Professional Documents
Culture Documents
Foreword
This book is an outgrowth of a number of activities of the author in the elds
of Derivatives Analytics and Python Programming at Visixion GmbH on the
one hand and of teaching Mathematical Finance at Saarland University on
the other hand.
It is the second preliminary edition of the book, nished in March 2013
(the rst was nished in January 2012), and it will most probably be corrected, revised and amended in a number of minor and even major ways.
The author is thankful for any hint with regard to errors, inconsistencies,
potential clarications and improvements in general.
The book is targeted at practitioners, researchers and students interested
in the market-based valuation of options from a practical perspective, i.e. the
single implementation steps that make up such an eort. It is also for those
who want to learn how Python can be used for Derivatives Analytics and
Financial Engineering. However, apart from being primarily practical and
implementation-oriented, the book also provides the necessary theoretical
foundations and numerical tools.
My hope is that the book will contribute to the increasing acceptance of
Python in the nancial community. If you are interested in getting the Python
scripts accompanying the book, send an email to contact@visixion.com.
I thank my familyand in particular my wife Sandrafor their support
and understanding that such a project requires many hours of solitude. I
also want to thank my colleague Michael Schwed for his continuous help and
support. Discussions with participants of seminars and of my lectures at
Saarland University also helped the project signicantly. Parts of this book
have beneted from talks I have given at Python conferences in Florence,
Paris and Leipzig during 2011 and 2012.
4
I dedicate this book to my lovely son Henry Nikolaus whose direct approach to living and clear view of the world I admire.
Vlklingen, Saarland, Germany
o
27. March 2013
Yves Hilpisch
Contents
1 A Quick Tour
1.1 Market-Based Valuation
1.2 Structure of the Book . .
1.3 Why Python? . . . . . .
1.4 Further Reading . . . . .
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
The Market
17
17
18
20
21
23
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
25
25
29
31
31
33
33
34
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
37
37
38
40
44
44
45
50
50
52
54
57
58
.
.
.
.
.
.
.
CONTENTS
3.8.1
3.8.2
3.8.3
3.8.4
3.8.5
II
GBM Analysis . . . . . . . . . .
DAX Analysis . . . . . . . . . .
BSM Implied Volatilities . . . .
DAX Implied Volatilities . . . .
EURIBOR Analysis . . . . . . .
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
Theoretical Valuation
69
4 Risk-Neutral Valuation
4.1 Introduction . . . . . . . . . . . .
4.2 Discrete-Time Uncertainty . . . .
4.3 Discrete Market Model . . . . . .
4.3.1 Primitives . . . . . . . . .
4.3.2 Basic Denitions . . . . .
4.4 Central Results in Discrete Time
4.5 Continuous-Time Case . . . . . .
4.6 Proofs . . . . . . . . . . . . . . .
4.6.1 Proof of Lemma 1 . . . . .
4.6.2 Proof of Proposition 1 . .
4.6.3 Proof of Theorem 1 . . . .
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
58
61
63
64
65
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
71
71
72
77
77
78
80
85
91
91
92
93
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
95
95
96
96
97
98
102
106
109
109
110
112
113
.
.
.
.
115
. 115
. 116
. 117
. 119
.
.
.
.
.
.
.
.
.
.
.
CONTENTS
6.5
6.6
6.7
6.8
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
III
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
139
. 139
. 140
. 141
. 141
. 143
. 146
. 146
. 147
. 149
. 150
. 150
. 151
Market-Based Valuation
8 A First Example
8.1 Introduction .
8.2 Market Model
8.3 Valuation . .
8.4 Calibration .
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
119
122
124
124
126
127
127
128
132
133
133
133
134
135
135
136
136
137
157
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
159
. 159
. 159
. 160
. 161
CONTENTS
8.5
8.6
8.7
Simulation . . . . . . . . . . . . . . . . . .
Conclusions . . . . . . . . . . . . . . . . .
