## Asian Options II: Monte Carlo

In a recent post, I introduced Asian options, an exotic option which pay the average of the underlying over a sequence of fixing dates.

The payoff of an Asian call is

$C(T)&space;=&space;\Big({1&space;\over&space;N}\sum^N_{i=0}&space;S_{t_i}&space;-&space;K&space;\Big)^+$

and to price the option at an earlier time via risk-neutral valuation requires us to solve the integral

$C(t)&space;=&space;P_{t,T}\&space;\big(&space;\iint\cdots\int&space;\big)&space;\Big({1&space;\over&space;N}\sum^N_{i=0}&space;S_{t_i}&space;-&space;K&space;\Big)^+&space;\phi(S_{t_1},S_{t_1},\cdots,S_{t_N})&space;dS_{t_1}dS_{t_2}\cdots&space;dS_{t_N}$

A simple way to do this is using Monte Carlo – we simulate a spot path drawn from the distribution $\inline&space;\phi(S_{t_1},S_{t_1},\cdots,S_{t_N})$ and evaluate the payoff at expiry of that path, then average over a large number of paths to get an estimate of C(t).

It’s particularly easy to do this in Black-Scholes, all we have to do is simulate N gaussian variables, and evolve the underlying according to a geometric brownian motion.

I’ve updated the C++ and Excel Monte Carlo pricer on the blog to be able to price asian puts and calls by Monte Carlo – have a go and see how they behave relative to vanilla options. One subtlety is that we can no longer input a single expiry date, we now need an array of dates as our function input. If you have a look in the code, you’ll see that I’ve adjusted the function optionPricer to take a datatype MyArray, which is the default array used by XLW (it won’t be happy if you tell it to take std::vector). This array can be entered as a row or column of excel cells, and should be the dates, expressed as years from the present date, to average over.

## The Dupire Local Vol Model

In this post I’m going to look at a further generalisation of the Black-Scholes model, which will allow us to re-price any arbitrary market-observed volatility surface, including those featuring a volatility smile.

I’ve previously looked at how we can produce different at-the-money vols at different times by using a piecewise constant volatility $\inline&space;\sigma(t)$, but we were still unable to produce smiley vol surfaces which are often observed in the market. We can go further by allowing vol to depend on both t and the value of the underlying S, so that the full BS model dynamics are given by the following SDE

$dS_t&space;=&space;S_t\cdot&space;\Big(\&space;r(t)&space;dt\&space;+\&space;\sigma(t,S_t)&space;dW_t\&space;\Big)$

Throughout this post we will make constant use of the probability distribution of the underlying implied by this SDE at future times, which I will denote $\inline&space;\phi(t,S_t)$. It can be shown [and I will show in a later post!] that the evolution of this distribution obeys the Kolmogorov Forward Equation (sometimes called the Fokker-Planck equation)

${\partial&space;\phi(t,S_t)&space;\over&space;\partial&space;t}&space;=&space;-{\partial&space;\over&space;\partial&space;S_t}\big(rS_t\phi(t,S_t)\big)&space;+&space;{1\over&space;2}{\partial^2&space;\over&space;\partial&space;S_t^2}\big(\sigma^2(t,S_t)&space;S_t^2&space;\phi(t,S_t)\big)$

This looks a mess, but it essentially tells us how the probability distribution changes with time – we can see that is looks very much like a heat equation with an additional driving term due to the SDE drift.

Vanilla call option prices are given by

$C(t,S_t)&space;=&space;P(0,t)\int_K^{\infty}&space;\big(S_t&space;-&space;K\big)\phi(t,&space;S_t)&space;dS_t$

Assuming the market provides vanilla call option prices at all times and strikes [or at least enough for us to interpolate across the region of interest], we can calculate the time derivative of the call price which is equal to

${\partial&space;C&space;\over&space;\partial&space;T}&space;=&space;-rC&space;+&space;P(0,T)\int_K^{\infty}\big(&space;S_T&space;-&space;K&space;\big)\&space;{\partial&space;\phi&space;\over&space;\partial&space;T}\&space;dS_T$

and we can substitute in the value of the time derivative of the probability distribution from the Kolmogorov equation above

$rC&space;+&space;{\partial&space;C&space;\over&space;\partial&space;T}&space;=&space;P(0,T)\int_K^{\infty}\big(&space;S_T&space;-&space;K&space;\big)\Big[&space;-{\partial&space;\over&space;\partial&space;S_T}\big(&space;rS_T\phi\big)&space;+&space;{1\over&space;2}{\partial^2&space;\over&space;\partial&space;S_T^2}\big(&space;\sigma^2S_T^2\phi\big)&space;\Big]dS_T$

These two integrals can be solved by integration by parts with a little care

\begin{align*}&space;-\int_K^{\infty}\big(&space;S_T&space;-&space;K&space;\big){\partial&space;\over&space;\partial&space;S_T}\big(&space;rS_T\phi\big)dS_T&space;&&space;=&space;-\Big[rS_T\phi&space;\big(&space;S_T&space;-&space;K&space;\big)\Big]^{\infty}_{K}&space;+&space;\int_K^{\infty}rS_T\phi\&space;dS_T&space;\\&space;&&space;=&space;r\int_K^{\infty}&space;(S_T\phi)\&space;dS_T&space;\end{align*}\begin{align*}&space;\int_K^{\infty}\big(&space;S_T&space;-&space;K&space;\big){\partial^2&space;\over&space;\partial&space;S_T^2}\big(&space;\sigma^2&space;S_T^2\phi\big)dS_T&space;&&space;=\Big[\big(&space;S_T&space;-&space;K&space;\big){\partial&space;\over&space;\partial&space;S_T}(\sigma^2&space;S_T^2\phi)&space;\Big]^{\infty}_{K}&space;-&space;\int_K^{\infty}{\partial&space;\over&space;\partial&space;S_T}(\sigma^2&space;S_T^2\phi)\&space;dS_T&space;\\&space;&&space;=&space;-\sigma^2&space;K^2\phi(K,T)&space;\end{align*}where in both cases, the boundary terms disappear at the upper limit due to the distribution $\inline&space;\phi(t,S_t)$ and its derivatives, which go to zero rapidly at high spot.

