →∞ N →∞ N
i=1
with probability one.
Squared-Error I
Moreover, we may quantify the quality of the estimator X̄N by considering the
expectation of the squared-error as
2 2
E (X̄N − µ)2 = E X̄N − E X̄N h i
PN
= Var X̄N = N12 Var i=1 X i
PN (4)
1
= N 2 i=1 Var [X i ]
σ2
= N ,
where σ 2 = Var [Xi ] may be estimated by a sample variance, say σ̄N

2
.
2
Therefore, beside an unbiased sample mean X̄N , an unbiased sample variance σ̄N
may be given as
N N
!
2 1 X 2 N 1 X 2 2
σ̄N = Xi − X̄N = X − X̄N . (5)
N − 1 i=1 N −1 N i=1 i
Squared-Error II
It is not difficult to show that
2
E σ̄N = Var [Xi ] = σ 2
holds by using the second equality in (5).
Central Limit Theorem
Theorem (Central Limit Theorem)

∞
For a family of i.i.d. random variables {Xi }i=1 with finite mean µ and finite
variance σ 2 > 0, let
SN − N µ X̄N − µ
ZN = √ =p .
σ N σ 2 /N
Then, for x ∈ R,
Z x
1 2
/2
lim P {ZN ≤ x} = Φ(x) = √ e−ξ dξ,
N →∞ 2π −∞
where Φ is the standard normal distribution function.
Confidence Interval I
Now, a (1 − α)th level of confidence interval for a random variable Z is defined by
the interval [−z1−α/2 , z1−α/2 ] such that the critical number z1−α/2 is found from
the equation

P −z1−α/2 ≤ Z ≤ z1−α/2 = 1 − α. (6)
If, further, the random variable Z is standard normally distributed, then
1 − α = Φ(z1−α/2 ) − Φ(−z1−α/2 ) = 2 Φ(z1−α/2 ) − 1.
In other words,
Φ(z1−α/2 ) = 1 − α/2. (7)
Therefore, using the inverse of the error function, erf−1 ,
√
z1−α/2 = Φ−1 (1 − α/2) = 2 erf−1 (1 − α). (8)
Commonly used critical numbers are

Confidence Interval II
z0.975 = Φ−1 (1 − 0.05/2) ≈ 1.96, for α = 0.05, (9)

z0.995 = Φ−1 (1 − 0.01/2) ≈ 2.58, for α = 0.01, (10)
for the (1 − α)th level of confidence interval for a standard normally distributed
random variable.
Thus, if the number of samples N is large enough, then the random variable
X̄N − µ
Z=p 2
σ̄N /N
can be considered to be approximately standard normally distributed by the

central limit theorem.
Confidence Interval III

Therefore,
( )
X̄N − µ
1−α ≈ P −z1−α/2 ≤ p 2 ≤ z1−α/2
σ̄N /N
q q
= 2 2
P X̄N − z1−α/2 σ̄N /N ≤ µ ≤ X̄N + z1−α/2 σ̄N /N
implies that an approximate (1 − α)th level confidence interval for the parameter
µ = E [Xi ] may be computed from the sample mean X̄N and the sample variance
2
σ̄N as
q q
2 /N , X̄ + z
X̄N − z1−α/2 σ̄N 2 /N .
σ̄N (11)
N 1−α/2
This
palso implies
that the rate of convergence of Monte Carlo method is of order
O 2
σ̄N /N .
Monte Carlo Methods Option Pricing by Monte Carlo Simulation
Outline


Antithetic Variates
Control Variates

Monte Carlo Methods Option Pricing by Monte Carlo Simulation
Algorithm
Monte Carlo Simulation for European Options

for k = 1, 2, . . . , N do
if the option is path dependent then
simulate a path to get (ST )k % by numerical methods (for SDEs)
calculate the payoff, Vk
else
draw Zk ∼ N (0,n1)
√ o
(ST )k = S0 exp r − 21 σ 2 T + σZk T
calculate the payoff, Vk
end if
end for
b (V ) = 1 PN Vk
E % estimate of risk-neutral expectation
N k=1
Vb = e−rT E b (V ) % approximate value of option
b (V ) ≈ V (S0 , 0) = e−rT EQ [V (ST , T )]