Python Scripts . . . . . . . . . . . . . . .
8.7.1 Valuation by Numerical Integration
8.7.2 Valuation by FFT . . . . . . . . . .
8.7.3 Calibration to Three Maturities . .
8.7.4 Calibration to Short Maturity . . .
8.7.5 Valuation by MCS . . . . . . . . .
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
162
166
167
167
168
170
171
173
.
.
.
.
.
.
.
.
.
.
.
.
.
175
. 175
. 175
. 177
. 180
. 180
. 181
. 183
. 184
. 185
. 185
. 185
. 186
. 187
CONTENTS
11 Model Calibration
11.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . .
11.2 General Considerations . . . . . . . . . . . . . . . . . . .
11.2.1 Why Calibration At All? . . . . . . . . . . . . . .
11.2.2 Which Role Play Dierent Model Components? .
11.2.3 What Objective Function? . . . . . . . . . . . . .
11.2.4 What Market Data? . . . . . . . . . . . . . . . .
11.2.5 What Optimization Algorithm? . . . . . . . . . .
11.3 Calibration of Short Rate Component . . . . . . . . . . .
11.3.1 Theoretical Foundations . . . . . . . . . . . . . .
11.3.2 Calibration to German Bund Yield Curve . . . .
11.4 Calibration of Equity Component . . . . . . . . . . . . .
11.4.1 Valuation via Fourier Transform Method . . . . .
11.4.2 Calibration to DAX Call Option Quotes . . . . .
11.5 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . .
11.6 Python Scripts for Cox-Ingersoll-Ross Model . . . . . . .
11.6.1 Calibration of CIR85 . . . . . . . . . . . . . . . .
11.6.2 Calibration Results for CIR85 Model . . . . . . .
11.6.3 Bond Valuation in CIR85 Model . . . . . . . . . .
11.7 Python Scripts for Bakshi-Cao-Chen Model . . . . . . . .
11.7.1 Call Option Valuation in BCC97 Model . . . . . .
11.7.2 BSM Valuation Algorithms and Implied Volatility
11.7.3 Option Data and Calibration Results . . . . . . .
11.7.4 Calibration of Jump-Diusion Part of BCC97 . .
11.7.5 Calibration of Complete Model of BCC97 . . . .
11.7.6 Short Rate Calculation . . . . . . . . . . . . . . .
11.7.7 Comparison of Implied Volatilities . . . . . . . . .
12 Simulation and Valuation
12.1 Introduction . . . . . . . . . . . . . . . . .
12.2 Simulation of BCC97 Model . . . . . . . .
12.3 Valuation of Equity Options . . . . . . . .
12.3.1 European Options . . . . . . . . .
12.3.2 American Options . . . . . . . . . .
12.4 Conclusions . . . . . . . . . . . . . . . . .
12.5 Python Scripts . . . . . . . . . . . . . . .
12.5.1 Simulating the BCC97 Model . . .
12.5.2 Valuation of European Call Options
12.5.3 Valuation of American Call Options
. .
. .
. .
. .
. .
. .
. .
. .
by
by
. . .
. . .
. . .
. . .
. . .
. . .
. . .
. . .
MCS
MCS
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
237
. 237
. 238
. 238
. 240
. 241
. 243
. 244
. 244
. 244
. 246
. 249
. 249
. 253
. 256
. 258
. 258
. 260
. 261
. 262
. 262
. 265
. 269
. 270
. 272
. 274
. 274
.
.
.
.
.
.
.
.
.
.
277
. 277
. 277
. 281
. 281
. 282
. 282
. 283
. 283
. 285
. 286
10
CONTENTS
13 Dynamic Hedging
13.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . .
13.2 Hedging Study for BSM Model . . . . . . . . . . . . .
13.3 Hedging Study for BCC97 Model . . . . . . . . . . . .
13.4 Conclusions . . . . . . . . . . . . . . . . . . . . . . . .
13.5 Python Scripts . . . . . . . . . . . . . . . . . . . . . .
13.5.1 LSM Delta Hedging in BSM (Single Path) . . .
13.5.2 LSM Delta Hedging in BSM (Multiple Paths) .
13.5.3 LSM Algorithm for American Put in BCC97 . .
13.5.4 LSM Delta Hedging in BCC97 (Single Path) . .
13.5.5 LSM Delta Hedging in BCC97 (Multiple Paths)
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
14 Executive Summary
A Python in a Nutshell
A.1 Python Fundamentals . . . . . . . . . .
A.1.1 Installing Python Packages . . .
A.1.2 First Steps with Python . . . .
A.1.3 Array Operations . . . . . . . .
A.1.4 Random Numbers . . . . . . . .
A.1.5 Plotting . . . . . . . . . . . . .
A.2 European Option Pricing . . . . . . . .
A.2.1 Black-Scholes-Merton Approach
A.2.2 Cox-Ross-Rubinstein Approach
A.2.3 Monte Carlo Approach . . . . .
A.3 Selected Financial Topics . . . . . . . .
A.3.1 Approximation . . . . . . . . .
A.3.2 Optimization . . . . . . . . . .
A.3.3 Numerical Integration . . . . .
A.4 Advanced Python Topics . . . . . . . .
A.4.1 Classes and Objects . . . . . .
A.4.2 Data Import and Export . . . .
A.5 Rapid Financial Engineering . . . . . .
289
. 289
. 290
. 295
. 299
. 300
. 300
. 302
. 304
. 305
. 308
311
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
313
. 313
. 313
. 314
. 317
. 320
. 320
. 323
. 323
. 324
. 329
. 331
. 331
. 334
. 335
. 336
. 336
. 337
. 341
Bibliography
345
Index
354
List of Tables
3.1
3.2
5.1
7.1
Valuation results from the LSM and DUAL Monte Carlo algorithms for the American put option . . . . . . . . . . . . . . 149
Valuation results from the LSM and DUAL Monte Carlo algorithms for the Short Condor Spread . . . . . . . . . . . . . 150
7.2
10.1 Monte Carlo valuation results for European call and put options in Hestons stochastic volatility model (I) . . . . . . . .
10.2 Monte Carlo valuation results for European call and put options in Hestons stochastic volatility model (II) . . . . . . .
10.3 Monte Carlo valuation results for American put options in
Heston-Cox-Ingersoll-Ross stochastic volatility and short rate
model (I) . . . . . . . . . . . . . . . . . . . . . . . . . . . .
10.4 Monte Carlo valuation results for American put options in
Heston-Cox-Ingersoll-Ross stochastic volatility and short rate
model (II) . . . . . . . . . . . . . . . . . . . . . . . . . . . .
10.5 Monte Carlo valuation results for American put options in
Heston-Cox-Ingersoll-Ross stochastic volatility and short rate
model (III) . . . . . . . . . . . . . . . . . . . . . . . . . . .
11
. 200
. 202
. 206
. 208
. 209
12
LIST OF TABLES
List of Figures
2.1
2.2
3.1
3.2
3.3
3.4
3.5
3.6
3.7
3.8
3.9
3.10
3.11
3.12
3.13
3.14
3.15
13
41
41
43
43
46
46
47
47
49
49
53
53
55
56
56
14
LIST OF FIGURES
3.16 Daily quotes of 1 week, 1 month, 6 months and 1 year EURIBOR over the period from 01. Jan 1999 to 01. Feb 2013 . . . 57
5.1
5.2
5.3
5.4
5.5
5.6
5.7
6.1
6.2
7.1
7.2
8.1
8.2
8.3
. 100
. 101
. 103
. 104
. 104
. 105
. 105
LIST OF FIGURES
15
248
251
251
255
256
257
257
258
. 279
. 279
. 280
. 280
. 291
. 294
. 295
. 297
. 297
16
LIST OF FIGURES
13.6 Frequency distribution of (discounted) P&L at exercise date of
10,000 dynamic replications of American put option in general
market model . . . . . . . . . . . . . . . . . . . . . . . . . . . 298
13.7 Dynamic replication of American put option in general market
model with huge loss at exercise due to an index jump . . . . 299
A.1
A.2
A.3
A.4
A.5
A.6
A.7
A.8
.
