Proceedings of the National Institute for Mathematical Sciences Vol. 2, No. 10(2008), pp.

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A HIGH ORDER COMPACT SCHEME FOR OPTION PRICING WITH JUMPS

HAI-WEI SUN AND SPIKE T. LEE

Abstract. In this paper we consider a partial integro-dierential equation (PIDE), which arises from the option pricing problem in jump-diusion model. A fourth order compact nite dierence scheme is proposed to discretize the spatial variable of this PIDE. The computation of the discretized system involves matrix-vector multiplication, where the matrix generated from the jump integral term is Toeplitz-like. Hence fast Fourier transform can be used to perform these multiplications eciently. Numerical results are given to show that our approach indeed has fourth order accuracy in space, which is much better than the classical second order central dierence scheme.

1. Introduction In this paper, we consider option pricing under the jump-diusion model presented by Merton [10]. In this model, the asset return follows a standard Wiener process driven by a compound Poisson process with normally distributed jumps. Furthermore, by choosing the parameters of the jump process properly, volatility smiles and skews can be generated under this model [3]. The value of a contingent claim under a jump-diusion process satises a partial integro-dierential equation (PIDE). This kind of equation generally contains dierential operators and a non-local integral term. Numerical solutions for the PIDE were widely studied in the past several years [1, 2, 3, 8, 16]. But these methods are at most second order accuracy for both space and time. For time direction, Feng and Linetsky [6] recently suggested an implicit-explicit (IMEX) scheme, where the dierential part is treated implicitly and the integral part explicitly, with a new high order extrapolation approach. Their method is independent of the choice of spatial discretization and can be added to any PIDE solver based on the IMEX scheme. For spatial direction, most of the schemes ever proposed exploit standard central dierence discretization, which only has second order convergence. In this paper, we apply a fourth order compact scheme (FOCS) for pricing European call options. The PIDE is discretized in time by an IMEX method. Inspired by Feng and Linetskys idea [6], we employ the Richardson extrapolation, which is less accurate than theirs but comparatively straightforward, to achieve high order accuracy in time. Moreover, we exploit numerical quadrature method for evaluating the jump integral term. It guarantees the Toeplitz-like structure of the integral operator such that a fast algorithm can be applied. This rest of the paper is arranged as follows. In Section 2 we review the jump-diusion model for option pricing and the IMEX scheme with extrapolation approach for the PIDE. In Section 3 we propose the FOCS for the PIDE. Issues regarding the evaluation of the non-local integral term are discussed in Section 4. In Section 5 we give some numerical results.
The research was partially supported by the research grant RG-UL/07-08S/Y1/JXQ/FST and CG016/0809W/SHW/FST from University of Macau. This is a brief review article for 2008 NIMS International Conference in October, 2008 joint with The 4th East Asia SIAM Conference. Some of the contents in the article may appear somewhere else.
c 2007 National Institute for Mathematical Sciences

High Order Scheme for Option Pricing with Jumps

2. Option Pricing in Jump-Diffusion Model and the IMEX Scheme In jump-diusion model, the risk-neutral dynamics of the asset price S( ) with [0, T ] (T is the expiration) can be described by the following diusion process: dS = d + dz + ( 1)dq, S where is the drift rate, is the stock return volatility, 1 is an impulse function making S jump to S, dz is the increment of a Brownian motion and dq is a Poisson process with arrival intensity (dq = 0 with probability 1 d and dq = 1 with probability d ). We denote the expectation of the impulse function by = E( 1). Let V (S( ), ) be the value of a contingent claim on the asset S( ). Then V (S, ) can be computed by solving a PIDE on [0, +) [0, T ]: (1) V = 2 2 S VSS + (r )S VS (r + )V + 2

V (S, )g()d,
0

where r is the risk-free interest rate and g() is the density function of the jump size distribution. It is common to change the variables as follows: S = ex , = ez and t = T .

Then equation (1) is reduced to a forward PIDE on (, +) [0, T ]: (2) Vt = 2 2 Vxx + (r )Vx (r + )V + 2 2 V (y, t)f (y x)dy.

where y = x + z, f (y x) = g(eyx )eyx and V (y, t) = V (ey , T t). We refer the readers to see [8] for details. For a European call option, the initial condition is given by V (x, 0) = max(ex K, 0), where K is the strike price. Boundary conditions are V (x, t) 0, V (x, t) ex Kert , as x , as x +.