Vb = e−rT E
Variance Reduction Techniques Antithetic Variates
Outline


Antithetic Variates
Control Variates

Antithetic Variates I
Consider the idea of generating two sequences of independent identically
distributed samples,
1 N N
Xi i=1 = X11 , X21 , . . . , XN
1
, Xi2 i=1
= X12 , X22 , . . . , XN
2
. (12)
These samples may separately be used in Monte Carlo simulations, and so may
the pair-averaged samples
1
Xi = Xi1 + Xi2 , i = 1, 2, . . . , N, (13)
2
since these are also i.i.d..
Assuming a correlation between the samples as

Cov Xi1 , Xi2 < 0,
Antithetic Variates II
for each i = 1, 2, . . . , N . By using the identity
n o
Cov Xi1 , Xi2 ≤ 1 Var Xi1 + Var Xi2 ,
2
it follows that
1n o
Var [Xi ] = Var Xi1 + Var Xi2 + 2 Cov Xi1 , Xi2
4
1
≤ Var Xi1 + Var Xi2 .
2
Hence,
N
" #
1 X
Var X̄N = Var Xi
N i=1
1 1
= Var [Xi ] ≤ Var Xi1 + Var Xi2 .
N 2N
This is the idea of antithetic variates.
Up-and-In Call, with antithetic variates

for i = 1, 2, . . . , M do
for j = 0, 1, . . . , N − 1 do
Zj ∼ N (0, 1) n
√ o
Sj+1 = Sj exp r − 21 σ 2 ∆t + σZj ∆t % introduce
n √ o
Sbj+1 = Sbj exp r − 12 σ 2 ∆t − σZj ∆t % correlation
end for
Sim = max Sj , Sbim = max Sbj
0≤j≤N 0≤j≤N
if Sim > B then
Vi1 = e−rT max{SN − K, 0}, else Vi1 = 0
end if
if Sbim > B then
Vi2 = e−rT max{SbN − K, 0}, else Vi2 = 0 % antithetic variates
end if
Vi = 21 (Vi1 + Vi2 ) % pair-averaged sample
end for
M M
1 X 1 X
V̄M = Vi , σ̄M2
= (Vi − V̄M )2
M i=1 M − 1 i=1
Antithetic Variates for Up-and-In Call (Comparison)
Table: A comparison of the confidence intervals for plain Monte Carlo and the use of
Antithetic Variates
Monte-Carlo Monte-Carlo Ratio
M (Plain) (Antithetic Variates) (Widths)
102 [0.0754, 0.3857] [0.1392, 0.3709] 1.3387

103 [0.1740, 0.2656] [0.2055, 0.2716] 1.3843
104 [0.2372, 0.2696] [0.2356, 0.2570] 1.5150
105 [0.2411, 0.2511] [0.2417, 0.2485] 1.4799
Variance Reduction Techniques Control Variates
Outline


Antithetic Variates
Control Variates

Control Variates I
Suppose that we wish to estimate the parameter
θ = E [X]
and that there is another random variable Y (control variable) with a known
ν = E [Y ] .
We introducing the controlled estimator,
Xc = X + c (Y − ν), (14)
where c is a parameter that has to be chosen later.

The expectation and the variance are
E [Xc ] = E [X] = θ
Var [Xc ] = Var [X] + c2 Var [Y ] + 2c Cov [X, Y ] .
Control Variates II
Hence,
Cov [X, Y ]
c∗ = − .
Var [Y ]
At this optimal case, when c = c∗ , the variance of the controlled estimator
becomes
Var [Xc∗ ] = Var [X] + (c∗ )2 Var [Y ] + 2c∗ Cov [X, Y ] , (15)
where Xc∗ ∗ ∗
= X + c (Y − ν). Inserting c into (15) and using the correlation
coefficient ρXY ,
Cov [X, Y ]
ρXY = p p ,
Var [X] Var [Y ]
we deduce that
Var [Xc∗ ]
= 1 − ρ2XY . (16)
Var [X]
Control Variates III