.
.
.
.
.
.
321
322
331
333
333
339
341
. 344
Chapter 1
A Quick Tour
1.1 Market-Based Valuation
This book is about the market-based valuation of (stock) index options. In
the domain of Derivatives Analytics this is an important task which every
major investment bank and buy-side decision maker in this market is concerned with on a daily basis. While theoretical valuation approaches develop
a model, parametrize it and then derive values for options, the market-based
approach works the other way round. Prices from liquidly traded options
are taken as given (i.e. they are input instead of output) and one tries to
parametrize a market model in a way that replicates the observed option
prices as good as possible. This activity is generally referred to as model
calibration. Being equipped with a calibrated model, one then proceeds with
the task at hand, be it valuation, trading, investing, hedging or risk management. A bit more specic, one might be interested in pricing and hedging
an exotic derivative instrument with such a modelhoping that the results
are in line with the overall market due to the previous calibration to more
simple, vanilla instruments.
To accomplish a market-based valuation, four areas have to be covered:
1. market: knowledge about market realities is a conditio sine qua non
for any sincere attempt to develop market-consistent models and to
accomplish market-based valuation
2. theory: every valuation must be grounded on a sound market model,
ensuring, for example, the absence of arbitrage opportunities and providing means to derive option values from observed quantities
3. numerics: one can not hope to work with analytical results only; numerical techniques, like Monte Carlo simulation, are generally required
17
18
This book covers all of these areas in an integrated manner. It uses equity
index options as the prime example for derivative instruments throughout.
19
20
21
Python skill in 2011 as compared to 2009; over the same period the
average daily rate increased from 400 GBP to 475 GBP1
All in all, Python seems to be a good choice for our purposes. And that it
is possible to develop a commercial, full-edged Derivatives Analytics suite
with Python is illustrated by the solution DEXISION of Visixion GmbH. It
is the rst derivatives analytics suite whose core is completely built in this
language.2 The cover story Python Takes a Bite of the March 2010 issue
of Wilmott Magazine (cf. [72]) also illustrates that Python is gaining ground
in the nancial world.
22
Bibliography
[1] Andersen, Torben and Luca Benzoni (2009): Realized Volatility.
in Handbook of Financial Time Series, T. Andersen et al. (ed.), Springer
Verlag, Berlin et al., 555575.
[2] Andersen, Leif, Peter Jackel and Christian Kahl (2010): Simulation of Square-Root Processes. in Encyclopedia of Quantitative Finance, Rama Cont et al. (ed.), John Wiley & Sons, Hoboken, New Jersey.
[3] Andersen, Leif (2008): Simple and Ecient Simulation of the Heston
Stochastic Volatility Model. Journal of Computational Finance, Vol. 11,
No. 3, 142.
[4] Bakshi, Gurdip, Charles Cao and Zhiwu Chen (1997): Empirical Performance of Alternative Option Pricing Models. Journal of
Finance, Vol. 52, No. 5, 20032049.
[5] Bali, Turan and Liuren Wu (2006): A Comprehensive Analysis of
the Short-Term Interest-Rate Dynamics. Journal of Banking & Finance,
Vol. 30, 12691290.
[6] Bates, David (1996): Jumps and Stochastic Volatility: Exchange
Rates Processes Implicit in Deutsche Mark Options. Review of Financial
Studies, Vol. 9, No. 1, 69107.
[7] Baxter, Martin and Andrew Rennie (1996): Financial Calculus
An Introduction to Derivative Pricing. Cambridge University Press, Cambridge.
