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Fast option calibration: more non-affine stochastic volatility models.

2/27/2018

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When it comes to stochastic volatility (SV) models (whether in their pure form, or typically in combination with local volatility and/or jumps), their adoption in practice has been largely driven by whether they offer an "analytical" solution for vanilla options. The popularity of the Heston model probably best exemplifies this. When such a solution doesn't exist, calibration (to the vanilla option market) is considered more difficult and time consuming. But what are the chances that a model that happens to have a (semi-) analytical solution is also the best for the job? It could happen of course, but obviously this isn't the right criterion when choosing the model. Another model may well fit the market's implied volatility surfaces better and describe its dynamics more realistically.

In my last couple of posts I spoke about how a fairly simple PDE / finite differences approach can actually enable fast and robust option calibrations of non-affine SV models. I also posted a little console app that demonstrates the approach for the GARCH diffusion model. I have since played around with that app a little more, so here I'm giving a second version that can calibrate the following 5 non-affine SV models (plus Heston for comparison).​
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For the GARCH diffusion or power-law model (and the PDE pricing engine used for all the models implemented in this demo) see [1].  For the Inverse Gamma (aka "Bloomberg") model see for example [2]. ​The XGBM model was suggested to me by Alan Lewis, who has been working on an exact solution for it (to be published soon). Here pricing is done via the PDE engine. The ACE-X1 model is one of the models I've tried calibrating, which seems to be doing a very good job in various market conditions. All the above models calibrate to a variance (or volatility) process that is arguably more realistic than that of the Heston model (which when calibrated, very often has zero as its most probable value in the long-run). 
Non-affine SV Option Calibrator demo (Windows)
Please bear in mind that the above demo is just that, i.e. not production-level. In [1] the PDE engine was developed just for the GARCH diffusion model and Excel was used for the optimization. I then quickly coupled the code with a Levenberg-Marquardt implementation and adjusted the PDE engine for the other models without much testing (or specific optimizations). That said,  it works pretty well in general, with calibration times ranging from a few seconds up to a minute. It offers three speed / accuracy settings, but even with the fastest setting calibrations should be more accurate (and much faster) than any Monte-Carlo based implementation. A production version for a chosen model would be many times faster still. Note that you will also need to download the VC++ Redistributable for VS2013. The 64-bit version (which is a little faster) also requires the installation of Intel's MKL library. The demo is free but please acknowledge if you use it and do share your findings.
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EDIT April 2020: After downloading and running this on my new Windows 10 laptop I saw that the console was not displaying the inputs as intended (it was empty). To get around this please right click on the top of the console window, then click on Properties and there check "Use legacy console". Then close the console and re-launch.
As a small teaser, here's the performance of these models (in terms of IV-RMSE, recalibrated every day) for SPX options during two months at the height of the 2008 crisis. Please note that I used option data (from www.math.ku.dk/~rolf/Svend/) which include options +- 30% in moneyness only. Expirations range from 1M to 3Y. Including further out-of-the-money options does change the relative performance of the models. As does picking a different market period. That being said, my tests so far show that the considered models produce better IV fits than Heston in most cases, as well as representing arguably more realistic dynamics. Therefore they seem to be better candidates to be combined with local volatility and/or jumps than Heston.
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  Heston GARCH Power_law_0.8 ACE-X1 I-Ga XGBM
average IV-RMSE 0.91% 0.81% 0.82% 0.66% 0.73% 0.45%

References

[1] Y. Papadopoulos, A. Lewis, “A First Option Calibration of the GARCH Diffusion Model by a PDE Method.,” arXiv:1801.06141v1 [q-fin.CP],  2018.
[2] N. Langrené, G. Lee and Z. Zili, “Switching to non-affine stochastic volatility: A closed-form expansion for the Inverse Gamma model,” arXiv:1507.02847v2 [q-fin.CP], 2016.
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Option calibration of non-affine stochastic volatility models.                      Case study: The GARCH diffusion model.

1/21/2018

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My last two posts were really about just a couple of the many experiments I did as part of a project I had been working on. The aim was to design a method for efficient option calibrations of the GARCH diffusion stochastic volatility model. This (and other non-affine) models are usually thought of as impractical for implied (risk-neutral) calibrations because they lack fast semi-analytic (characteristic function-based) vanilla option pricing formulas. But using an efficient PDE-based solver may be an alternative worth looking at. It may prove fast enough to be used for practical calibrations, or at the very least provide insight on the overall performance of (non-affine) models that have seen increased interest in recent years. Besides, analytical tractability definitely shouldn't the main criterion for choosing a model.

For those interested there's now a detailed report of this joint collaboration with Alan Lewis on the arXiv: A First Option Calibration of the GARCH Diffusion Model by a PDE Method. Alan's blog can be found here.
GARCH Diffusion Option Calibrator demo (Windows)
EDIT: For the results reported in the paper, Excel's solver was used for the optimization. I've now quickly plugged the PDE engine into M. Lourakis' Levenberg-Marquardt implementation (levmar) and built a basic demo so that perhaps people can try to calibrate the model to their data. It doesn't offer many options, just a fast / accurate switch. The fast option is typically plenty accurate as well. So, if there's some dataset you may have used for calibrating say the Heston model, it would be interesting to see how will the corresponding GARCH diffusion fit compare. Irrespective of the fit, GARCH diffusion is arguably a preferable model, not least because it typically implies more plausible dynamics than Heston. Does this also translate to more stable parameters on recalibrations? Are the fitted (Q-measure) parameters closer to those obtained from the real (P-measure) world? If the answers to the above questions are mostly positive, then coupling the model with local volatility and/or jumps could give a better practical solution than what the industry uses today. (Of course one could just as easily do that with the optimal-p model instead of GARCH diffusion, as demonstrated in my previous post.)  Something for the near future.  
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​If you do download the calibrator and use it on your data, please do share your findings (or any problems you may encounter), either by leaving a comment below, or by sending me an email. As a bonus, I've also included the option to calibrate another (never previously calibrated) non-affine model, the general power-law model with p = 0.8 (sitting between Heston and GARCH diffusion, see [1]). 
Note that (unless you have Visual Studio 2013 installed) you will also need to download the VC++ Redistributable for VS2013. The 64-bit version (which is a little faster) also requires the installation of Intel's MKL library. 