Note that European put options can be handled in a similar way. We consider the jump-diusion model presented by Merton [10]. The jump size distribution is normal with mean and standard deviation , and g() is given by g() = After changing the variable, we have e(yx) /2 . (3) f (y x) = g(e )e = 2 Note that f is the probability density function of the Gaussian distribution, hence the following property holds:
yx yx
2 2

e(log()) 2

/2 2

f (y x)dy = 1.

In the following, we introduce the IMEX scheme for a PIDE. Suppose a PIDE is given by: Vt = DV + LV, where D is a dierential operator and L is an integral operator. As L usually makes the system dense, we utilize the IMEX scheme which is noted for avoiding dense matrices inversion. First the

H. Sun & S. Lee

time interval [0, T ] is divided into J time steps, with t = T /J and tj = jt, j = 0, 1, 2, ..., J. Let V j = V (tj ), j = 0, 1, 2, ..., J. We then apply the IMEX scheme, where the dierential part is treated implicitly and the integral part is treated explicitly for j = 0, 1, 2, ..., J 1: V j+1 V j = DV j+1 + LV j , t or (4) V j+1 tDV j+1 = V j + tLV j .

Our ultimate goal is to nd V J = V (T ) . At each time step, the linear system (4) is solved to determine the vector V j+1 with V 0 being the given initial guess. However, the IMEX scheme is only rst order accurate in time. If the IMEX scheme is unconditionally stable, we can employ the Richardson extrapolation method to achieve higher accuracy. Denote the solution obtained at time J T with step size t/2p1 , p = 1, 2, ..., s, by Vp,1 , where s is the stage number. Then the Richardson extrapolation formula is given by (5)
J Vp,q = J J 2p1 Vp,q1 Vp1,q1 , p = 2, 3, ..., s, q = 2, 3, ..., p. 2p1 1

Graphically, it can be illustrated as follows:

J V1,1 J V2,1 . . . J Vs,1 J V2,2 . . . J Vs,2

. ...

..

J Vs,s

J By this process, we have achieved a better approximation Vs,s which is of order O(ts ) after s extrapolation stages.

3. The Fourth Order Compact Scheme We now proceed to consider the FOCS for option pricing. The FOCS was proposed by Gupta [7], which is known for restraining the numerical oscillations [11, 12, 13, 14]. Recall that the PIDE (2) on (, +) [0, T ] is given by Vt = aVxx + bVx + cV + V f, where a= and V f =

1 2 2 , b = r , c = (r + ), 2 2

V (y, t)f (y x)dy.

First the innite x-domain (, ) is truncated to a nite computational domain [xmin , xmax ] using mesh size xmax xmin . x = I0 Then the computational grid with N0 = I0 + 1 points is denoted by x = {x0 , x1 , x2, ..., xK , ..., xI0 1 , xI0 },

High Order Scheme for Option Pricing with Jumps

where x0 = xmin , xK = log K and xI0 = xmax . Divide the time interval [0, T ] into J time steps, with t = T /J and tj = jt, j = 0, 1, 2, ..., J. Dene V j = V (x, tj ), j = 0, 1, 2, ..., J. Then the IMEX scheme is applied as discussed in Section 2: V j+1 V j j+1 j+1 = aVxx + bVx + cV j+1 + V j f. t We then consider the following semi-discretized equation: (6)
j+1 j+1 atVxx btVx + (1 ct)V j+1 = V j + tV j f.

Since the right-hand side of the above equation is given for the current time step, it can be treated as a convection-diusion equation. Thus FOCS can be applied for (6). Let Vij = V (xi , tj ) for i = 1, 2, ..., I0 1. We derive the three point FOCS as follows, (7)
j+1 j+1 Vij+1 [1 (i + i ) + t(i + i + r + )] + (i ti )Vi1 + (i t i )Vi+1 j j = Vij [1 (i + i )] + i Vi1 + i Vi+1 + t