[8] Black, Fischer and Myron Scholes (1973): The Pricing of Options
and Corporate Liabilities. Journal of Political Economy, Vol. 81, No. 3,
638659.
[9] Bhattacharya, Rabi and Edward Waymire (2007): A Basic Course
in Probability Theory. Springer Verlag, New York.
345
346
BIBLIOGRAPHY
[10] Bittman, James (2009): Trading Options as a Professional. McGrawHill, New York et al.
[12] Bjork, Tomas (2004): Arbitrage Theory in Continuous Time. 2nd ed.,
Oxford University Press, Oxford.
[13] Boyle, Phelim (1977): Options: A Monte Carlo approach. Journal
of Financial Economics, Vol. 4, No. 4, 322338.
[14] Brandimarte, Paolo (2006): Numerical Methods in Finance and Economics. 2nd ed., John Wiley & Sons, Hoboken, New Jersey.
[15] Brigo, Damiano and Fabio Mercurio (2006): Interest Rate
ModelsTheory and Practice. 2nd ed., Springer Verlag, Berlin et al.
[16] Brigo, Damiano and Fabio Mercurio (2001): On DeterministicShift Extensions of Short-Rate Models. Working Paper, Banca IMI, Milano, www.damianobrigo.it.
[17] Broadie, Mark and Ozgur Kaya (2006): Exact Simulation of
Stochastic Volatility and other Ane Jump Diusion Processes. Operations Research, Vol. 54, No. 2, 217231.
[18] Carr, Peter and Dilip Madan (1999): Option Valuation using
the Fast Fourier Transform. Journal of Computational Finance, Vol. 2,
No. 4, 6173.
[19] Cerny, Ale (2004): Introduction to Fast Fourier Transform in Fis
nance. Journal of Derivatives, Vol. 12, No. 1, 73-88.
[20] Cetin, Umut, Robert Jarrow and Philip Protter (2004): Liquidity Risk and Arbitrage Pricing Theory. Finance and Stochastics, Vol.
8, No. 3, 131.
[21] Chaudhury, Mo (2011): Option Bid-Ask Spread and Liquidity.
Working Paper, McGill University, Desautels Faculty of Management,
www.ssrn.com.
[22] Cheng, Peng and Olivier Scaillet (2006): Linear-Quadratic
Jump-Diusion Modeling. Working Paper, Swiss Finance Institute, University of Geneva, Geneva, www.hec.unige.ch.
BIBLIOGRAPHY
347
[23] Cherubini, Umberto, Giovanni Della Lunga, Sabrina Mulinacci and Pietro Rossi (2009): Fourier Transform Methods in Finance. John Wiley & Sons, West Sussex.
[24] Christoffersen, Peter and Kris Jacobs (2004): The Importance of the Loss Function in Option Valuation. Journal of Financial
Economics, Vol. 72, 291318.
[25] Cipra, Barry (2000): The Best of the 20th Century: Editors Name
Top 10 Algorithms. SIAM News, Vol. 33, No. 4, 12.
[26] Clement, Emmanuelle, Damien Lamberton and Philip Protter (2002): An Analysis of a Least Squares Regression Algorithm for
American Option Pricing. Finance and Stochastics , Vol. 17, 448471.
[27] Cont, Rama (2001): Empirical Properties of Asset Returns: Stylized
Facts and Statistical Issues. Quantitative Finance, Vol. 1, 223236.
[28] Cont, Rama and Peter Tankov (2004a): Financial Modelling With
Jump Processes. 2nd ed., CRC Press UK, London.
[29] Cont, Rama and Peter Tankov (2004b): Non-Parametric Calibration of Jump-Diusion Option Pricing Models. Journal of Computational Finance, Vol. 7, No. 3, 149.
[30] Cont, Rama, Peter Tankov and Ekaterina Voltchkova (2007):
Hedging with Options in Models with Jumps. in: Stochastic Analysis
and Applicationsthe Abel Symposium 2005, Springer Verlag, Berlin et
al.