EDIT April 2020: After downloading and running this on my new Windows 10 laptop I saw that the console was not displaying the inputs as intended (it was empty). To get around this please right click on the top of the console window, then click on Properties and there check "Use legacy console". Then close the console and re-launch.
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I am also including in the download a sample dataset I found in [2] (DAX index IV surface from 2002), so that you can readily test the calibrator. I used it to calibrate both Heston (also calibrated in [2], together with many other affine models) and GARCH diffusion. In contrast to the two datasets we used in the paper, in this case GARCH diffusion (RMSE = 1.14%) "beats" Heston (RMSE = 1.32%). This calibration takes about 5 secs. This is faster than the times we report on the paper and the reason is that the data we considered there include some very far out-of-the-money options that slow things down as they require higher resolution. The Levenberg-Marquardt algo is also typically faster than Excel's solver for this problem. It is also "customizable", in the sense that one can adjust the grid resolution during the calibration based on the changing (converging) parameter vector. Still, this version is missing a further optimization that I haven't implemented yet, that I expect to reduce the time further by a factor of 2-3.
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​The fitted parameters are:
GARCH:  v0 = 0.1724, vBar = 0.0933, kappa = 7.644, xi = 7.096, rho = -0.5224.
Heston:  v0 = 0.1964, vBar = 0.0744, kappa = 15.78, xi = 3.354, rho = -0.5118.
Note that both models capture the short-term smile/skew pretty well (aided by the large fitted xi's, aka vol-of-vols), but then result in a skew that decays (flattens) too fast for the longer expirations.

References

[1] Y. Papadopoulos, A. Lewis, “A First Option Calibration of the GARCH Diffusion Model by a PDE Method.,” arXiv:1801.06141v1 [q-fin.CP],  2018.
[2] Kangro, R., Parna, K., and Sepp, A., (2004), “Pricing European Style Options under Jump Diffusion Processes with Stochastic Volatility: Applications of Fourier Transform,” Acta et Commentationes Universitatis Tartuensis de Mathematica 8, 123-133.
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The ROD stochastic volatility 'model'

12/11/2017

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​It well known that pure diffusion stochastic volatility (SV) models like Heston struggle to reproduce the steep smiles observed in the implied volatilities of short-term index options. Trying to remedy this deficiency, the usual approach is to introduce jumps. More recently and as an alternative to jumps, some researchers have been experimenting with the use of fractional Brownian motion as the driver for the volatility process. Volatility they say is rough. Such a model is apparently able to capture steep short-term smiles. Basically both these approaches assume that pure diffusion models are not up to the task so alternatives are needed.

However, other voices suggest that this isn't necessarily true and that models of the Heston type have simply not been used to their full potential. They say why use a deterministic starting point $v_0$ for the variance when the process is really hidden and stochastic? Instead, they propose to give such traditional SV models a "hot start", that is assume that the variance today is given by some distribution and not a fixed value. Mechkov [1] shows that when the Heston model is used like that it is indeed capable of "exploding" smiles as expiries tend to zero. Jacquier & Shi [2] present a study of the effect of the assumed initial distribution type. 

The idea seems elegant and it's the kind of "trick" I like, because it's simple to apply to an existing solver so it doesn't hurt trying it out. And it gets particularly straightforward when the option price is found through a PDE solution. Then the solution is automatically returned for the whole range of possible initial variance values (corresponding to the finite difference grid in the v-direction). So all one has to do in order to find the "hot-started" option price at some asset spot $ S_0 $ is average the solution across the $ S=S_0 $ grid line using the assumed distribution. Very simple. Of course we have to choose the initial distribution family-type and then we can find the specific parameters of that distribution that best fit our data. How? We can include them in the calibration.

So here I'm going to try this out on a calibration to a chain of SPX options to see what it does. But why limit ourselves to Heston? Because it has a fast semi-analytical solution for vanillas you say. I say I can use a fast and accurate PDE solver instead, like the one I briefly tested in my previous post. Furthermore, is there any reason to believe that a square root diffusion specification for the variance should fit the market, or describe its dynamics better? Maybe linear diffusion could work best, or something in between. The PDE solver allows us to use any variance power p for the diffusion coefficient between 0.5 and 1, so why not let the calibration decide the optimal p, together with the initial distribution parameters and the other model parameters. Let's call this the Randomized Optimal Diffusion (ROD) SV "model".
 
Sounds complicated? It actually worked on the first try. Here's what I got for the end of Q1 2017. Just using the PDE engine and Excel's solver for the optimization. The calibration involved 262 options of 9 different expiries ranging from 1W to 3Y and took a few minutes to complete. If one restricts the calibration to mainly short-term expiries then better results are obtained, but I wanted to see the overall fit when very short and long expiries are fitted simultaneously. I am also showing how the plain Heston model fares. Which on the face of it is not bad, apart for the very short (1W) smile. Visually what it does is try to "wiggle its way" into matching the short-term smiles. The wiggle seems perfectly set up for the 3W smile, but then it turns out excessive for the other expiries. The ROD model on the other hand avoids excessive "wiggling" and still manages to capture the steep smiles of the short expiries pretty well. The optimal model power p here was found to be 0.84. This is responsible for the less wiggly behavior compared to Heston's p = 0.5. The ability to capture the steep short-term smiles is solely due to the hot-start. And it's the hot-start that "allows" for that higher p. To put it another way, by making it easy to fit the short-term smiles it then allows for a better fit for all expiries. The overall RMSE for the Heston model is 1.56% while for the ROD model it's 0.86%. 

But the RMSE only tells half the story. The Feller ratio corresponding to Heston's fitted parameters is 0.09, which basically means that the by far most probable (risk-neutral) long-run volatility value is zero. In other words, the assumed volatility distribution is not plausible. The randomization idea is neither without any issues, despite the impressive improvement in fit. The optimizer calibrated to a correlation coefficient of -1 for this experiment, which seems extreme and not quite realistic.
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By the way, this experiment is part of some research I've been doing in collaboration with Alan Lewis, the results of which will be available/published soon.

References

​[1] Serguei Mechkov.  'Hot-Start' Initialization of the Heston Model.
[2] Antoine Jacquier, Fangwei Shi. The randomized Heston model.
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How efficient is your Heston (or similar) PDE solver?