Remarks
Var [Xc ] < Var [X] if and only if c lies between zero and 2c∗ , where c∗ may
be either negative or positive.
In practice, the optimal value of c must be estimated since the covariance
Cov [X, Y ], and possibly Var [Y ], are not known. Of course, a set of pilot
replications can be used to estimate Cov [X, Y ] as well as Var [Y ].
Exploring Matlab Codes Monte Carlo Method for European Options
Outline


Antithetic Variates
Control Variates

MC for a Vanilla Call Option

MonteCarlo Call.m
function [Price, CI] = MonteCarlo_Call(S0,K,r,sigma,T,NRepl)
% NRepl : number of replications (paths)
muT = (r - 0.5*sigma^2)*T; sigmaT = sigma * sqrt(T);

DiscPayoff = exp(-r*T) * max( 0, S0*exp(muT+sigmaT*randn(NRepl,1)) - K );
% Matlab command for the Mean and Standard Deviation and the Confidence Interval
%[Price, SDev, CI] = normfit(DiscPayoff);
Price = mean(DiscPayoff); width = 1.96*std(DiscPayoff)/sqrt(NRepl);
CI = [Price-width, Price+width];
MC for a Vanilla Call Option (Script)

MC Call Eg.m
% test MC_Call
clear all, close all, randn(’state’,13);
S0 = 10; K = 9; sigma = 0.1; r = 0.06; T = 1; M = 17;
for i = 1:M
NRepl = 2^(i+4);
[P, CI] = MonteCarlo_Call(S0,K,r,sigma,T,NRepl);
Price(i) = P; confInterval(i,:) = CI;
end
format long; Price, confInterval
[C, Cdelta, P, Pdelta] = CallPut_Delta(S0,K,r,sigma,T);
plot([1:M], Price, ’o’), hold on
plot([0:M+1], ones(1,M+2)*C, ’r’)
for i=1:M
plot([i,i], confInterval(i,:), ’g--’ )
end
xlabel(’M (2^{M+4} Number of Samples)’,’FontSize’,12), ylabel(’V’,’FontSize’,12)
print -r900 -deps ’../figures/MC_Call_eg’
MC for a Vanilla Call Option (Convergence)
1.9
1.8
1.7
1.6
V
1.5
1.4
1.3
1.2
1.1
0 2 4 6 8 10 12 14 16 18
M+4
M (2 Number of Samples)
Figure: Convergence of Monte Carlo approximations to European Call
MC for Asian Arithmetic Average Option

Assume that the price St is observed at discrete times t = ti for i = 1, 2, . . . , N
with equidistant time interval ∆t := T /N , where T is the maturity. Hence,
ti = i ∆t for i = 0, 1, . . . , N . Then, the arithmetic mean, S̄t , becomes
N N
1 X 1X
S̄t = S ti = ∆t Sti .
N i=1 T i=1
Asian Arithmetic.m
% Euler-Maruyama: Asian option with Arithmetic Mean
clear all, close all, randn(’state’,13)
K = 1; r = 0.05; T = 1; N = 2^8; dt = T/N; M = 10000;
mu = r; S_0 = 1; sigma_0 = 0.8;
S = S_0*ones(M,1); Sigma = sigma_0*ones(M,1); sumOfS = S;
for j = 1:N
dW_1 = sqrt(dt)*randn(M,1); dW_2 = sqrt(dt)*randn(M,1); % independent of dW_1
% To be safe!
S = abs(S + dt*mu*S + sqrt(S).*Sigma.*dW_1);
Sigma = abs(Sigma + dt*(sigma_0 - Sigma) + sqrt(Sigma).*dW_2);
sumOfS = sumOfS + S;
end
meanOfX = sumOfS/(N+1); Price = exp(-r*T)*mean(max(0,meanOfX-K))
MC for Spread Option (Correlated Assets)