348
BIBLIOGRAPHY
The
[37] Delbaen, Freddy and Walter Schachermayer (1998): The Fundamental Theorem of Asset Pricing for Unbounded Stochastic Processes.
Mathematische Annalen, Vol. 312, 215250.
[38] Delbaen, Freddy and Walter Schachermayer (1994): A General Version of the Fundamental Theorem of Asset Pricing. Mathematische Annalen, Vol. 300, 463520.
[39] Detlefsen, Kai (2005): Hedging Exotic Options in Stochastic
Volatility and Jump Diusion Models. Master Thesis, HumboldtUniversity Berlin, Berlin.
[40] de Weert, Frans (2008): Exotic Options Trading. John Wiley &
Sons, Chichester, West Sussex.
[41] Duffie, Darrell, Jun Pan and Kenneth Singleton (2000):
Transform Analysis and Asset Pricing for Ane Jump-Diusions.
Econometrica, Vol. 68, No. 6, 13431376.
[42] Duffie, Darrell and Kenneth Singleton (2003): Credit Risk
Pricing, Measurement and Management. Princeton University Press,
Princeton, New Jersey.
[43] Elliot, Robert and Ekkehard Kopp (2005): Mathematics of Financial Markets. 2nd ed., Springer Verlag, New York.
[44] Fengler, Matthias (2005): Semi-Parametric Modeling of Implied
Volatility. Springer Verlag, Berlin et al.
BIBLIOGRAPHY
349
[48] Fries, Christian (2005): Foresight Bias and Suboptimality Correction in Monte Carlo Pricing of Options with Early Exercise: Classication, Calculation & Removal. Working Paper, www.christian-fries.
de.
[49] Galluccio, Stefano and Yann Le Cam (2008): Implied Calibration and Moments Asymptotics in Stochastic Volatility Jump Diusion
Models. Working Paper, BNPParibas, London, www.ssrn.com.
[50] Gatheral, Jim (2006): The Volatility SurfaceA Practitioners
Guide. John Wiley & Sons, Hoboken, New Jersey.
[51] Gilbert, Charles, K. Ravindran and Robert Reitano (2007):
Results of the Survey on Variable Annuity Hedging Programs for Life
Insurance Companies. Report, Society of Actuaries, www.soa.org.
[52] Glasserman, Paul (2004): Monte Carlo Methods in Financial Engineering. Springer Verlag, New York et al.
[53] Grzelak, Lech, Cornelis Oosterlee and Sacha van Weeren
(2009): Extension of Stochastic Volatility Equity Models with HullWhite Interest Rate Process. Working Paper, Delft University of Technology, Delft, www.ssrn.com.
[54] Haastrecht, Alexander and Antoon Pelsser (2008): Ecient,
Almost Exact Simulation of the Heston Stochastic Volatility Model.
Working Paper, University of Amsterdam, Amsterdam, www.ssrn.com.
350
BIBLIOGRAPHY
[59] Haugh, Martin and Leonid Kogan (2004): Pricing American Options: A Duality Approach. Operations Research, Vol. 52, No. 2, 258
270.
[60] Heath, David, Robert Jarrow and Andrew Morton (1992):
Bond Pricing and the Term Structure of Interest Rates: A New Methodology for Contingent Claims Valuation. Econometrica, Vol. 60, No. 1,
77105.
[61] Heston, Steven (1993): A Closed-From Solution for Options with
Stochastic Volatility with Applications to Bond and Currency Options.
The Review of Financial Studies, Vol. 6, No. 2, 327343.
[62] Hilpisch, Yves (2001): Dynamic Hedging, Positive Feedback, and
General Equilibrium. Dissertation Thesis, Saarland University, Saarbruecken, www.hilpisch.com.
[63] Hilpisch, Yves (2009): Calibrating Hestons Stochastic Volatility
ModelWith Complete Set of Python Scripts. Working Paper, Visixion
GmbH, Voelklingen, www.visixion.com.