12/4/2017

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Last year I wrote an overly long post comparing the performance of an old Heston PDE solver of mine with those available in QuantLib. I was surprised to see that despite not using ADI techniques, it still seemed to produce very accurate solutions in a few seconds, just like QuantLib's ADI solvers. Published papers from the last 10 years or so also indicate that the calculation time in order to get high-accuracy prices from this 2D PDE is a few seconds give or take (on 5-10 yrs old CPUs). I've even seen a paper from last year presenting a "very efficient", state-of-the-art finite element method that gets Heston vanilla prices in 30 (!) seconds.
This year though I've worked a lot more on such solvers and I now realise that those run times are clearly not what one should be expecting, nor aim for with (fine-tuned) implementations. So just how fast should your numerical solver of the Heston (or similar) PDE be? What kind of run time should be expected for high-accuracy solutions? The answer is: a few milliseconds.  Back in that Aug 2016 post I used some test cases from various papers and I'll use those again here, all puts:
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  κ η σ ρ rd rf T K νo
Case 0 5 0.16 0.9 0.1 0.1 0 0.25 10 0.0625
Case 1 1.5 0.04 0.3 -0.9 0.025 0 1 100 0.0625
Case 2 3 0.12 0.04 0.6 0.01 0.04 1 100 0.09
Case 3 0.6067 0.0707 0.2928 -0.7571 0.03 0 3 100 0.0625
Case 4 2.5 0.06 0.5 -0.1 0.0507 0.0469 0.25 100 0.0625
Case 5 3 0.04 0.01 -0.7 0.05 0 0.25 100 0.09
My current "state-of-the-art" solver uses second-order spatial discretization and the Hundsdorfer-Verwer ADI scheme. For the results below I used the solver "as is", so no fine-tuning for each case, everything (grid construction) decided automatically by the solver. In order to give an idea of the accuracy achieved overall for each case I plot the solution error in the asset direction (so across the moneyness spectrum). The plots are cut-off where the option value becomes too small, the actual grids used by the solver extend further to the right. I am showing results for two different grid resolutions  (NS x NV x NT), grid A (60 x 40 x 30) and grid B (100 x 60 x 50). The timings were taken on an i7-920 PC from 2009 in single-threaded mode. Obviously one can expect at least double single-thread speed from a modern high-spec machine. (ADI can be parallelized as well with almost no extra effort, with a parallel efficiency of about 80% achieved using basic OpenMP directives). The errors in each case are calculated by comparing with the exact (semi-analytic) values obtained using QuantLib at the highest precision. Note that I am using the relative errors which are harder to bring down as the option value tends to zero. But when one wants to use the PDE solver as the pricing engine for a calibration, then it is important to price far out-of-the-money options with low relative errors in order to get accurate implied volatilities and properly capture any smile behavior. The present solver can indeed be used to calibrate the Heston model (or any other model in this family) accurately in less than a minute and in many cases in just a few seconds.

So, if you have a Heston PDE solver then this is an efficiency reference you can use to benchmark against. Price the 6 options above and compare error plots and timings with those below. Let me know what you get. If you're getting larger errors than I do with the above resolutions, I'll tell you why that is!

There is of course another important quality for a PDE solver, robustness. The scheme I used here (H-V) is fairly robust, but can still produce some spurious oscillations when one uses too low NT/NS. I may expand this post testing other schemes in the near future.
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Smoothing discontinuities - Discrete barrier option pricing

1/8/2017

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As briefly discussed here, the presence of discontinuities negatively affects the accuracy and achieved order of convergence of finite difference (and other discretization) methods. In some cases the effect is so significant that one really needs to apply special treatment. One such case in finance is discretely monitored barrier option pricing. At each monitoring date the solution profile along the asset axis is flattened after the barrier (for knock-out type options), to zero or the rebate amount. Thankfully the treatment needed is very simple and consists in adjusting the value at the grid point that sits nearer to the barrier, to its average from half (grid) spacing to its left to half spacing to its right. We thus need to find the area under the solution using the known values at the nearest grid points. We can simply assume piecewise linear variation between adjacent grid values and so use the trapezoidal rule (I'll call that linear smoothing). Or if we want to be a little more sophisticated we can fit a 2nd order polynomial to the three nearest points and integrate using that (let's call that quadratic smoothing).  

As an example let's try to price a daily monitored up and out put option. I'll use simple Black Scholes to demonstrate, but the qualitative behaviour would be very similar under other models. In order to show the effect clearly I'll start with a uniform grid. The discetization uses central differences and is thus second order in space (asset S) and Crank-Nicolson is used in time. That will sound alarming if you're aware of C-N's inherent inability to damp spurious oscillations caused by discontinuities, but a bit of Rannacher treatment will take care of that (see here). In either case in order to take time discretization out of the picture here, I used 50000 time steps for the results below so there's no time-error (no oscillation issues either) and thus the plotted error is purely due to the S-dicretization. The placement of grid points relative to a discontinuity has a significant effect on the result. Having a grid point falling exactly on the barrier will produce different behaviour as opposed to having the barrier falling mid-way between two grid points. So Figure 1 has the story. The exact value (4.53888216 in case someone's interested) was calculated on a very fine grid. It can be seen that the worst we can do is place a grid point on the barrier and solve with no smoothing. The error using the coarsest grid (which still has 55 points up to the strike and it's close to what we would maybe use in practice) is clearly unacceptable (15.5%). The best we can do without smoothing (averaging), is to make sure the barrier falls in the middle between two grid points. This can be seen to significantly reduce the error, but only once we've sufficiently refined the grid (curve (b)). We then see what can be achieved by placing the barrier on a grid point and smooth by averaging as described above. Curve (c) shows linear smoothing already greatly improves things again compared to the previous effort in curve (b). Finally curve (d) shows that quadratic smoothing can add some extra accuracy yet.
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Figure 1. Solution grid convergence for a European, daily monitored up and out put, using uniform grid in S.
S = 98, K = 110, B = 100, T = 0.25, vol = 0.16, r = 0.03, 63 equi-spaced monitoring dates (last one at T)
This case is also one which greatly benefits from the use of a non-uniform grid which concentrates more points near the discontinuity. The slides below show exactly that. Quadratic smoothing with the barrier on a grid point is used. First is the solution error plot for a uniform grid with of dS = 2, which corresponds to the first point from the left of curve (d) in figure 1. The second slide shows the error we get when a non-uniform grid of the same size (and hence same execution cost) is used. The error curve has been pretty much flattened even on this coarsest grid. The error now has gone from 15.5% on a unifom grid with no smoothing, down to 0.01% on a graded grid with smoothing applied, for the same computational effort. Job done. Here's the function I used for it: SmoothOperator.cpp.
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Monte Carlo pricing of continuous barrier options with Heston