V (y, tj )(y xi , x)dy,

where i =

1 bx , 12 24a

bx di ei ei 1 di + , i = , i = + , 2 2 12 24a x 2x x 2x b2 x2 cx2 bcx2 di = a + + , ei = b + 12a 12 12a i = bx2 f (y x) x2 2 f (y x) + . 12a x 12 x2

and (8) (y x, x) = f (y x) +

Consequently, we can write the discretized equation (7) in matrix form for j = 0, 1, 2, ..., J 1: (9) M1 Vj+1 = M2 Vj + tVj , where Vj = (V1j , V2j , ..., VIj0 1 ) . Note that M1 and M2 are tridiagonal matrices when the computational grid is uniform. At each time step, a tridiagonal system can be solved by using the LU decomposition. After solving the linear system (9), the resulting VJ = V(T ) is regarded as the approximation to the true solution. In order to achieve high order accuracy for the time direction, as discussed in Section 2, in the following we study the unconditional stability of the IMEX scheme with the FOCS (7). Lemma 3.1. [9] For the kernel function (y x, x) in (8), we have

(y x, x)dy = 1.

According to lemma 3.1, we have the following theorem by using the Fourier stability analysis. Theorem 3.2. [9] The FOCS (7) is unconditionally stable. 4. Evaluation of the Integral Term Evaluation of the integral term is required to solve the linear system (9) at each time step. Therefore a higher order approximation to the convolution integral is also necessary. The numerical quadrature method is used for evaluating the integral term in our case. The truncation is achieved by extending x to a uniform grid y with mesh size x as follows: xmax xmin y = {yk R : yk = ymin + ky, k = 0, 1, ..., n, y = x = }, I0

H. Sun & S. Lee

where y0 = ymin and yn = ymax . Note that y equals to the mesh size x. Hence we can write the integral in discrete form by using fourth order composite Simpsons rule for i = 1, 2, ...I0 1, (10) y V (y, t)(y xi , x)dy = [V (y0 , t)(y0 xi , x) + 2 3
n/2 n/21

V (y2k , t)(y2k xi , x)
k=1

+4
k=1

V (y2k1 , t)(y2k1 xi , x) + V (yn , t)(yn xi , x)],

Furthermore, (10) can be written in matrix form LVy , where (y0 x1 , x) (y1 x1 , x) (y2 x1 , x) ... (y0 x2 , x) (y1 x2 , x) (y2 x2 , x) ... L= . . . . . . . . . (y0 xI0 1 , x) (y1 xI0 1 , x) (y2 xI0 1 , x) . . . and Vy =

(yn xI0 1 , x)

(yn x1 , x) (yn x2 , x) . . .

y (V (y0, t), 4V (y1, t), 2V (y2, t), 4V (y3, t), 2V (y4, t), ..., V (yn, t)) . 3 Note that we have the following relation for i = 1, 2, ...I0 1, k = 0, 1, ..., n: xi+1 xi = x = y = yk+1 yk . Therefore yk xi = yk+1 xi+1 and (yk xi , x) = (yk+1 xi+1 , x). Thus L is a Toeplitz matrix, and the fast Fourier transform can be applied to compute LVy [4, 5]. Remark 4.1. There exists a non-smooth region around the strike price xK when pricing a European call option. Consequently it will aect the high order accuracy. Thus it is necessary to concentrate grid points near xK . The local mesh renement strategy [9] is employed for numerical testing in the next section to guarantee the high accuracy. 5. Numerical Results In this section, we give the numerical results of pricing European call options under Mertons jumpdiusion model [10]. In our numerical tests, we have to make sure the error in temporal direction is small enough not to aect the convergence rate of the spatial discretization. Thus sixth order Richardson extrapolation method is utilized to obtain sixth order accuracy in time. Assume the J extrapolation stage number s = 6 and t = 102 at the rst stage. The value V6,6 in (5), which is of order O(t6 ) after six extrapolation stages is accepted as the approximation to VJ . The input parameters are T = 0.25, K = 100, = 0.25, r = 0.05, = 0.9 and = 0.45. N is the number of points in the x-direction and x is the mesh size. Error at xK is the dierence between the true solution (in [10]) and the approximation at strike price xK . l error denotes the innity norm error between the true solution and the approximation. The results in Table 1 show that the standard central dierence scheme clearly attains second order accuracy. As comparison, we can see from Table 2 that the FOCS with local mesh renement restores fourth order convergence. References
[1] A. Almendral and C. Oosterlee, Numerical Valuation of Options with Jumps in the Underlying, Applied Numerical Mathematics, Vol. 53 (2005), pp. 118. [2] K. Amin, Jump Diusion Option Valuation in Discrete Time, Journal of Finance, Vol. 48 (1993), pp. 18331863. [3] L. Andersen and J. Andreasen, Jump-Diusion Processes: Volatility Smile Fitting and Numerical Methods for Option Pricing, Review of Derivatives Research, Vol. 4 (2000), pp. 231262.

