Importance Sampling for Option Pricing. Steven R. Dunbar. Put Options. Monte Carlo Method. Importance. Sampling. Examples.

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1 for for January 25, / 26

2 Outline for / 26

3 Put Option for A put option is the right to sell an asset at an established price at a certain time. The established price is the strike price, K. The certain time is the exercise time T. At the exercise time, the value of the put option is a piecewise linear, decreasing function of the asset value. Option Intinsic Value VP (S, T ) = max(k S, 0) 3 / 26 K Asset Price

4 What is the price? for 4 / 26 For an asset with a random value at exercise time: What is the price to buy a put option before the exercise time? Six factors affect the price of a asset option: the current asset price S; the strike price K; the time to expiration T t where T is the expiration time and t is the current time; the volatility of the asset price; the risk-free interest rate; and (the dividends expected during the life of the option.)

5 Geometric Brownian Motion for How do asset prices vary randomly? Approximate answer is Geometric Brownian Motion: Stock prices can be mathematically modeled with a stochastic differential equation ds(t) = rs dt +σs dw (t), S(0) = S 0. The solution of this stochastic differential equation is Geometric Brownian Motion: S(t) = S 0 exp((r σ2 )t + σw (t)). 2 5 / 26 Simplest case S(t) = e W (t).

6 Log-Normal Distribution for At time t Geometric Brownian Motion has a lognormal probability density with parameters m = (ln(s 0 ) + rt 1 2 σ2 t) and s = σ t. 1 ( f X (x; m, s) = 1 1 exp 2πs 2 [ ] ) 2 ln(x) m. s lognormal pdf and cdf, m = 1, s = / x

7 Statistics of Log-Normal Distribution for The mean stock price at any time is E [S(t)] = S 0 exp(rt). The variance of the stock price at any time is Var [S(t)] = S 2 0 exp(2rt)[exp(σ 2 t) 1]. 7 / 26

8 Sample Mean for Assume a security price is modeled by Geometric Brownian Motion, with lognormal pdf. Draw n (pseudo-)random numbers x 1,..., x n from the lognormal distribution modeling the stock price S. Approximate a put option price as the (present-value of the) expected value of the function g(x) = max(k x, 0), with the sample mean [ ] V P (S, t) = e r(t t) E [g(s)] e r(t t) 1 n g(x i ) n = e r(t t) ḡ n. i=1 8 / 26

9 Central Limit Theorem for The Central Limit Theorem implies that the sample mean ḡ n is approximately normally distributed with mean E [g(s)] and variance Var [g(s)] / n, ḡ n N(E [g(s)], Var [g(s)]). Recall that for the standard normal distribution P [ Z < 1.96] 0.95 A 95% confidence interval for the estimate ḡ n is ( ) Var [g(s)] Var [g(s)] E [g(s)] 1.96, E [g(s)] n n 9 / 26

10 Estimating the Mean and Variance for A small problem with obtaining the confidence interval: The mean E [g(s)] and the variance Var [g(s)] are both unknown. These are respectively estimated with the sample mean ḡ n and the sample variance s 2 = 1 n 1 n (g(x i ) ḡ n ) 2 i=1 10 / 26

11 Using Student s t-distribution for The sample quantity (ḡ n E [g(x)]) s/ n has a probability distribution known as the Student s t-distribution, so the 95% confidence interval limits of ±1.96 must be modified with the corresponding 95% confidence limits of the appropriate Student-t distribution. 11 / 26

12 Confidence Interval for The 95% level confidence interval for E [g(x)] ( ) s s ḡ n t n 1,0.975, ḡ n + t n 1, n n 12 / 26

13 Example for Confidence interval estimation to calculate a simplified put option price for a simplified security. The simplified security has a risk-free interest rate r = σ 2 /2, a starting price S = 1, a standard deviation σ = 1. K = 1, time to expiration is T t = / 26 V P (S, t) = e r(t t) max(0, K x)p [ e W (T t) dx ] 0

14 R Program for Estimation for #+name Rexample n < S <- 1 sigma <- 1 r <- sigma^2/2 K <- 1 Tminust <- 1 x <- rlnorm(n) #Note use of default meanlog=0, y <- sapply(x, function(z) max(0, K - z )) t.test(exp(-r*tminust) * y) # all simulation re 14 / 26

15 Problems with for Applying estimation to a random variable with a large variance creates a confidence interval that is correspondingly large. Increasing the sample size, the reduction is 1 n. Variance reduction techniques increase the efficiency of estimation. Reduce variability with a given number of sample points, or for efficiency achieve the same variability with fewer sample points. 15 / 26

16 for sampling is a variance reduction technique. Some values in a simulation have more influence on the estimation than others. The probability distribution is carefully changed to give important outcomes more weight. If important values are emphasized by sampling more frequently, then the estimator variance can be reduced. The key to importance sampling is to choose a new sampling distribution that encourages the important values. 16 / 26

17 Choosing a new PDF for 17 / 26 Let f(x) be the density of the random variable, so we are trying to estimate E [g(x)] = g(x)f(x) dx. We will attempt to estimate E [g(x)] with respect to another strictly positive density h(x). Then easily E [g(x)] = g(x) f(x) h(x) dx. h(x) or equivalently, we are now trying to estimate [ ] g(y )f(y ) E Y = E Y [ g(y )] h(y ) R where Y is a new random variable with density h(y). R

18 Reducing the variance for For variance reduction, determine a new density h(y) so Var Y [ g(y )] < Var X [g(x)]. Consider Var [ g(y )] = E [ g(y ) 2] (E [ g(y )]) 2 g 2 (x)f 2 (x) = dx E [g(x)] 2. h(x) R 18 / 26 By inspection, we can see that we can make Var [ g(y )] = 0 by choosing h(x) = g(x)f(x)/e [g(x)]. This is the ultimate variance reduction. Need E [g(x)], what we are trying to estimate!

19 Educated Guessing for sampling is equivalent to a change-of-measure from P to Q with dq dp = f(x) h(x) Choosing a good importance sampling distribution requires educated guessing. Each instance of importance sampling depends on the function and the distribution. 19 / 26

20 Trivial Parameters for Calculate confidence intervals for a estimate of a European put option price, where g(x) = max(k x, 0) and S is distributed as a Geometric Brownian Motion. To keep parameters simple risk free interest rate r = σ 2 /2, the standard deviation σ = 1, the strike price K = 1 and time to expiration is 1 20 / 26

21 The quantity to estimate for = 0 0 max(0, 1 x) P[e W dx] ( ) 1 ln(x) 2 max(0, 1 x) exp dx. 2πσx T 2T 21 / 26

22 First Change of variable for Want 0 max(0, 1 x) P[e W (1) dx]. After a first change of variable the integral is E [g(s)] = 0 (1 e x /2 ) e x2 dx 2π 22 / 26

23 Another Change of variable for x = y for x < 0. Then dx = dy 2 y expectation integral becomes 0 1 e y 2π y e y/2 2 and the dy. 23 / 26

24 Comparative results for n putestimate confintleft confintright B-S MC MC MC Norm Norm Norm Exp Exp Exp / 26

25 A real example for Put option on S & P 500, SPX131019P S = r = 0.8% (estimated, comparable to 3 year and 5 year T-bill rate) σ = 18.27% (implied volatility) T t = 110/365 (07/01/2013 to 10/19/2013) K = 1575 n = 10,000 Quoted Price: $ / 26

26 Results for Value Confidence Interval Black-Scholes MonteCarlo ( , ) Sample ( , ) 26 / 26

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