11/28/2016

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Pricing discretely monitored barrier options with Monte Carlo comes natural. One just mimics what would really happen, which is to check if the underlying asset crosses the barrier at specific times only. The "simulation" bias is thus zero. In this case pricing can be accurate if our discretization bias is low (preferably using something better than Euler). But things change when the contract specifies continuous monitoring. The simulation cannot mimic the reality of continuous monitoring since we can only use a finite number of time steps for which we can check if the barrier has been crossed. And one would be forgiven to think that using many time steps (such as corresponding to daily monitoring) would be almost equivalent to true continuous monitoring. But this isn't the case. The probability that the asset could have crossed the barrier in between the implemented time steps is still significant and increasing the number of time steps makes the solution converge only slowly towards the continuous limit. Such a naive simulation will therefore always overestimate the value of a continuous barrier option since it ignores the probability that the option knocks out when we are not looking (i.e. in between time steps).

Now there are generally two ways of reducing, or even getting rid of this simulation bias in special cases. The first is to shift the barrier closer to the asset spot in order to compensate for the times when we "blink". The question is by how much should the barrier be shifted? This was first treated by Broadie, Glasserman & Kou [1], for the Black-Scholes model, where they introduced a continuity correction based on the "magical" number 0.5826. Check it out if you haven't. This trick works pretty well when the spot is not very near the barrier and/or when we have many monitoring dates. But in the opposite case, it can be quite bad and produce errors of 5% or more (Gobet, [2]). This gets worse when there is a steep drop of the value near the barrier, as in a down and out put, or an up and out call with low volatility. 

The second way is to use an analytic expression for the probability of hitting the barrier between two realized points in a simulated asset path. This is usually referred to as the probabilistic method, or the Brownian bridge technique, since it uses the probability of Brownian motion hitting a point conditional on two fixed end points. As already implied this probability is known analytically (see [2]) for Brownian motion (and consequently for GBM as well). So for the usual GBM asset model (Black-Scholes), this technique can remove the simulation bias completely. One can just use the probability directly, multiplying each path's payoff with the total path survival probability (based on the survival probability of each path segment S[i], S[i+1]). This is preferable when applicable since it results in lower simulation variance. Alternatively one can sample this probability through a uniform variate draw and use it to decide whether the barrier has been crossed or not. This is the only option when we have to perform regression for American exercise. All this is implemented for the Black-Scholes model in the current version of the pricer which you can download here and check this technique in action (see also here). Below is just a simple example. 
As can be seen the probabilistic method (enabled by checking "continuous monitoring") enables exact Monte Carlo pricing of this continuously monitored up and out call (for which of course the exact analytic solution is available and is shown as well and marked by the blue line). By contrast, the barrier-shifting method misprices this option by quite some margin (3.4%), as can be seen in the second slide where the probabilistic correction is unchecked and instead the barrier has been shifted downwards according to BGK's (not so magic here) formula. ​
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Same trick but now with Heston
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Now the analytical (Brownian Bridge) hitting probability is only available for a BM/GMB process. But what if we have a not so simple process? Well, as long as the discretization scheme we use for the asset makes it locally BM/GBM (always the case when we use Euler to discretize S, or log(S)), then we can still use this trick. It won't remove the simulation bias completely, but it may do a good job nonetheless. So I thought I'd try it with Heston and see how it performs. I only have two discretization schemes set up, the Full Truncation Euler and the Quadratic Exponential (with Martingale correction). Both are considered short-stepping schemes, though QE-M can do pretty well with long steps as well, especially for vanillas, not so much for path-dependent options. FTE definitely needs short time steps to give acceptable accuracy. Both schemes though use normal increments to march log(S) in time, conditional on the variance process path realization which comes first. So we can still use our BB probability formulas like we did with the Black-Scholes model. The only catch here is that the BB formulas assume constant variance and we have stochastic variance instead (not to mention correlation between the variance and the asset processes). That's why it will only be an approximation. For each asset path segment S[i], S[i+1] we have the corresponding variances v[i] and v[i+1] which we can use in the BB probability formula. Now since we want to see to what extent the simulation (monitoring) bias can be removed, we'd like to get the discretization bias out of the way so that it doesn't cloud the results. For this reason I used the QE-M scheme with daily time steps. The test cases considered are in table 1, all Up and Out calls  for 5 different Heston parameter sets, chosen from the literature without too much thought, although I did try to set up case 4 to be a kind of torture test and the Feller condition is violated in case 7. Those two cases are the ones with the largest error as can be seen in table 2. The "exact" price for the continuously monitored options was calculated by the PDE/FDM solver presented in the previous post. The price when the monitoring is discrete (daily) is also shown for comparison. A large number of Sobol-driven paths were used so that the (Q)MC prices shown are converged to all digits shown (last digit may be off by one). As can be seen, it seems that the method yields accurate approximations of the correct continuous price indeed, the highest error being 0.35%. Note also that even with daily monitoring the discrete version prices (plain MC, no correction) are quite different from the continuous ones (up to 37%), showcasing the need for the probabilistic (BB) correction when it's a continuous barrier price we're after.
Table 1. Test cases parameter sets for Up and Out call options.
  κ η σ ρ rd rf T K U So vo
Case 1 5 0.16 0.9 0.1 0.1 0 0.25 100 120 100 0.0625
Case 2 5 0.16 0.9 0.1 0.1 0 0.25 100 135 130 0.0625
Case 3 1.5 0.04 0.3 -0.9 0.025 0 0.25 100 115 100 0.0625
Case 4 1.5 0.04 0.3 -0.9 0.025 0 0.25 100 135 130 0.0625
Case 5 3 0.12 0.04 0.6 0.01 0.04 0.25 100 120 100 0.09
Case 6 2.5 0.06 0.5 -0.1 0.0507 0.0469 0.5 100 120 100 0.0625
Case 7 6.21 0.019 0.61 -0.7 0.0319 0 0.5 100 110 100 0.010201
Table 2. Effectiveness of Monte Carlo with the Probabilistic Continuity Correction for the pricing of cont. monitored barrier options under the Heston model.  The MC prices are converged and the time-discretization error is negligible.
  Solver Price Difference
Case 1 PDE/FDM cont. monitoring (exact) 1.8651 -
MC with 63 timesteps & PCC 1.8652 0.01%
Plain MC with 63 timesteps  2.1670 16%
Case 2 PDE/FDM cont. monitoring (exact) 2.5021 -
MC with 63 timesteps & PCC 2.5032 0.04%
Plain MC with 63 timesteps  3.4159 37%
Case 3 PDE/FDM cont. monitoring (exact) 2.1312 -
MC with 63 timesteps & PCC 2.1277 -0.16%
Plain MC with 63 timesteps  2.3369 10%
Case 4 PDE/FDM cont. monitoring (exact) 3.6519 -
MC with 63 timesteps & PCC 3.6394 -0.34%
Plain MC with 63 timesteps  4.6731 28%
Case 5 PDE/FDM cont. monitoring (exact) 1.6247 -
MC with 63 timesteps & PCC 1.6249 0.01%
Plain MC with 63 timesteps  1.8890 16%
Case 6 PDE/FDM cont. monitoring (exact) 1.7444 -
MC with 125 timesteps & PCC 1.7438 -0.03%
Plain MC with 125 timesteps  1.9209 10.1%
Case 7 PDE/FDM cont. monitoring (exact) 1.9856 -
MC with 125 timesteps & PCC 1.9790 -0.33%
Plain MC with 125 timesteps  2.0839 4.95%
​Finally regarding the variance value used in the probability formulas, my brief testing showed that the best results were obtained when using the variance corresponding to the one of the two nodes S[i] and S[i+1] which is closer to the barrier. This was the choice for the results of Table 2.​
Once I set up a more accurate long stepping discretization scheme, I may test to see how well this approximation holds when one uses fewer/longer time steps.