[64] Jarrow, Robert (1999): In Honor of the Nobel Laureates Robert
C. Merton and Myron S. Scholes: A Partial Dierential Equation That
Changed the World. Journal of Economic Perspectives, Vol. 13, No. 4,
229248.
[65] Jarrow, Robert (2005): Liquidity Risk and Classical Option Pricing
Theory. in Mathematical Modeling of Market Liquidity Risk, ed. by P.
Neu and L. Matz, John Wiley & Sons, Singapore.
[66] Kahale, Nabil (2004): An Arbitrage-Free Interpolation of Volatilities. Risk Magazine, Vol. 17, May, 102106.
[67] Kahl, Christian (2007): Modelling and Simulation of Stochastic
Volatility in Finance. Dissertation.com, Boca Raton.
BIBLIOGRAPHY
351
352
BIBLIOGRAPHY
BIBLIOGRAPHY
353
Index
algebra, 72
algebra generation, 75
American options, 139, 201
Bakshi-Cao-Chen (1997), 282
Black-Scholes-Merton (1973), 146,
290
Cox-Ross-Rubinstein (1979), 142
dual problem, 142
early exercise premium, 282
least-squares algorithm, 203
primal problem, 141
American put option, 146
American short condor spread, 147
approximation, 331
cubic splines, 332
rst order, 290
ordinary least-squares regression
(OLS), 331
regression, 331
second order, 295
arbitrage opportunity
continuous time, 88
discrete time, 81
weak, 81
Arrow-Debreu security, 84
ask quote, 50
at-the-money, 26
Brownian motion, 87
call option, 25
call option transform, 119
characteristic function, 118
Bakshi-Cao-Chen (1997), 184, 252
Black-Scholes-Merton (1973), 249
Heston (1993), 183, 252
Merton (1976), 128, 160
Merton (1976) jump part, 184, 252
contingent claim, 80
attainable, 80
convergence
binomial model, 109
convolution, 130
correlation
historical, 39
instantaneous, 40
correlation risk, 31
INDEX
Higham-Mao, 198
partial truncation, 197
reection, 197
simple Euler scheme, 197
simple reection, 198
truncation, 197
dynamic hedging, 289, 312
Bakshi-Cao-Chen (1997), 295
Black-Scholes-Merton (1973), 290
355
valuation accuracy, 250
Fourier inversion, 117
Fourier series, 124
Fourier transform, 117
discrete, 129
fundamental theorem of asset pricing
continuous time, 89
discrete time, 82
gains process
continuous time, 86
Euler formulas, 124
discrete time, 79
EURIBOR, 55
gamma, 103
stochasticity, 55
Greeks, 102
term structure, 57
delta, 102
EURO STOXX 50, 161, 243
gamma, 102
European options, 25, 196
rho, 102
Bakshi-Cao-Chen (1997), 253, 281
theta, 102
Black-Scholes-Merton (1973), 98,
vega, 102
99, 249, 323, 336
Cox-Ross-Rubinstein (1979), 324
hedging, 33, 289
Monte Carlo simulation, 184, 329
PDE approach, 181
in-the-money, 26
Python classes, 336
inner value, 25
transform methods, 183
interest rate
exotic instruments, 29
mean reversion, 54
expectation, 74
positivity, 54
conditional, 76
stochasticity, 54
term structure, 55
fat tails, 45
interest rate market, 54
ltration, 74
interest rate risk, 31
forward rates, 245
interpolation, 331
Cox-Ingersoll-Ross (1985), 245
IPython, 22, 313
Fourier approach, 311
Its lemma
o
advantages, 115
Bakshi-Cao-Chen (1997), 185
Bakshi-Cao-Chen (1997), 183, 249
Black-Scholes-Merton, 109
Black-Scholes-Merton (1973), 249
Carr-Madan (1999), 122, 161, 183 jump risk, 31
fast Fourier transform (FFT), 126, jump-diusion model
250, 328
Bates (1996), 176
Merton (1976), 127, 178
Lewis (2001), 119, 120, 161, 183,
249
jumps, 45
356
kurtosis, 39