High Order Scheme for Option Pricing with Jumps

N x Error at xK l error Order 33 1/5 1.62 1.62 65 1/10 4.51e-1 4.51e-1 1.847 129 1/20 9.76e-2 1.06e-1 2.083 257 1/40 2.38e-2 2.67e-2 1.992 513 1/80 5.91e-3 6.69e-3 1.998 1025 1/160 1.47e-4 1.67e-3 1.999 Table 1. Innity norm error and convergence rates of central dierence scheme for pricing a European call option under Mertons jump-diusion model.

N x Error at xK l error Order 33 1/5 1.69e-2 2.20e-2 65 1/10 1.82e-3 4.67e-3 2.234 129 1/20 1.16e-4 3.87e-4 3.593 257 1/40 5.49e-6 2.77e-5 3.802 513 1/80 6.61e-7 1.88e-6 3.883 1025 1/160 4.66e-8 1.23e-7 3.935 Table 2. Innity norm error and convergence rates of FOCS with local mesh renement for pricing a European call option under Mertons jump-diusion model.

[4] R. Chan and M. Ng, Conjugate Gradient Methods for Toeplitz Systems, SIAM Review, Vol. 38 (1996), pp. 427482. [5] R. Chan and X. Jin, An Introduction to Iterative Toeplitz Solvers, SIAM, Philadelphia (2007). [6] L. Feng and V. Linetsky, Pricing Options in Jump-Diusion Models: An Extrapolation Approach, Oper. Res. 56 (2008), pp. 304325. [7] M. Gupta, A fourth-order Poisson solver, J. Comput. Phys. Vol. 55(1) (1984), pp. 166172. [8] Y. dHalluin, P. Forsyth and K. Vetzal, Robust Numerical Methods for Contingent Claims under Jump Diusion Processes, IMA Journal of Numerical Analysis, Vol. 25 (2005), pp. 87112. [9] S. Lee and H. Sun, Fourth Order Compact Scheme with Local Mesh Renement for Option Pricing in JumpDiusion Model, Manuscript. [10] R. Merton, Option Pricing When Underlying Stock Returns Are Discontinuous, Journal of Financial Economics, Vol. 3 (1976), pp. 125144. [11] W. Spotz and G. Carey, High-Order Compact Finite Dierence Schemes for Computational Mechanics, PhD Thesis, University of Texas at Austin (1995). [12] W. Spotz and G. Carey, High-Order Compact Scheme for the Steady Stream-Function Vorticity Equations, Int. J. Numer. Methods Engrg., Vol. 38 (1995), pp. 34973512. [13] J. Zhang, An Explicit Fourth-Order Compact Finite Dierence Scheme for Three Dimensional Convection-Diusion Equation, Communications in Numerical Methods in Engineering, Vol. 14 (1998), pp. 263280. [14] J. Zhang L. Ge and M. Gupta, Fourth Order Compact Scheme for 3D Convection Diusion Equation with Boundary Layers on Nonuniform Grids, Neural, Parallel & Scientic Computationss, Vol. 8, Num. 3-4 (2000), pp. 373392. [15] J. Zhang, H. Sun and J. Zhao, High Order Compact Scheme with Multigrid Local Mesh Renement Procedure for Convection Diusion Problems, Comput. Methods Appl. Mech. Engrg., Vol. 191 (2002), pp. 46614674. [16] X. Zhang, Numerical Analysis of American Option Pricing in A Jump-Diusion Model, Mathematics of Operations Research, Vol. 22(3) (1997), pp. 668690. Department of Mathematics, University of Macau, Macao, China. E-mail address: hsun@umac.mo Department of Mathematics, University of Macau, Macao, China. E-mail address: ma76522@umac.mo