References

[1] Broadie M, Glasserman P, & Kou S.  A continuity correction for discrete barrier options, Mathematical Finance, Vol. 7 (4) (1997), pp. 325-348.
[2] Emmanuel Gobet. Advanced Monte Carlo methods for barrier and related exotic options. Bensoussan A., Zhang Q. et Ciarlet P. Mathematical Modeling and Numerical Methods in Finance, Elsevier, pp.497-528, 2009, Handbook of Numerical Analysis
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Old-fashioned Heston pricer vs the state of the art

8/9/2016

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My old option pricer (which you can download "refurbished" here) had a basic stochastic volatility (Heston) solver which never really passed the testing phase, so I kept it hidden. Besides, it was using SOR to solve the full system at each time-step, so it can't compete with the modern "state of the art" ADI variants. Or can it?
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Well I decided to give it another try and see how it compares really after a few optimizing tweaks. 


The Heston Partial Differential Equation

We are trying to solve the following PDE by discretizing it with the finite difference method:

$$\frac{\partial V}{\partial t} = \frac{1}{2} S^2 \nu\frac{\partial^2 V}{\partial S^2}+\rho \sigma S \nu \frac{\partial^2 V}{\partial S \partial \nu} + \frac{1}{2}\sigma^2\nu\frac{\partial^2 V}{\partial \nu^2} + (r_d-r_f)S \frac{\partial V}{\partial S}+ \kappa (\eta-\nu) \frac{\partial V}{\partial \nu}-r_d V $$
where $\nu$ is the variance of the underlying asset $S$ returns, $\sigma$ is the volatility of the $\nu$ process, $\rho$ the correlation between the $S$ and $ \nu$ processes and $\eta$ is the long-term variance to which $\nu$ is mean-reverting with rate $\kappa$. Here $S$ follows geometrical Brownian motion and $\nu$ the CIR (Cox, Ingersoll and Ross) mean-reverting process.
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Time-discretization: Four-level fully implicit (4LFI, or FI-BDF3)

After we discretize the PDE we are left with an algebraic system of equations relating the values at each grid point (i,j) with those at its neighboring points. With the standard implicit scheme (Euler) the values at time ​n+1 are found as $ V_{i,j}^{(n+1)} = (B \cdot dt+V_{i,j}^{(n)})/(1-a_{i,j} \cdot dt) $ for each grid point (i,j). $B$ is a linear combination of $ V^{(n+1)} $ at (i,j)'s neighboring points and $a_{i,j}$ the coefficient of $ V_{i,j} $ arising from the spatial discretization. So we need to solve the system of unknowns $ V_{i,j}^{(n+1)} $.
The 3LFI (otherwise known as implicit BDF2) scheme just adds a little information from time point n-1 and can simply be described as: $ V_{i,j}^{(n+1)} = (B \cdot dt+2 \cdot V_{i,j}^{(n)}-0.5 \cdot V_{i,j}^{(n-1)})/(1.5-a_{i,j} \cdot dt) $, $a_{i,j}$ and $B$ being the same as before. This little addition makes the 3LFI/BDF2 scheme second order in time, whereas the standard implicit is only first order.

This scheme is strongly A-stable (?), so unlike something like Crank-Nicolson (CN) it has built-in oscillation-damping on top of being unconditionally stable. So I tested this first and while it worked pretty well, I found that it produced slightly larger errors than CN. That is while they're both second-order accurate, CN's error-constant was lower. Which is not surprising, central discretizations often produce higher accuracy than their one-sided counterparts of the same order. Moreover it was notably less time-converged compared to the ADI schemes using the same number of time-steps. 

So I decided to go for higher-spec. Especially since it comes really cheap in terms of implementation. Adding an extra time-point gives us the 4LFI or BDF3 scheme, which is third order:
​​$$ BDF3 : \quad V_{i,j}^{(n+1)} = \left (B \cdot dt+3 \cdot V_{i,j}^{(n)}-\frac 3 2 \cdot V_{i,j}^{(n-1)}+\frac 1 3 \cdot V_{i,j}^{(n-2)}\right)/\left(\frac {11} 6 - a_{i,j} \cdot dt\right)  \qquad  (1)$$
While such a scheme is no longer strictly unconditionally stable (it's almost A-stable), it should still be almost as good as and should preserve the damping qualities of 3LFI/BDF2. As it happens, the results it produces are significantly more accurate than both the 3LFI/BDF2 and the ADI schemes for any number of time-steps. Third order beats second order easily here, despite being a one-sided one. Finally as an added bonus, it adds a little to the diagonal dominance of the iteration matrix of the SOR solver so it helps convergence as well.

