Lecture Finite Difference Crank
Lecture Finite Difference Crank
Lecture Finite Difference Crank
Dr P. V. Johnson
School of Mathematics
2013
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods
Exotic options
Summary
O UTLINE
1 R EVIEW
Last time...
Todays lecture
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods
Exotic options
Summary
O UTLINE
1 R EVIEW
Last time...
Todays lecture
2 I MPROVED F INITE D IFFERENCE M ETHODS
The Crank-Nicolson Method
SOR method
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods
Exotic options
Summary
O UTLINE
1 R EVIEW
Last time...
Todays lecture
2 I MPROVED F INITE D IFFERENCE M ETHODS
The Crank-Nicolson Method
SOR method
3 E XOTIC OPTIONS
American options
Convergence and accuracy
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods
Exotic options
Summary
O UTLINE
1 R EVIEW
Last time...
Todays lecture
2 I MPROVED F INITE D IFFERENCE M ETHODS
The Crank-Nicolson Method
SOR method
3 E XOTIC OPTIONS
American options
Convergence and accuracy
4 S UMMARY
Overview
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods Last time...
Exotic options Todays lecture
Summary
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods Last time...
Exotic options Todays lecture
Summary
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods Last time...
Exotic options Todays lecture
Summary
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods Last time...
Exotic options Todays lecture
Summary
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods The Crank-Nicolson Method
Exotic options SOR method
Summary
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods The Crank-Nicolson Method
Exotic options SOR method
Summary
Crank-Nicolson grid
Focus attention on i, j-th value Vji, and a little
piece of the grid around that point
upper boundary
SU
S
lower boundary
0
0 t 2t ... it (i+1)t ... T
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods The Crank-Nicolson Method
Exotic options SOR method
Summary
V Vji+1 Vji
t t
V 1
+1
(V i Vji1 + Vji+ i+1
1 Vj 1 )
S 4S j+1
2 V 1
+1
(V i 2Vji + Vji1 + Vji+ i+1
1 2Vj
+1
+ Vji 1)
S 2 2S2 j+1
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods The Crank-Nicolson Method
Exotic options SOR method
Summary
2 j2 r 1
1 2 2
4 ( j rj)Vji1 + ( )Vji + 14 (2 j2 + rj)Vji+1 =
2 2 t
2 j2 r 1 1
+1
14 (2 j2 rj)Vji 1 ( 2 2 + t )Vj
i+1
(2 j2 + rj)Vji++1
1
4
There is one of these equations for each point in the grid
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods The Crank-Nicolson Method
Exotic options SOR method
Summary
M ATRIX EQUATIONS
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods The Crank-Nicolson Method
Exotic options SOR method
Summary
M ATRIX EQUATIONS
where:
1 2 2
aj = 4 ( j rj)
2 j2 r 1
bj =
2 2 t
1 2 2
cj = 4 ( j + rj)
2 j2 r 1
+1
dj = 14 (2 j2 rj)Vji 1 ( + )Vji+1
2 2 t
+1
14 (2 j2 + rj)Vji+ 1
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods The Crank-Nicolson Method
Exotic options SOR method
Summary
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods The Crank-Nicolson Method
Exotic options SOR method
Summary
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods The Crank-Nicolson Method
Exotic options SOR method
Summary
M ATRIX E QUATIONS
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods The Crank-Nicolson Method
Exotic options SOR method
Summary
J ACOBI I TERATION
Rearrange these equations to get:
1 i
Vji = (d aj Vji1 cj Vji+1 )
bj j
The Jacobi method is an iterative one that relies upon the
previous equation.
Taking an initial guess for Vji , denoted as Vji,0
iterate using the formula below for the (k + 1)th iteration:
1 i
Vji,k+1 = (d aj Vji,k i,k
1 cj Vj+1 )
bj j
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods The Crank-Nicolson Method
Exotic options SOR method
Summary
J ACOBI I TERATION
Rearrange these equations to get:
1 i
Vji = (d aj Vji1 cj Vji+1 )
bj j
The Jacobi method is an iterative one that relies upon the
previous equation.
Taking an initial guess for Vji , denoted as Vji,0
iterate using the formula below for the (k + 1)th iteration:
1 i
Vji,k+1 = (d aj Vji,k i,k
1 cj Vj+1 )
bj j
SOR
The SOR method is another slight adjustment. It starts
from the trivial observation that
Vji,k+1 = Vji,k + (Vji,k+1 Vji,k )
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods The Crank-Nicolson Method
Exotic options SOR method
Summary
SOR
The SOR method is another slight adjustment. It starts
from the trivial observation that
Vji,k+1 = Vji,k + (Vji,k+1 Vji,k )
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods American options
Exotic options Convergence and accuracy
Summary
S
Impose lower boundary at 0
0
0 t 2t ... it (i+1)t ... T
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods American options
Exotic options Convergence and accuracy
Summary
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods American options
Exotic options Convergence and accuracy
Summary
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods American options
Exotic options Convergence and accuracy
Summary
PSOR
A simple solution to this problem is to project our SOR
method (Projected SOR)
In order to project, check whether or not it would be
optimal to exercise at each iteration.
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods American options
Exotic options Convergence and accuracy
Summary
PSOR
A simple solution to this problem is to project our SOR
method (Projected SOR)
In order to project, check whether or not it would be
optimal to exercise at each iteration.
This changes
1 i
yji,k+1 = (d aj Vji,k +1 i,k
1 cj Vj+1 )
bj j
Vji,k+1 = Vji,k + (yi,k
j
+1
Vji,k )
to (in the case of the American put option)
1 i
yji,k+1 = (d aj Vji,k +1 i,k
1 cj Vj+1 )
bj j
Vji,k+1 = max(Vji,k + (yi,k
j
+1
Vji,k ), X jS)
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods American options
Exotic options Convergence and accuracy
Summary
C ONVERGENCE
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods American options
Exotic options Convergence and accuracy
Summary
C ONVERGENCE
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods American options
Exotic options Convergence and accuracy
Summary
N ON - LINEARITY ERROR
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods American options
Exotic options Convergence and accuracy
Summary
N ON - LINEARITY ERROR
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods American options
Exotic options Convergence and accuracy
Summary
B ARRIER OPTIONS
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods American options
Exotic options Convergence and accuracy
Summary
B ARRIER OPTIONS
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods
Overview
Exotic options
Summary
O VERVIEW
Dr P. V. Johnson MATH60082
Review
Improved Finite Difference Methods
Overview
Exotic options
Summary
O VERVIEW
Dr P. V. Johnson MATH60082