SpreadOption MC.m
% At maturity the payoff from a call spread option is max(S1-S2-K,0)
% At maturity the payoff from a put spread option is max(K-S1+S2,0)
clear all, close all, randn(’state’, 13)
flag_CallPut = ’c’; S1 = 110; S2 = 100; K = 1; r = 0.06; sum=0;

mu1 = r; mu2 = r; sigma1 = .2; sigma2 = .3; rho = .5; T = 1; nPaths = 10000;
if flag_CallPut == ’c’
z = 1; % Will return call option value
else
z = -1; % Will return put option value
end
drift1 = (mu1 - sigma1^2 / 2) * T; drift2 = (mu2 - sigma2^2 / 2) * T;
sigma1Sqrdt = sigma1 * sqrt(T); sigma2Sqrdt = sigma2 * sqrt(T);
for i = 1:nPaths,
Z1 = randn; Z2 = rho * Z1 + randn * sqrt(1 - rho ^ 2);
St1 = S1 * exp(drift1 + sigma1Sqrdt * Z1);
St2 = S2 * exp(drift2 + sigma2Sqrdt * Z2);
sum = sum + max(z * (St1 - St2 - K), 0);
end
Price = exp(-r * T) * (sum / nPaths)
Exploring Matlab Codes Variance Reduction Techniques
Outline


Antithetic Variates
Control Variates

Arithmetic Average Asian Option

MC ArithmeticAsian.m
function [P,CI] = MC_ArithmeticAsian(S0,K,r,sigma,T,NSamples,NRepl)
Payoff = zeros(NRepl,1);
for i=1:NRepl
Path=AssetPaths_gBM(S0,r,sigma,T,NSamples,1);
Payoff(i) = max(0, mean(Path(2:(NSamples+1))) - K);
end
% for simplicity use
[P,approxsigma,CI] = normfit( exp(-r*T) * Payoff);
AssetPaths gBM.m
function SPaths = AssetPaths_gBM(S0,mu,sigma,T,NSteps,NRepl)
% Calculates the asset paths using the exact formula
% NSteps = number of time steps to be taken
% NRepl = number of paths to be simulated
dt = T/NSteps; mudt = (mu-0.5*sigma^2)*dt; sidt = sigma*sqrt(dt);

Increments = mudt + sidt*randn(NRepl, NSteps);
LogPaths = cumsum([log(S0)*ones(NRepl,1) , Increments] , 2);
SPaths = exp(LogPaths);
Arithmetic Average Asian Option (Control Variable)
" N
# N
X X
E [Y ] = E S ti = E [Si∆t ]
i=0 i=0
N
X N
X i er(N +1)∆t − 1
= S0 eri∆t = S0 er∆t = S0 ,
i=0 i=0
er∆t − 1
Arithmetic Average Asian Option (Control Variable, cont.)

MC ArithmeticAsian Control SumOfS.m
function [P,CI] = MC_ArithmeticAsian_Control_SumOfS(...
S0,K,r,sigma,T,NSamples,NRepl,NPilot)
% pilot replications to set control parameter

TryPath=AssetPaths_gBM(S0,r,sigma,T,NSamples,NPilot);
StockSum = sum(TryPath,2); PP = mean( TryPath(:,2:(NSamples+1)), 2 );
TryPayoff = exp(-r*T) * max(0, PP - K);
MatCov = cov(StockSum, TryPayoff); c = - MatCov(1,2) / var(StockSum);
dt = T / NSamples;
ExpSum = S0 * (1 - exp((NSamples + 1)*r*dt)) / (1 - exp(r*dt));
% MC run
ControlVars = zeros(NRepl,1);
for i=1:NRepl
StockPath = AssetPaths_gBM(S0,r,sigma,T,NSamples,1);
Payoff = exp(-r*T) * max(0, mean(StockPath(2:(NSamples+1))) - K);
ControlVars(i) = Payoff + c * (sum(StockPath) - ExpSum);
end
[P,approxSigma,CI] = normfit(ControlVars);
Control Variates, Testing (Script)