Now since this is a multi-step scheme (it needs the values not just from the previous time level but also from two levels before that), we need to use something different for the first couple of time steps, a starting procedure. For the very first step we need a two-level (single step) scheme. We cannot use CN because this will allow spurious oscillations to occur given the non-smooth initial conditions of option payoff functions. Instead one can use the standard Implicit Euler scheme plus local extrapolation: we first use the IE scheme for 4 sub-steps of size dt/4 to get the values $ V_{fine}^1$ at the end of the first time step. We then repeat, this time using 2 sub-steps of size dt/2 to obtain $ V_{coarse}^1$ and get the final composite values for the first time step as $(4V_{fine}^1-V_{coarse}^1)/3 $. For the second time step we just use the 3LFI/BDF2. 

Space-discretization and boundary conditions

Central finite differences are used for everything, except again for the v = 0 boundary, where we need to use a one-sided (three-point) upwind second-order discretization for the first v-derivative. Hout & Foulon [1] also use that upwind discretization in some cases where v > 1, but I stick to the central formula here. And of course I make sure that the strike falls in the middle between two grid points, which is something that occasionally people seem to neglect in a few publications I've seen. Suitable Neumann and/or Dirichlet boundary conditions are used everywhere except for the v = 0 variance boundary where we require that the PDE itself (with many terms being zero there) is satisfied, all as described in Hout & Foulon [1]. 

System solver

I used successive over-relaxation (SOR) to solve the resulting system because it's so easy to set up and accommodate early exercise features. On the other hand it is in general quite slow and moreover its speed may depend significantly on the chosen relaxation factor $\omega$. This is where the hand-made part comes in. I am using an SOR variant called TSOR together with a simple algorithm that adjusts $\omega$ as it goes, monitoring proceedings for signs of divergence as well (e.g. residual increasing instead of decreasing). I am not 100% sure my implementation is bug free, but it seems that the resulting SOR iteration matrix is not always such that it leads to convergence. There's a maximum $\omega$ which presumably makes the spectral radius of the iteration matrix less than one, but I've not pursued any further analysis on that, relying instead on the heuristic algorithm to keep it safe and close to optimal. All in all the modifications compared to the standard SOR amount to a few lines of code. I may write details of TSOR in another post but for the moment let's just say that it speeds things up about 3 times compared to standard SOR, plus it seems less dependent on $\omega$.  

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Higher-order accuracy: Richardson extrapolation vs native higher-order scheme in 2D

4/15/2016

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​The other day I noticed this interesting graph lying in a corner on my desktop and I thought I might as well post it here. It was part of the background tests I did while I was calculating the benchmark results for the driven cavity flow problem. In order to have first an idea of how well I could expect my 2D Richardson extrapolation (RE) set-up to work under "perfect" conditions, I thought I would apply it first on a simpler, more benign problem. To this end I solved the 2D Laplace equation for the steady state temperature distribution on a unit square plate, with the top side maintained at a constant unit temperature and the remaining three sides at zero (Dirichlet-type boundary conditions). This problem has an analytic solution in the form of an infinite (Fourier) series, which we can use to calculate the error of different numerical methods/schemes. So I was curious to see to what extent can RE improve on a second-order scheme's accuracy and especially how the results fare against a proper, natively fourth-order scheme. 
I remember reading long time ago that RE will indeed improve the accuracy of a second-order scheme, increase its convergence order to $O({h^4})$ if implemented properly, but will not produce as accurate results as a scheme that is fourth-order accurate ($O({h^4})$ truncation error) by design. I had seen examples of this in 1D, but I hadn't seen results for 2D so I thought I'd do this test. Let's imagine for now that grid points are uniformly spaced, as was indeed the case in this test. The second-order scheme used is the standard 5-point stencil and the fourth-order scheme is the fantastic 9-point compact stencil.
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$O({h^2})$ scheme, 5-point stencil
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$O({h^4})$ scheme, 9-point stencil

​RE implementation
The RE solution is a linear combination of two solutions calculated on two different grids (representing the solution on two different sets of discrete points, or nodes if you prefer). In order to combine the two solutions we need to have them at the same locations, so if there's no common set of points we then need to somehow bring/project one solution onto the grid of the other. So we need to interpolate. Usually people will perform RE by combining the solution on a grid with say N steps in each dimension (h=1/N), with that on a grid with half or double the spacing h. This way there's no need to use interpolation if we're projecting our final RE result on the coarser grid, because the finer grid already has the solution on all the coarser grid's points. If we want the RE results "printed" on the finer grid's resolution instead, then we need to interpolate in order to "guess" what the coarser grid's solution is at those extra points that the finer grid has. In the 2D case this means we would need to produce N$\times$N values based on information from only 25% as many (the 0.5$\times$0.5$\times$N$\times$N values of our coarse grid). 
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I prefer keeping the two grid resolutions closer to each other. Too close is not good either though because then the two solutions are not "distinct" enough and the extrapolation loses accuracy. My tests here showed that a spacing ratio of 0.85 is about right. In this case when we interpolate the results of the coarser (0.85$\times$0.85$\times$N$\times$N) grid "upwards", we generate our N$\times$N values now using 72% as many values, as opposed to 25% in the half spacing case. We now definitely need to interpolate of course because the two grids' sets of points are going to be distinct. Simple (2D) local polynomial interpolation was used here. The important detail is that the interpolating polynomial accuracy (degree) needs to be the same or higher than that which we expect to obtain from the extrapolation. I used sixth-degree polynomials for the results in the graph below. That worked fine because the combination of the smoothly-varying field and the high grid resolutions meant that any 7 contiguous points used to fit the polynomials were always pretty much on a straight line. When the function we are trying to find a solution for is less benign, using such high-order polynomials will in general make things worse due to Runge's phenomenon. We would then need to cramp many more grid points in order to avoid this problem. In practice, non-uniform grids are often used anyway in order to properly resolve areas of steep gradients by concentrating more points there, regardless of whether we plan to extrapolate or not.  
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Results
So here's the graph I was talking about. It shows how the average absolute error (across all solution grid points) falls as we make the grid spacing h smaller. Well not exactly all grid points. I've actually excluded the first 5% from the top side of the square domain downwards. The reason is that due to the singularities in the top two corners (the boundary conditions there change discontinuously from unit at the top to zero at the sides), the solution in their vicinity misbehaves. Here we don't care about that so in order to get a clean picture of the orders of convergence under "normal" circumstances, I left those points out of the average error calculation. So on to the results. Expectations were generally confirmed, or even exceeded in the case of the double RE. The latter basically combines two (fourth-order) RE results to extrapolate to a theoretically sixth-order accurate result. With double RE being an extrapolation based on other (single RE) extrapolations (all of which based on interpolations!), I was not sure at all I'd get anywhere near sixth-order. But sure enough, $O({h^{6+}})$ was obtained for this smooth field. As expected, even though the single RE actually achieved slightly better order of convergence than the native fourth-order 9-point scheme in this case, the actual error it produced was significantly higher, about 22 times higher to be exact for the range of h used. The double RE though managed to beat the fourth-order scheme for actual accuracy achieved, producing lower errors when the grid is reasonably fine (for h < 0.01 roughly).
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Monte Carlo wins: How can randomly placed points perform better than a regular grid for integral evaluation in higher dimensions?