INDEX
non-uniqueness, 240
uniqueness, 84
Lvy process, 87
e
matplotlib, 313, 320
leverage eect, 45
bars, 322
liquidity risk, 31
dots, 322
lines, 321
market completeness
model calibration, 161, 237, 311
continuous time, 91
DAX call option quotes, 253
discrete time, 84
degeneracy, 253
market incompleteness
equity index component, 249
narrow sense, 238
German Bund yield curve, 246
numerical example, 239
implied volatilities, 256
wider sense, 238
indeterminacy, 253
market microstructure, 50
market data, 243
market model
market incompleteness, 238
Bakshi-Cao-Chen (1997), 176, 249,
mean squared error (MSE), 242
252, 277
numerical results, 254
Bates (1996), 176, 178
objective function, 241
binomial model, 106, 324
optimization algorithm, 244
Black-Scholes-Merton (1973), 96,
role of model components, 240
140, 178, 323
short rate component, 244
complete, 95
Tikhonov regularization, 254
continuous time, 85, 89, 140, 159, model risk, 33
176
Monte Carlo simulation, 277, 311, 341
Cox-Ingersoll-Ross (1985), 176, 192,
accuracy vs. speed, 208
201, 244
algorithm features, 205
Cox-Ross-Rubinstein (1979), 106,
Bakshi-Cao-Chen (1997), 277, 295
324
Black-Scholes-Merton (1973), 290,
discrete time, 77, 79, 324
329
Heston (1993), 178, 196, 201, 252
dual algorithm, 145
Merton (1976), 159, 178, 252
Heston (1993), 197
requirements, 57
least-squares algorithm, 139, 143,
market realities, 17, 21
201, 205, 282, 290, 311
market risks, 311
Merton (1976), 162
market-based valuation, 17, 30, 159,
recipe, 184
166
square-root diusion, 192
American options, 282
variance reduction, 199, 201, 278
European options, 281
process, 34
no arbitrage condition (NA), 88
martingale, 76
no free lunches with vanishing risk
condition (NFLVR), 88
martingale measure, 76
INDEX
numerical integration, 335
numerical methods, 18, 21
NumPy, 22, 313
arange, 319
array operations, 318
arrays, 317
iterations, 327
loops, 327
polyt, 332
polyval, 332
random, 320
objective function
degeneracy, 253
indeterminacy, 253
mean squared error (MSE), 242
operational risk, 33
optimization
brute force algorithm, 162
global, 162, 244, 334
local, 162, 244, 334
simplex algorithm, 162
option denition, 25
option markets, 50
option price
moneyness, 101
short rate, 101
time-to-maturity, 101
volatility, 102
option quote spread, 50
option value factors, 27
out-of-the-money, 27
pandas, 22, 313, 341
data storage, 341
DataFrame, 340
Excel spreadsheets, 340
nancial data gathering, 341
plotting, 340, 343
Parsevals relation, 118
partial dierential equation
357
Bakshi-Cao-Chen (1997), 181
Black-Scholes-Merton (1973), 98
portfolio, 78
value, 78
predictability, 78
price risk, 31
price system
linear, 81
probability measure, 73
probability space, 73
ltered, 74
PyTables, 198, 313
Python, 313
arrays, 317
class, 336
class attributes, 336
class methods, 336
data, 337
dynamic typing, 315
Excel spreadsheets, 338
function denition, 316
integrated development environment (IDE), 314
iterations, 326
loops, 326
math, 316
module, 317
object, 336
random numbers, 320
range, 319
string replacement, 319
xlrd, 313
xlwt, 313
Python programming language, 20
Python(x,y), 314
qualitative model features, 30
quantitative model features, 30
Radon-Nikodym derivative, 77
random variable, 73
358
INDEX