test ControlVariate Sums
% test MC and Control Variate with Asset Sums
clear all, close all, rand(’state’, 13), randn(’state’, 13)
howMany = 5;
for k=2:howMany
[Pmc,CI] = MC_ArithmeticAsian(50,50,0.1,0.4,5/12,5,5*10^k);
[Pcv,CIcv] = MC_ArithmeticAsian_Control_SumOfS( ...
50,50,0.1,0.4,5/12,5,5*10^k,5*10^(k-1));
TC = [k, CI(1), CI(2), CIcv(1), CIcv(2), ...
( CI(2)-CI(1) ) / ( CIcv(2)-CIcv(1) ) ]
end
Arithmetic Average Asian Option (Comparison)
Table: A comparison of the confidence intervals for plain Monte Carlo and the use of
Control Variates
Pilot Monte-Carlo Monte-Carlo Ratio
Replications Replications (Plain) (Control Variate) (Widths)
5 · 102 5 · 101 [3.1562, 4.1555] [3.8204, 4.2510] 2.3207

5 · 103 5 · 102 [3.7335, 4.0564] [3.9444, 4.0817] 2.3501
5 · 104 5 · 103 [3.9182, 4.0224] [3.9536, 3.9971] 2.3991
5 · 105 5 · 104 [3.9467, 3.9796] [3.9574, 3.9710] 2.4117
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Monte Carlo Methods for Options

Institute of Applied Mathematics

July 24, 2010

1 Monte Carlo Methods

2 Variance Reduction Techniques

3 Exploring Matlab Codes

1 Monte Carlo Methods

2 Variance Reduction Techniques

3 Exploring Matlab Codes

Monte Carlo Integration

with probability one.

Monte Carlo Integration (cont.)

This is an unbiased estimator of the parameter

Strong Law of Large Numbers

Theorem (Strong Law of Large Numbers)

with probability one.

where σ 2 = Var [Xi ] may be estimated by a sample variance, say σ̄N

holds by using the second equality in (5).

Central Limit Theorem

Theorem (Central Limit Theorem)

where Φ is the standard normal distribution function.

If, further, the random variable Z is standard normally distributed, then

1 − α = Φ(z1−α/2 ) − Φ(−z1−α/2 ) = 2 Φ(z1−α/2 ) − 1.

Commonly used critical numbers are

z0.975 = Φ−1 (1 − 0.05/2) ≈ 1.96, for α = 0.05, (9)

can be considered to be approximately standard normally distributed by the

Confidence Interval III

1 Monte Carlo Methods

2 Variance Reduction Techniques

3 Exploring Matlab Codes

Monte Carlo Simulation for European Options

b (V ) ≈ V (S0 , 0) = e−rT EQ [V (ST , T )]

1 Monte Carlo Methods

2 Variance Reduction Techniques

3 Exploring Matlab Codes

Up-and-In Call, with antithetic variates

Antithetic Variates for Up-and-In Call (Comparison)

102 [0.0754, 0.3857] [0.1392, 0.3709] 1.3387

1 Monte Carlo Methods

2 Variance Reduction Techniques

3 Exploring Matlab Codes

We introducing the controlled estimator,

where c is a parameter that has to be chosen later.

Var [Xc ] = Var [X] + c2 Var [Y ] + 2c Cov [X, Y ] .

Control Variates III

1 Monte Carlo Methods

2 Variance Reduction Techniques

3 Exploring Matlab Codes

MC for a Vanilla Call Option

muT = (r - 0.5*sigma^2)*T; sigmaT = sigma * sqrt(T);

MC for a Vanilla Call Option (Script)

MC for a Vanilla Call Option (Convergence)

Figure: Convergence of Monte Carlo approximations to European Call

MC for Asian Arithmetic Average Option

MC for Spread Option (Correlated Assets)

flag_CallPut = ’c’; S1 = 110; S2 = 100; K = 1; r = 0.06; sum=0;

1 Monte Carlo Methods

2 Variance Reduction Techniques

3 Exploring Matlab Codes

Arithmetic Average Asian Option

dt = T/NSteps; mudt = (mu-0.5*sigma^2)*dt; sidt = sigma*sqrt(dt);

Arithmetic Average Asian Option (Control Variable)

Arithmetic Average Asian Option (Control Variable, cont.)

% pilot replications to set control parameter

muT = (r - 0.5sigma^2)T; sigmaT = sigma * sqrt(T);

dt = T/NSteps; mudt = (mu-0.5sigma^2)dt; sidt = sigma*sqrt(dt);