10/8/2015

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​I decided to run a short numerical experiment the other day after reading, thinking about and trying to offer an intuitive answer to this question: Why does Monte Carlo integration work better than naive numerical integration in high dimensions? The first thing that comes to mind is the "curse of dimensionality": If we want to keep adding points uniformly to a regular grid, then the total number of points increases exponentially with the dimension d and a regular grid is just not a viable option. Say for example that we want to evaluate the integral of a function that depends on the value that some quantity takes on each month of the year. This is a problem of dimension 12. Why? Because each evaluation of the function requires a set of 12 different variables (one for each month). Now if we wanted the same accuracy that we would get in 2-D from say a 10$\times$10 (really coarse!) grid (total grid points $N=100$), we would need a total of $N=10^{12}$, i.e. a trillion points. That would be a lot of work to get a poor result. To get a noticeable increase in accuracy we could go up to 20 points per dimension (which would still be pretty coarse). But even that modest increase would mean that we would then need $N=20^{12}$ points, which is 4096 times more than before! What if our function depended on daily observations (d=365)? Let's not even go there.

The actual question though was not referring to that fundamental problem that regular grids face in high dimensions, but rather asked more specifically: "Why does Monte Carlo's random point selection lead to more accurate integral evaluations than a regular grid approach using the same total number of points N?". This may certainly seem counter-intuitive as one should probably be forgiven to assume that the regular grid point placement should represent the space better than a random one and thus lead to better integral estimation. I looked into this for a second (OK, maybe an hour) and as it happens, maybe surprisingly, the regular grid placement is just not optimal for integration. ​This was part of my answer:

"Placing points on a regular grid is not the best you can do integration-wise, as it leaves large holes that can be avoided by smarter placement. Think of a 3D regular grid. When you look at it from any side, i.e. when you look at a 2D projection of the points, all the points from the third dimension fall on the same place (they overlap) and thus leave large holes that don't aid the integration. The same happens in higher dimensions, so for better integral estimation any lower-dimensional face (projection) should be as homogeneously and uniformly filled with points as possible, without having points overlapping and creating holes. This is what Quasi-Monte Carlo (QMC) sequences try to do. They place points (deterministically) at locations that (should) avoid leaving them overlapping in lower dimensional projections and for this reason they can beat the regular grid even in 2D and 3D. Think then of Monte Carlo as having the same advantage as QMC (i.e. leaving less glaring holes in lower-dimensional faces, exactly because it lacks that regular structure that is responsible for the holes) but with the extra disadvantage of not placing those points very uniformly and homogeneously (like a regular grid and QMC do). At some point (at around d > 4) the advantage wins over the disadvantage and MC starts beating the regular grid."

So does a typical numerical experiment support the above claims?

Estimating Pi via Monte Carlo evaluation of the volume of an n-ball

Let's take a closer look at the introductory Monte Carlo experiment of trying to calculate the value of $\pi$ through a "dartboard" approach. This is usually done by estimating the ratio of the area of a circle to the area of the square that just superscribes it, by randomly "throwing darts" (simulated by generating random point coordinates (x,y)) inside the square and calculating the proportion of the total points that fall into the inscribed circle. This ratio can also be calculated through calculus in terms of $\pi$ as $\pi/4$. At this point the "unknown" $\pi$ is defined as the ratio of a circle's circumference to its diameter. 

Here we are going to do the same, but using a sphere and a 5-D ball instead. The purpose is not really to find $\pi$, but to contrast the efficiency of Monte Carlo integration against a regular Reimann sum and also Quasi Monte Carlo (QMC) as dimension goes up. In other words see which particular point placing strategy gives the better results, i.e. more accurate estimation of $\pi$ for a given number N of sampling points. Monte Carlo places the points in a way that intents to be random (but it's really deterministic since we use computer algorithms (pseudo-random number generators) to generate them. For a Reimann sum we use a regular grid of points that places $N^{1/d}$ points uniformly along each axis. Finally QMC places the points seemingly randomly but really deterministically, seeking some desirable space distribution properties.

Figures 1 and 2 show the results which seem to be confirming the theory. It can be seen that in 3-D MC (whose error should be of order $O(1/\sqrt{N})$) still loses to the mid-point regular grid ($O(1/{N^{2/3}})$), as expected, and beats the plain regular grid ($O(1/{N^{1/3}})$) again as expected. It can also be seen that QMC beats the mid-point regular grid even in 3-D, as was suggested in my answer above. Presumably because the combination of its uniformity and lower-dimension projection hole-filling properties beats the "perfect" regularity (and point "wasting") of the grid. In 5-D MC (still $O(1/\sqrt{N})$) starts overtaking the mid-point regular grid (now $O(1/{N^{2/5}})$) but still loses to QMC, again as expected.

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Figure 1. Pi estimation absolute error through calculation of a sphere volume with different sampling point placement strategies.
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Figure 2. Pi estimation absolute error through calculation of a 5-ball volume with different sampling point placement strategies.