We already have an expression for $\inline&space;\phi(t,S_t)$ in terms of C and its derivatives from our survey of risk-neutral probabilities,

$\phi(t,S_t)&space;=&space;{1&space;\over&space;P(0,t)}{\partial^2&space;C&space;\over&space;\partial&space;K^2}$

and we can re-arrange the formula above for call option prices

\begin{align*}&space;P(0,T)\int_K^{\infty}&space;S_T\&space;\phi\&space;dS_T&space;&&space;=&space;C&space;+&space;P(0,T)\int_K^{\infty}&space;K\phi\&space;dS_T&space;\\&space;&&space;=&space;C&space;+&space;K&space;{\partial&space;C&space;\over&space;\partial&space;K}&space;\end{align*}and substituting these expressions for $\inline&space;\phi(t,S_t)$ and $\inline&space;\int^{\infty}_K&space;(S_T&space;\phi)\&space;dS_T$ into the equation above

\begin{align*}&space;rC&space;+&space;{\partial&space;C&space;\over&space;\partial&space;T}&space;&&space;=&space;P(0,T)\cdot&space;\Big[&space;r\int_K^{\infty}&space;(S_T\phi)\&space;dS_T&space;+&space;\sigma^2&space;K^2\phi(K,T)&space;\Big]\\&space;&&space;=&space;rC&space;+&space;rK&space;{\partial&space;C&space;\over&space;\partial&space;K}&space;+&space;\sigma^2&space;K^2{\partial^2&space;C&space;\over&space;\partial&space;K^2}&space;\end{align*}

and remember that $\inline&space;\sigma&space;=&space;\sigma(t,S_t)$, which is our Dupire local vol. Cancelling the rC terms from each side and re-arranging gives

$\sigma(T,K)&space;=&space;\sqrt{&space;{\partial&space;C&space;\over&space;\partial&space;T}&space;+&space;rK&space;{\partial&space;C&space;\over&space;\partial&space;K}&space;\over&space;K^2{\partial^2&space;C&space;\over&space;\partial&space;K^2}}$

It’s worth taking a moment to think what this means. From the market, we will have access to call prices at many strikes and expires. If we can choose a robust interpolation method across time and strike, we will be able to calculate the derivative of price with time and with strike, and plug those into the expression above to give us a Dupire local vol at each point on the time-price plane. If we are running a Monte-Carlo engine, this is the vol that we will need to plug in to evolve the spot from a particular spot level and at a particular time, in order to recover the vanilla prices observed on the market.

A nice property of the local vol model is that it can match uniquely any observed market call price surface. However, the model has weaknesses as well – by including only one source of uncertainty (the volatility), we are making too much of a simplification. Although vanilla prices match, exotics priced using local vol models typically have prices that are much lower than prices observed on the market. The local vol model tends to put most of the vol at early times, so that longer running exotics significantly underprice.

It is important to understand that this is NOT the implied vol used when calculating vanilla vol prices. The implied vol and the local vol are related along a spot path by the expression

$\Sigma^2&space;T&space;=&space;\oint_0^T\sigma^2(S_t,t)dt$

(where $\inline&space;\Sigma$ is the implied vol) and the two are quite different. Implied vol is the square root of the average variance per unit time, while the local vol gives the amount of additional variance being added at particular positions on the S-t plane. Since we have an expression for local vol in terms of the call price surface, and there is a 1-to-1 correspondence between call prices and implied vols, we can derive an expression to calculate local vols directly from an implied vol surface. The derivation is long and tedious but trivial mathematically so I don’t present it here, the result is that the local vol is given by (rates are excluded here for simplicity)

$\sigma(y,T)&space;=&space;\sqrt{{\partial&space;w&space;\over&space;\partial&space;T}&space;\over&space;\Big[&space;1&space;-&space;{y&space;\over&space;w}{\partial&space;w&space;\over&space;\partial&space;y}&space;+&space;{1\over&space;2}{\partial^2&space;w&space;\over&space;\partial&space;y^2}+&space;{1&space;\over&space;4}\Big(&space;-{1&space;\over&space;4}&space;-&space;{1&space;\over&space;w}+&space;{y^2&space;\over&space;w}\Big)\Big({\partial&space;w&space;\over&space;\partial&space;y}\Big)^2&space;\Big]}$

where $\inline&space;w&space;=&space;\Sigma^2&space;T$ is the total implied variance to a maturity and strike and $\inline&space;y&space;=&space;\ln{K&space;\over&space;F_T}$ is the log of ‘moneyness’.

This is probably about as far as Black-Scholes alone will take you. Although we can reprice any vanilla surface, we’re still not pricing exotics very well – to correct this we’re going to need to consider other sources of uncertainty in our models. There are a wide variety of ways of doing this, and I’ll being to look at more advanced models in future posts!