​These graphs might look "wrong" at first sight, the MC error shown as a straight line and the mid-point regular grid a jagged one! That's because I have plotted the mean absolute error for each experiment size N for the MC simulation, instead of plotting just a single simulation's error progression with increasing N. This can be determined numerically for each experiment size, for example obtain 10000 estimations $\hat \pi$ from N=1024-point experiments and find the average of $|\hat \pi-\pi|$. Or we can use this as an opportunity to work a bit of statistics and calculate the expectation $\mathbb E$($|\hat \pi-\pi|$) analytically. Here's how: Calculus tells us that the ratio of the volume of the sphere to the volume of the cube supersribing it is $\pi/6$. So $\pi$ can be estimated as 6 times the proportion of the total N points that will fall into the sphere. One "dart throw" then corresponds to a binomial variate which takes a value of 6 if it (a point) falls into the sphere and zero otherwise. We also know the probability of these outcomes which are $\pi/6$ and $(1-\pi/6)$ respectively. Then the mean of our variate is of course $\pi$ and its variance $\sigma_b^2=$ $(6-\pi)^2(\pi/6)+(0-\pi)^2(1-\pi/6)=$ $2.996657^2$. Then we note that the estimator $\hat\pi$ is just the sum of N such variates divided by N. The Central Limit Theorem tells us that for large N $\hat\pi$ will follow a normal distribution like $\hat\pi\sim \mathcal{N}\left(\mu=\pi,\sigma_{\pi N}^2=\frac{\sigma_b^2}{N}\right)$. It follows that $\hat\pi-\pi\sim \mathcal{N}\left(\mu=0,\sigma_{\pi N}^2=\frac{\sigma_b^2}{N}\right)$. And finally the absolute value of this (i.e. the mean absolute error of our MC experiment using N points) follows a half-normal distribution (special case of the folded normal distribution) and as such will have a mean of $\sigma_{\pi N}\sqrt2/\sqrt\pi$ and variance of $\sigma_{\pi N}^2(1-2/\pi)$. These formulas were used for the MC mean and and indication of the max (3 standard deviations) error in the graph. The mid-point regular grid error on the other hand does show some fluctuation depending on the exact number of points used per dimension. One point more or less leads to a slightly different error magnitude line. The regular grid does not show this.  

For the 5-D experiment the equivalent calculus result relates the volume of the 5-ball inscribed in the unit 5-hypercube to $\pi^2$ instead of $\pi$, as $\pi^2/60$. So our dartboard experiment will actually give us an estimate of $\pi^2$. Then the estimate of $\pi$ would just be the square root of that, right? Well almost. Similarly to the sphere case we give a value of 60 if a point falls into the 5-ball and 0 if it doesn't. We also know (a posteriori!) the probability of these outcomes which are $\pi^2/60$ and $(1-\pi^2/60)$ respectively. The single "dart throw" is then a binomial variate with mean $\pi^2$ and variance $\sigma_b^2=(60-\pi^2)^2(\pi^2/60)+$ $(0-\pi^2)^2$ $(1-\pi^2/60)$ $=22.2433624^2$. And when we throw a large number of darts N, then the average of their outcomes follows a normal distribution like $\hat{\pi^2}\sim \mathcal{N}\left(\mu=\pi^2,\sigma_{\pi^2 N}^2=\frac{\sigma_b^2}{N}\right)$. But is $\mathbb E(\sqrt{\hat{\pi^2}})$ equal to $\pi$? Not really. The square root of our $\pi^2$ estimator follows a different distribution with expectation generally smaller than $\pi$, depending on N (Jensen's inequality ensures this is the case, combined with the fact that the square root is a concave function). For N=100, the expectation of our experiment would actually be 3.121. So even if we had say 1 billion estimations of $\pi$ from our 100-dart-throwing into the 5-hypercube experiment, the average of all those estimations would come out as 3.121, not 3.14... So in reality our 5-D experiment does not provide us with an unbiased way of estimating $\pi$, like the 2-D and 3-D experiments do. And assuming we really didn't know the value of $\pi$ then we wouldn't know how big the bias was either. This bias though is rapidly removed as N goes up, for N=1024 the expectation becomes 3.13964 and for N = 1048256 it is 3.141591 (see below how to actually calculate this when we know $\pi$ already). Moreover, this inherent bias in our estimator is always much smaller than the mean absolute error of the experiment (as shown in figures 1 and 2). And as all three methods of point-sampling integration are affected the same, the picture of their comparative performance is not affected.

Finally, out of curiosity, let's see how we can calculate the actual expectation of our 5-D experiment's $\pi$ estimator $\pi_{est}$, $\mathbb E(\pi_{est})$ = $\mathbb E(\sqrt{\hat{\pi^2}})$. Since $\hat{\pi^2}\sim \mathcal{N}\left(\mu=\pi^2,\sigma_{\pi^2 N}^2=\frac{\sigma_b^2}{N}\right)$, the cumulative distribution function (CFD) of $\pi_{est}$ can be seen to be: $F_{\pi_{est}}(x) = $ $\Pr\left(\pi_{est}\leqslant x\right) = \Pr\left(\hat{\pi_2} \leqslant x^2\right) = $ $\Phi\left(\frac{x^2-\pi^2}{\sigma_b/{\sqrt N}}\right) $ where $\Phi$ is the standard normal CDF. The probability density function (PDF) of $\pi_{est}$ is then $ f_{\pi_{est}}(x) = F_{\pi_{est}}^\prime(x)$ $=\frac{2x}{\sigma_b/{\sqrt N}}\phi\left(\frac{x^2-\pi^2}{\sigma_b/{\sqrt N}}\right) $ where $\phi$ is the standard normal PDF. Substituting for $\phi$ we get $ f_{\pi_{est}}(x) = \sqrt {2N/{\pi\sigma_b^2}} \cdot x \cdot exp\left(-N(x^2-\pi^2)^2 / {2\sigma_b^2}\right)$. Then: $$\mathbb E(\pi_{est}) = \int_0^\infty{x \cdot f_{\pi_{est}}(x) dx} = \int_0^\infty{\sqrt {\frac{2N}{\pi\sigma_b^2}} \cdot x^2 \cdot exp\left(\frac{-N(x^2-\pi^2)^2} {2\sigma_b^2}\right)dx}$$ I could not find an analytical solution to this integral, but one can always calculate it numerically with something like Simpson's rule, which is what I did for the figures I quoted above.
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    Yiannis Papadopoulos

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